Bonds have long been seen as the backbone of a balanced investment portfolio – and traditionally the quiet partner to more volatile equities.
Yet Liz Truss’s 2022 ‘mini-budget’ and the September 2025 spike in long-term bond yields to near thirty-year highs became global news stories, dramatic reminders of this asset class’s importance.
Bonds are a vital part of the financial system. Globally, this market was worth $145 trillion in 2024, compared with $127 trillion for global equities.
What happens in bond markets impacts household finances. The cost of mortgages and car loans, and the levels of borrowing and savings rates offered by banks, are linked to government bond yields.
Governments can only spend as much as they do on defence, public services and welfare and pension payments, by issuing bonds. Many companies, both high street names as well as private ones, also use bonds to finance their expansion.
Bonds (also known as fixed income) play an important role in portfolios by providing investors with income and diversification. Relative to blue chip shares, bonds issued by major developed economies are regarded as lower risk, offering a regular income stream and capital repayment. They make a valuable contribution to portfolios at all stages of an investment journey.
Yet to many non-specialist investors, bonds remain shrouded in mystery. Questions such as “what makes a bond cheap or expensive?”, “why do bond yields and prices move in opposite directions?” or “why is a bond yield more widely followed than its price?” often act as barriers to understanding and investing in this important asset class.
What are bonds?
Bonds are loans, effectively IOUs in the financial markets. Tax revenues are insufficient to cover all a state’s annual expenditure and so government (‘sovereign’) bonds will regularly be issued. In the UK, these are known as gilts and in the US, Treasuries.
Bonds are bought by financial institutions such as pension funds and insurance companies. Governments also buy each other’s bonds. Many of these will be held by the original buyers until maturity, but some will also trade on the secondary market like shares.
When an investor buys a bond, they are lending money to the issuer until the bond matures. In return, most buyers will receive regular payments based on the interest rate (‘coupon’) attached to the bond. When it expires (‘the maturity date’), the bond’s original value (‘principal’) is repaid. A wide range of companies also issue bonds.
Credit rating agencies such as S&P Global and Moody’s assess the ability of existing and potential bond issues to repay their loans. The higher the issuer’s quality, the better the rating and the lower the coupon offered. The strongest rated corporate bonds will often behave in a similar fashion to high quality (‘investment grade’) sovereign bonds and shares in terms of their risk/reward profile.
The other main category of bonds is high yield, also known as ‘junk bonds’, offering a higher yield than investment grade bonds. Despite the name, many junk bond issuers have an unblemished credit rating. This makes them potentially interesting to yield-hungry clients.
The relationship between bond pricing and bond yields
One of the most important characteristics of bonds is the inverse (opposite) relationship between its price and the yield. A bond’s price reflects the combined value of its income stream until maturity, and the principal. As investors push up the price, its yield will fall and vice versa.
A bond yield shows investors what they earn by holding a particular bond. Investors can use this and other yield-based calculations to compare and rank a range of bonds. In contrast, a bond price provides information on its cost.
Taking the example of the UK 10-year gilt which is issued at £100, with a fixed 4% yield. If the bond’s price doesn’t change, the bond’s yield is 4% (£4). If investors push the price up to £105, the yield declines to 3.81% (4%/£105). Conversely, if the bond price falls to £95, the bond’s yield will rise to 4.2%.
When deciding whether to buy a particular bond, investors will be considering factors such as the interest rate (coupon) offered, the period the bond will be trading (term), as well as the pricing for other similar bonds. What is happening to interest rates is also important. If new bonds are issued when interest rates are falling, they will be issued with lower coupons than bonds issued when rates were higher. This makes the existing (higher coupon) bonds more valuable and so their yields will fall as their prices rise.
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Why buy a bond?
High quality sovereign bonds are considered less risky investments than shares. This is because bondholders here benefit from fixed repayment dates covering the interest and loan repayment. During periods of market uncertainty, government bond prices in major economies such as the US, UK and Germany will often rise (and yields will fall), reflecting a ‘flight to safety’.
In a diversified portfolio designed to maximise returns for a given level of risk, investors will often allocate a portion to bonds. Behaving differently from shares, this means they can help to smooth out the portfolio’s long-term performance. Investing in shares is more about capital growth, but with no guarantees on either share price returns or dividend payments. In contrast, should a bond issuer be declared bankrupt, bondholders rank above shareholders. This means they will usually receive something, even if shareholders do not.
Inflation, defaults and other risks
Inflation and bonds don’t mix. Most bonds are fixed-rate investments and this means inflation erodes the value of a bond’s future income stream, affecting both short term and longer-term bonds. With a longer income stream, the purchasing power of long-term bond payments is more vulnerable to higher inflation. When inflation is high, investors demand higher yields to compensate for this potential loss in value.
Other inflation-linked factors can also influence how bonds behave. If inflation is high, investors should expect central banks to raise interest rates. This could affect the performance of bonds, with investors demanding higher yields to compensate for the greater risk.
Meanwhile, over the past decade, a number of countries have defaulted on their sovereign bonds, including Argentina, Ghana and Sri Lanka. Although some form of debt restructuring often occurs so existing bond holders are not left empty handed, it usually makes the recently defaulted sovereign issuer a less attractive investment destination.
The role of bonds in portfolios
At their heart, bonds are simple loan instruments. They can have a central role to play in most investors’ portfolios. Bonds typically have a low or inverse (i.e. opposite) relationship with shares, making them a valuable source of diversification and helping smooth the investment returns.
This relationship is not guaranteed – as seen in 2022 when the S&P 500 and 10-year Treasury benchmark both ended the year in negative territory following the Russian invasion of Ukraine. Yet over the long-term, bonds can act to underpin a well-diversified portfolio, helping investors to reduce their overall risk during periods of market volatility.
Ben Stark is a chartered financial planner with over a decade of experience advising businesses and families. He is partnered with St. James’s Place Wealth Management.