What are bonds and how do they work?

What are bonds?

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Bonds are debts that investors can buy from borrowers - usually companies and governments - that want to raise money. 

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As the investor, you give the borrower a lump sum called the ‘principal’. 

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In return for buying the debt, the borrower pays interest (known as the ‘coupon’) to the investor.

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The bond will typically last until a set time, called the ‘maturity date’. You can get short-term bonds, usually lasting between one and five years, or as short as 30 days. Long-term bonds last as long as 10 or even 30 years.

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When the bond reaches maturity, the borrower pays back the principal sum to the investor.

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Bonds are normally issued by companies and governments.

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• Corporate bonds - businesses use the debt they issue to fund growth projects. They tend to pay higher interest than governments. However, this reflects the higher risk of the company going out of business and being unable to pay you back.
• Government bonds - governments issue debt to fund things like infrastructure projects. In the UK, these are known as ‘gilts’. Government bonds tend to pay a lower rate of interest than corporate bonds. However, they tend to be stabler, as it would require a government to collapse for it to be unable to pay you back.

Bond returns tend to be more stable and steady than stocks and shares. There’s less risk with bonds as it would take the borrower to default for you to lose your investment. 

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Meanwhile, stocks and shares can offer higher growth potential. However, your investment will likely move up and down in value more, and there’s a greater chance of losing value on it.

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A bond example

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You buy a five-year corporate bond for £1,000. It has a coupon rate of 3%, meaning it pays annual interest of £30.

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That means you’d earn £150 by the maturity date. You’d also get back your initial £1,000 investment.

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Note that bonds don’t compound in the same way interest on money in a savings account can. You’d have to reinvest your coupon payments into more bonds to achieve the same compounding effect.

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How do you earn a return from bonds?

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There are a couple of ways to make a return from your bonds.

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• Keep it and hold it until maturity - you’ll receive the agreed interest throughout the term of the bond, usually annually or when the bond matures. At maturity, you get back your initial investment (assuming the borrower doesn’t default).
• Sell it on a secondary market - rather than holding the bond until maturity, you could sell it. When interest rates change (more on this in a moment), bond prices can rise or fall. If your bond becomes more valuable, you could sell it for more than you paid, earning a return. However, you’d give over the rights to the coupon payments to your buyer.

Investors work out a bond’s ‘yield’ to decide how valuable it is to invest in. That’s calculated by dividing the coupon payment by the price. 

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What affects bond prices?

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While they tend to move less than stocks and shares, bond prices can still shift. In particular, that’s because of interest rates.

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A bond’s interest rate is usually linked to the base rate set by the central bank - in the UK, that’s the Bank of England (BoE).

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The BoE uses the base rate to influence interest rates across the economy. It largely determines the interest you’ll receive on your savings, and the rate you’ll pay on debts such as mortgages or other loans.

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Bond prices and interest rates move inversely - when one rises, the other falls, and vice versa.

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Think back to the example we discussed above of the £1,000 bond with a coupon rate of 3%. 

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Imagine that the BoE increases interest rates. Now, companies are issuing £1,000 bonds with a 4% rate.

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Suddenly, those newer bonds are more attractive than yours because they offer a higher yield. So, if you want to sell your bond before maturity, you’ll likely get less than £1,000 for it.

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Of course, the opposite is also true. If the BoE reduces interest rates, companies might start offering bonds at 2% instead. For you, your bond receiving 3% becomes more attractive, and someone might pay you more than your initial £1,000 investment for it.

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These shifts could happen multiple times throughout the term of the bond, especially if it’s a long-term one.

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Bonds and inflation

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The other factor you may want to consider when investing in bonds is inflation - that’s the speed at which consumer prices are rising.

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When saving and investing, you need to make sure that your returns keep you ahead of or at least in line with inflation. Otherwise, your money is losing its spending power. That’s because:

• if inflation is 4% for a year, £100 of goods and services costs £104 just 12 months later;
• a £100 bond returning less than 4% a year won’t be able to buy you as much when it matures; so
• your money has less spending power due to inflation being higher than your rate of return.

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You can use the PensionBee Inflation Calculator to see how inflation could affect your money as you save for later life.

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Inflation is also closely linked to interest rates, as the BoE will use the base rate to control inflation. 

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Generally, it’ll raise the rate when inflation is too high to bring it down, and cut it when inflation is low to kickstart the economy.

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So, your bonds could also be affected by the BoE changing interest rates to meet its 2% annual inflation target.

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Pros and cons of investment bonds

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Pros of bonds:

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• generally more stable and less risky than stocks and shares;
• earn a fixed rate of return that you can rely on, assuming the borrower doesn’t go broke; and
• useful for de-risking your investments or pension as you approach retirement and think about accessing your money.

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Cons of bonds:

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• might not perform as well as stocks and shares;
• highly sensitive to interest rate changes, which could reduce the value of your bond; and
• the coupon could fail to keep pace with inflation, with your investment losing value in real terms.

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How bonds can play a role in your investments

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Bonds can be a useful investment. They offer a lower-risk option to stocks and shares, can provide a bit of income to your investments, and might be useful for de-risking in later life.

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However, they’re exposed to interest rates moving. And, because of their lower growth potential, they're more at risk of inflation eating into your spending power.

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It can be sensible to strike a balance between bonds and other investments - a process called ‘diversification’ - so you can grow your wealth over time.

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With pension funds, your investments are usually diversified across different sectors, industries, and even asset classes. 

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For example, PensionBee’s 4Plus Plan - the default plan for those 50 and over - contains bonds, using them to reduce risk as you get closer to retirement.

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Risk warning

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As always with investments, your capital is at risk. Past performance isn’t a guide to future performance. The value of your investment can go down as well as up, and you may get back less than you invest. This information shouldn't be regarded as financial advice.

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Last edited: 30-04-2026