A bond: what is it?

Bonds are a tried-and-true mainstay of portfolio strategy, but not many investors understand what they are and how they operate

Bond investing is one way to diversify a portfolio and move away from solely stocks.

Several asset classes, including stocks and investment funds, commodities like gold or silver, possibly some real estate, and bonds, are all likely to be included in a well-balanced portfolio.

According to Laith Khalaf, head of investment analysis at AJ Bell, "bonds are a cornerstone of the financial markets, offering investors a reliable way to earn income and diversify their portfolios," BFIA reports. Bonds are helpful tools for anyone looking for diversification or a steady income stream, even though they might not have the same excitement as stocks.

But many bond investors don't fully comprehend what bonds are or how they operate.

A bond is, in effect, an IOU. When big businesses or governments need to borrow money, they frequently issue bonds that investors purchase.

As an illustration, suppose the UK government must borrow a specific amount of money over a ten-year period. A government bond with a ten-year maturity would be issued. This is called a gilt in the context of the UK government. A Treasury is what it would be if it were the US government.

What is the mechanism of bonds?

There is a face value or par value to the bond. That is how much the UK government will give the bond holder in the aforementioned example when the bond matures in ten years.

In addition, the bond has a coupon. That is the yearly interest that the bond issuer or the government will give the bondholder. Because of the typically fixed coupon payment, the bond market is also referred to as the fixed-income market.

In addition to receiving their money back at the conclusion of the loan term, bondholders receive annual interest.

Bonds are also tradeable; although they are IOUs, they can be purchased and sold, which means that although their face value remains constant, their price may fluctuate.

How does that work? Let's look at a simple example. Let's say we have a government bond issued by the UK some time ago. When it first came out, it had a face value of 100 and paid a 10 coupon annually. The problem is that ten percent is currently a desirable interest rate. An investor would now be prepared to spend much more than £100 for an investment that yielded £10 annually for essentially zero risk. Therefore, this bond's market price may be significantly higher than 100. This would result in a bond's yield or interest rate being less than 10%.

Because of its high credit rating, a highly regarded country like the US or a company like Apple (NASDAQ:AAPL) will be able to offer a low coupon. Smaller, riskier businesses or less dependable countries will pay more.

Bond prices are significantly influenced by interest rates as well. Because newer bonds offer higher yields, "the prices of existing bonds typically fall when rates rise," explains Khalaf.

How do bonds differ from one another?

"Investors have access to a wide variety of bond types," Khalaf says. "National governments issue government bonds, like US Treasury securities or UK gilts, which are regarded as some of the safest investments because of their low credit risk.

According to Jupiter Asset Management's sovereign debt investment manager Vikram Aggarwal, government bonds, also referred to as sovereign bonds, are "the bedrock of the financial system," as he tells BFIA. They are the largest bond type available and rank among the world's largest asset classes in terms of total market value.

Aggarwal goes on, "It's probably the most liquid asset class out there." "Sovereign bonds currently offer a very appealing value proposition with both yield and capital appreciation potential.

Bonds are another way for corporations to borrow funds. These can range from high-yield bonds, which also carry a higher default risk, to investment-grade bonds, which are extremely low-risk, similar to government bonds. They're referred to as "junk" bonds at their worst.

Therefore, before purchasing a bond, it is crucial to take the issuer into account. Smaller, less established alternatives are typically seen as riskier investments than larger, more established businesses or countries.

On the other hand, the bond's durationthe period of time it "matures"is also a crucial factor. Every bond has a maturity date, which is the day the bond issuer stops paying the bondholder interest each year and pays the bond's face value.

According to Khalaf, "bonds with short-term, medium-term, and long-term bonds available to investors are further differentiated by maturity periods." That "longer-term bonds are more sensitive to changes in interest rates" is something else he says.

What makes bond investing appealing?

Traditionally, investors would divide their portfolios between stocks and bonds to provide balance and diversification. This was a straightforward rule of thumb. The 50/50 portfolio, which is equally divided between stocks and bonds, and the 60/40 portfolio, which allocates 60% of the portfolio to stocks and the remaining portion to bonds, are two popular variations of this strategy.

The idea behind these strategies is that bonds will offer protection during market downturns while stocks (or equities, as they are commonly called in this context) will do well during market upturns.

Whether or not bonds offer this diversification in the modern era is up for debate. During a 2025 crystal ball webinar in November, Johanna Kyrklund, group chief investment officer at Schroders, stated that bonds have provided comparatively little diversification to equities in recent years.

She still advises investing in bonds, but this time for income rather than diversification.

Advice for bond investors.

"Bond investing has become more accessible to regular investors," Khalaf says.

A variety of bonds are available for direct purchase by investors via an investment platform or app.

"Alternatively, a more well-liked option is to purchase bonds via a fund or exchange-traded fund (ETF) that provides a professionally managed, diverse portfolio," Khalaf says.

Bond ETFs are becoming more widely accessible as actively-managed products, much like stocks. Jupiter Asset Management introduced its first exchange-traded fund (ETF) on February 19, 2025, called the Jupiter Global Government Bond Active UCITS ETF (LON:GOVE). This actively-managed fund makes investments in mispriced sovereign bonds from both developed and emerging markets, depending on Jupiter's assessment of the state of the economy.

"We make decisions using a combination of qualitative and quantitative inputs. As with any asset class, our main goal is to find value in the market, according to funds manager Aggarwal. Value in this context can take many different forms, such as the yield curve or the anticipated future of a specific nation.

According to Aggarwal, "we think of individual countries almost in the same way that an equity investor will think of individual companies."