Guide · Savings & Investing
How Bond Yields and Prices Work — and What They Mean for Investors
Bonds are the backbone of most diversified portfolios, yet the way their prices and yields interact confuses many investors. This guide explains the core mechanics, the inverse price-yield relationship, and when bonds deserve a place in your portfolio.
Bond basics: what you are actually buying
When you buy a bond, you are lending money to an issuer — a government, a local authority, or a company — for a fixed period. In return, the issuer promises to pay you a regular coupon (interest) and repay the face value (par value, typically £1,000 or $1,000) when the bond matures.
The four key terms every bond investor needs are: face value (the principal repaid at maturity), coupon rate (the annual interest as a percentage of face value), maturity date (when the principal is repaid), and yield to maturity (the actual annualised return at the current market price). The coupon is fixed forever; the yield moves every day as the bond trades.
A £1,000 bond with a 5% coupon pays £50 per year, split across two semi-annual payments in most markets. If you buy it at exactly £1,000 (par), your yield equals the coupon rate: 5%. If market conditions push the price to £900, your £50 coupon now represents a yield of 5.56% — the bond's yield rose as its price fell.
The inverse relationship: prices and interest rates
The most important concept in bond investing is that bond prices and interest rates move in opposite directions. When market interest rates rise, the prices of existing bonds fall. When rates fall, prices rise.
The intuition: if you own a bond paying 5% and the market now offers 7% on new bonds, your bond becomes less attractive. To sell it, you must discount the price until the effective yield matches 7%. Conversely, if rates drop to 3%, your 5% bond is suddenly more valuable and buyers will pay a premium.
Based on a £1,000 face value bond, 5% coupon, 10-year maturity. Prices are approximate and assume a single coupon per year for illustration.
This also explains why bond funds can lose money even though bonds are “safe”. When rates rise rapidly — as they did in 2022 — the market value of existing bond holdings falls sharply. Investors who hold to maturity still receive all their coupons and face value, but those who sell early may crystallise a loss.
Government bonds vs corporate bonds
Not all bonds carry the same risk. Government bonds from stable economies are considered the closest thing to a risk-free investment; corporate bonds pay a higher yield because investors demand compensation for the additional credit risk.
| Type | Coupon | Yield | Price (face £1,000) | Risk |
|---|---|---|---|---|
| UK Gilt 10yr | 4.25% | 4.25% | £1,000 | Very low |
| US Treasury 10yr | 4.50% | 4.50% | £1,000 | Very low |
| UK Investment Grade Corp 10yr | 5.75% | 5.75% | £1,000 | Low–medium |
The extra yield on the corporate bond — roughly 1.5% above the Gilt in this example — is called the credit spread. It compensates investors for the small but real risk that the company may default. High-yield (junk) bonds carry even wider spreads, sometimes 4–6% above government rates, reflecting materially higher default risk.
Duration: measuring sensitivity to rate changes
Duration is the standard measure of how sensitive a bond's price is to a change in interest rates. A bond with a duration of 7 years will fall in value by approximately 7% if interest rates rise by 1 percentage point, and rise by 7% if rates fall by 1 point. Longer-maturity bonds have higher duration and are therefore more volatile when rates move.
Practical implication: if you expect rates to rise, shorter-duration bonds protect you better because their prices are less sensitive. If you expect rates to fall, longer-duration bonds will gain more in price. Most investors manage duration by holding a mix of short, medium, and long-dated bonds rather than trying to predict rate movements.
When bonds make sense in your portfolio
Bonds serve three roles in a diversified portfolio:
- Diversification — Government bonds have historically had a low or negative correlation with equities during market crises. When shares fall sharply, investors often buy government bonds as a safe haven, pushing bond prices up. This cushioning effect reduces overall portfolio volatility.
- Income — Bonds deliver predictable, scheduled coupon payments. For retirees or income-focused investors, this reliability is valuable compared to variable equity dividends.
- Capital preservation near retirement — As your investment horizon shortens, a larger allocation to bonds reduces the risk that a market crash close to retirement permanently damages your pot. The conventional glide path gradually shifts from equities to bonds as retirement approaches.
For long-term investors in their 20s and 30s with decades of growth ahead, bonds are typically a small allocation (0–20%). As retirement nears, many target-date funds shift towards 40–60% bonds. The right allocation depends on your time horizon, income needs, and tolerance for short-term volatility.
Frequently asked questions
What is the difference between a bond's coupon and its yield?
The coupon is the fixed annual interest payment set when the bond is issued, expressed as a percentage of face value. A £1,000 bond with a 5% coupon pays £50 per year regardless of what happens in the market. The yield (or yield to maturity) is the actual annual return you receive if you buy the bond at its current market price and hold it to maturity. If the bond trades above face value, the yield is lower than the coupon; if it trades below face value, the yield is higher.
Why do bond prices fall when interest rates rise?
Because existing bonds become less attractive when new bonds offer higher coupons. If you hold a bond paying 5% and new bonds are issued at 7%, nobody will pay full price for yours — they will only buy it at a discount big enough to make your 5% coupon deliver a 7% yield. The maths works in reverse too: when rates fall, existing bonds paying above-market coupons become more valuable and their prices rise.
What is yield to maturity?
Yield to maturity (YTM) is the total annualised return you receive if you buy a bond at its current price, collect all coupon payments, and receive the face value at maturity. It accounts for any discount or premium you paid versus face value. YTM is the standard way to compare bonds with different prices, coupons, and maturities on an apples-to-apples basis.
Are bonds safer than shares?
Government bonds from stable economies (UK Gilts, US Treasuries) are among the safest investments available because the risk of default is extremely low. Corporate bonds carry more credit risk — if the company fails, bondholders rank above shareholders but may not recover everything. The trade-off is return: bonds typically deliver lower long-run returns than shares precisely because they are safer. Bonds serve a different purpose in a portfolio: income, stability, and capital preservation rather than growth.