Understanding the importance of bonds for investors

December 2025

By Will Glyn

When investing is discussed, equities tend to dominate the conversation. Yet behind the headlines sits a far larger and more influential market, one that quietly shapes mortgage rates, pension funding, government budgets, and even political outcomes. That market is bonds. With an estimated global value of around £150 trillion, the bond market forms the foundation of the modern financial system. Understanding how it works is essential for any investor.

What is a bond and how does it work?

At its most basic level, a bond is a loan. By purchasing a bond, you are lending money to an issuer, typically a government or a company. In return, the issuer agrees to pay you a regular interest payment, known as the coupon, and to repay your original capital at the end of a predetermined term, called maturity.

For example, if the UK government issues a 10-year bond with a face value of £100 and an annual coupon of £5, the investor receives £5 each year for a decade and then gets the £100 back at maturity, assuming the government meets its obligations. While the coupon is fixed, the market price of the bond is not, and this is where bonds become more dynamic than they first appear.

Bond prices fluctuate daily, and those price movements directly affect the yield an investor receives. Prices and yields move in opposite directions: when prices rise, yields fall, and when prices fall, yields rise.

If that same £100 bond were to fall in price to £90, the £5 coupon now represents a yield of around 5.56 per cent. If the investor holds the bond until maturity, they would also receive the £100 repayment, generating a £10 capital gain on top of the income.

Why do bond prices change?

The primary driver of bond prices is interest rate expectations. When central banks such as the Bank of England raise interest rates, newly issued bonds offer higher coupons, making older bonds less attractive. To compensate, the prices of existing bonds fall. When interest rates are expected to fall, the opposite occurs, with bond prices rising as investors seek out higher fixed coupons.

Inflation is another key factor. Because most bonds pay a fixed income, unexpected increases in inflation erode their real value, often leading to falling prices. Credit risk also matters. If investors become less confident in an issuer’s ability to repay its debt, they demand higher yields, pushing bond prices down.

Supply and demand play a role as well. Large-scale borrowing by governments or companies increases the supply of bonds, which can depress prices. Meanwhile, during periods of market stress, investors often move money into government bonds in a flight to safety, driving prices higher and yields lower.

The main types of bonds

The bond market covers a wide range of issuers and risk levels. Government bonds sit at its core. In the UK, these are known as gilts and are issued to fund spending not covered by tax revenues. Because the UK government has never formally defaulted on its debt, gilts are widely regarded as low risk. Other governments issue bonds too, ranging from US Treasuries, considered among the safest globally, to emerging market debt, which offers higher yields to compensate for greater default risk.

Companies also issue bonds, allowing them to borrow directly from investors rather than relying solely on banks. These corporate bonds fall into two broad categories. Investment-grade bonds are issued by financially robust companies with strong credit ratings, assessed by agencies such as S&P and Moody’s. They tend to offer lower yields in exchange for greater security. High-yield bonds, sometimes referred to as junk bonds, are issued by companies with weaker credit profiles and therefore pay higher yields to reflect the additional risk.

Beyond these, there are more specialised segments of the bond market, including inflation-linked bonds, supranational bonds, and asset-backed securities. These markets are substantial but typically require more detailed analysis and understanding.

Why bonds matter so much

Bonds are deeply embedded in the financial system. Government bond yields influence tax policy, public spending decisions, and economic strategy. Corporate bond markets affect how businesses raise capital and invest for growth. Pension funds, insurers, and banks rely heavily on bonds to generate income and manage risk.

The UK’s 2022 mini-Budget crisis demonstrated this influence clearly. A sharp rise in gilt yields led to higher government borrowing costs, rapidly rising mortgage rates, and severe stress within pension schemes, forcing asset sales to meet collateral requirements. Political consequences followed soon after. Movements in the bond market often ripple far beyond investors’ portfolios.

Why investors hold bonds

For individual investors, bonds can serve several important purposes. They can provide a more predictable income stream, help diversify portfolios that are heavily weighted towards equities, and offer a degree of protection during periods of market volatility. However, bonds are not without risk. Prices can fluctuate significantly in response to changes in interest rates, inflation, and credit conditions.

That said, bonds differ from shares in one crucial respect. If held to maturity, and provided the issuer does not default, the investor receives the agreed interest payments and the return of their capital. With yields now meaningfully higher than the near-zero levels seen throughout much of the 2010s, bonds are no longer just a defensive afterthought. They deserve careful consideration as part of a balanced long-term investment strategy.

Will is an Independent Financial Adviser with over a decade of experience helping expats make the most of their international status.