Bonds & Gilts
How bonds work, why UK gilts are important, the inverse relationship between bond prices and interest rates, and where NS&I savings fit in.
Bonds & Gilts
Bonds are the other pillar of a balanced portfolio. While equities represent ownership, bonds represent a loan, you are lending money and receiving interest in return.
How a Bond Works
Every bond has three key characteristics:
| Term | Meaning | Example |
|---|---|---|
| Coupon | The annual interest rate paid to the bondholder | 4.25 % |
| Maturity | When the loan is repaid in full (the par value) | 15 years |
| Yield | The effective annual return if you buy at today's price | 4.50 % |
If you buy a newly issued bond at par (£100) with a 4.25 % coupon, you receive £4.25 per year for the life of the bond and then get your £100 back at maturity. Simple enough, the complexity comes when you trade bonds on the secondary market.
Government Bonds: UK Gilts
Gilts are bonds issued by HM Treasury. They are called "gilts" because the original certificates had gilded (gold) edges. The UK government has never defaulted on a gilt, making them among the world's safest investments.
Gilts are categorised by maturity:
| Category | Maturity | Example |
|---|---|---|
| Short-dated | Under 7 years | Treasury 1 % 2027 |
| Medium-dated | 7-15 years | Treasury 4.25 % 2036 |
| Long-dated | Over 15 years | Treasury 3.75 % 2052 |
Corporate Bonds
Companies also issue bonds. Because they carry more credit risk than the government, corporate bonds typically offer a higher yield, known as the credit spread. Investment-grade corporates (rated BBB or above) offer moderate extra return; high-yield ("junk") bonds offer more but with meaningfully higher default risk.
Why Bond Prices Fall When Interest Rates Rise
This is the single most important concept in bond investing:
If you hold a bond paying 3 % and the Bank of England raises rates so new bonds pay 5 %, nobody wants your 3 % bond at full price. Its price falls until its effective yield matches the new market rate.
The longer a bond's maturity, the more sensitive its price is to interest rate changes. This is measured by duration, a bond with a duration of 10 years will fall roughly 10 % for every 1 percentage-point rise in rates.
This is why long-dated gilts fell dramatically in 2022-23 when the Bank of England raised rates from 0.1 % to 5.25 %.
Index-Linked Gilts
Index-linked gilts adjust both their coupon and principal in line with the Retail Prices Index (RPI). They protect against inflation but pay a lower initial coupon. If you believe inflation will be higher than the market expects, index-linked gilts can outperform conventional gilts.
NS&I: A Government-Backed Alternative
National Savings and Investments (NS&I) is a government savings institution. While not technically bonds in the traditional sense, its products are backed by HM Treasury:
| Product | Current Rate (indicative) | Tax Treatment | Access |
|---|---|---|---|
| Premium Bonds | ~4.0 % prize rate | Tax-free prizes | Instant |
| Income Bonds | ~4.0 % | Taxable (PSA applies) | Instant |
| Green Savings Bonds | ~3.95 % (fixed 3yr) | Taxable | Fixed term |
Premium Bonds are the UK's most popular savings product, over 24 million people hold them. The maximum holding is £50,000 and all prizes (from £25 to the £1 million jackpot) are tax-free.
When Do Bonds Make Sense?
Bonds serve several purposes in a portfolio:
- Capital preservation, less volatile than equities, particularly short-dated gilts
- Income, regular coupon payments can fund retirement spending
- Diversification, bonds have historically been negatively correlated with equities (though this broke down temporarily in 2022)
- Reducing drawdown, a portfolio with 20-40 % bonds typically suffers smaller peak-to-trough losses
This module is educational and does not constitute a recommendation to buy any specific bond or gilt.
Explain Like I'm 5
A bond is like lending your friend some pocket money and they promise to pay you back later with a little extra as a thank-you. If you lend to the government, they are really good at paying back so it is very safe. But when everyone else starts offering more thank-you money, your old deal does not look as good any more, so it is worth a bit less.
Key Takeaways
- Bond prices move inversely to interest rates, when rates rise, existing bond prices fall, and vice versa.
- UK gilts are government-issued bonds considered among the safest investments globally; they come in short, medium, and long-dated maturities.
- Duration measures a bond's sensitivity to rate changes, longer duration means more price volatility.
- Index-linked gilts adjust for inflation via the RPI, providing a real (after-inflation) return.
- NS&I Premium Bonds offer tax-free prizes up to £1 million, backed by HM Treasury, with a £50,000 maximum holding.
Put this to work on your own money
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Educational only - not financial advice