Understanding Bonds: Government Gilts and Corporate Bonds

What Is a Bond?

A bond is essentially a loan, but instead of you borrowing money from the bank, you’re the one lending money to a government or company.

In return, they promise to:

• Pay you regular interest (called the coupon), and

• Repay your original investment (the principal) at a set maturity date.

Bonds are one of the oldest and most widely used forms of investment. They provide predictable income and are often seen as lower-risk than shares. However, they still carry significant risks that every investor should understand.

Government Bonds — “Gilts” or “Gilt-Edged Securities”

In the UK, government bonds are called gilts, short for gilt-edged securities. The term dates back to the 19th century, when British government bonds were printed on paper with gilded (gold-coloured) edges — a mark of quality and reliability.

When you buy a gilt, you’re lending money to the UK government. In return, you receive:

• A fixed rate of interest, usually paid every six months.

• Repayment of the bond’s face value when it matures.

Gilts are guaranteed by the UK Treasury and are considered very low risk. The UK government has never defaulted on its debt, making gilts one of the safest forms of investment.

Corporate Bonds

Corporate bonds work the same way as gilts, but instead of lending to the government, you’re lending to a company.

Businesses issue bonds to raise money for growth, acquisitions, or to refinance existing debt. In exchange, they offer interest payments to investors.

Corporate bonds typically pay higher interest rates than gilts, because companies are more likely to default than governments — this extra return is known as the risk premium.

There are two broad types:

1. Investment-grade bonds – issued by financially strong companies with a low risk of default.

2. High-yield (“junk”) bonds – issued by companies with weaker credit ratings, offering higher returns but greater risk.

How Bonds Work in Practice

Here’s a simple example:

• You buy a £1,000 gilt with a 3% annual coupon and a 10-year maturity.

• The government pays you £30 per year in interest (usually £15 every six months).

• At the end of 10 years, you get your £1,000 back.

You can also buy and sell bonds before they mature. Their market price rises or falls depending on:

• Changes in interest rates,

• The issuer’s creditworthiness, and

• General economic conditions.

When interest rates rise, bond prices tend to fall — because new bonds pay higher coupons, making older ones less attractive.

Why People Invest in Bonds

Bonds offer several key advantages:

1. Regular income – predictable interest payments make them attractive for retirees and income-seekers.

2. Capital preservation – lower volatility compared to shares.

3. Diversification – bonds balance a portfolio, reducing overall risk.

4. Relative safety – government gilts, in particular, are among the most secure investments available.

5. Tradability – bonds can be sold on the secondary market if you need access to cash.

Many pension funds, insurance companies, and cautious investors rely on bonds to provide stability and steady returns.

The Risks and Dangers

Despite their reputation for safety, bonds are not risk-free. Key dangers include:

1. Interest Rate Risk – If interest rates rise, the value of existing bonds falls. This can lead to capital losses if you sell before maturity.

2. Inflation Risk – Fixed interest payments lose real value when inflation is high.

3. Credit Risk – Companies (and occasionally even governments) can default, failing to pay interest or repay the principal.

4. Liquidity Risk – Some bonds, especially from smaller companies, can be hard to sell quickly.

5. Currency Risk – If you buy foreign bonds, exchange rate movements can affect your returns.

In other words, “safe” doesn’t mean “risk-free.”

How Bonds Are Used in Portfolios

Financial advisers often recommend including bonds in an investment portfolio to balance higher-risk assets like shares.

A typical portfolio might include:

• Government gilts – for stability and security.

• Corporate bonds – for higher income potential.

• Inflation-linked gilts – to protect against rising prices.

The exact mix depends on your goals, time horizon, and risk tolerance. For example, younger investors might focus more on shares for growth, while retirees may prefer the steady income of bonds.

Final Thoughts

Bonds, whether UK gilts or corporate issues, remain a cornerstone of traditional investing. They offer security, regular income, and diversification benefits, making them attractive to cautious investors.

But as with all investments, understanding the risks and market behaviour is essential.

Rising interest rates, inflation, or corporate instability can erode returns and, in extreme cases, lead to losses.

Used wisely and with good advice, bonds can form the steady foundation of a balanced investment strategy. The key is knowing who you’re lending to, for how long, and at what level of risk you’re comfortable.