A UK Investor's Primer on Bonds, Credit, and Fixed Income
How to build a resilient portfolio and generate meaningful income in today's market
The long era of rock-bottom interest rates has passed, ushering in a new environment for investors. With higher rates now an established feature of the investment landscape, the role of bonds has been fundamentally upgraded. For UK investors long-focused on equities, the world of 'fixed income' now offers a compelling and competitive source of returns. Understanding the bond market is now a worthwhile skill, helping you build a resilient, diversified portfolio capable of generating a meaningful income stream.
This primer is designed to demystify the UK bond market. We'll start with the basics, explore the different types of bonds available, and then look at how you can apply this knowledge practically—including an exploration of fund types that make accessing this world straightforward.
Part 1: The Foundations of Fixed Income
What is a Bond? The Core Concept as a Simple Loan
Before we dive into strategy, we need to grasp the fundamentals. At its heart, a bond is simple. Think of it as a loan. When you buy a bond, you are lending money to an issuer—which could be a government or a corporation.
In return for your loan, the issuer makes two key promises:
To make regular interest payments, known as the coupon, over a set period.
At the end of that period, on the maturity date, to repay your original loan amount, known as the par value or face value.
You, the investor, are the lender. The government or corporation is the borrower. This simple relationship forms the basis of the multi-trillion-pound global bond market. While you may hear terms like 'fixed income' (the overall asset class) or 'credit' (referring to corporate bonds), 'bond' is the simple term for the specific loan you are making.
Yield vs. Price: The Crucial Relationship
This is the most critical dynamic for any bond investor to understand. The coupon rate on a bond is fixed, but its price can and does fluctuate in the open market after it is issued. This price movement creates an inverse relationship between a bond's price and its yield.
Think of it like a seesaw: when the price of a bond goes up, its yield goes down, and vice versa.
Example: Imagine you buy a new bond for £100 with a 4% coupon. A year later, the Bank of England has raised interest rates, and new, similar bonds are now being issued with a 6% coupon. Your 4% bond is now less attractive. To entice someone to buy it, you’d have to sell it at a lower price (a discount) to make its overall return competitive with the new 6% bonds. Conversely, if interest rates fall to 2%, your 4% bond becomes highly attractive, and its price will rise (it will trade at a premium).
This is why the most comprehensive measure of a bond's total return is its Yield to Maturity (YTM), which accounts for its current price, all remaining coupon payments, and the final repayment of principal.
Two Concepts Every Bond Investor Must Know: Duration and Real Yield
To properly understand risk and return, there are two more crucial terms to grasp.
Duration: This is a measure of a bond's sensitivity to interest rate changes. It's measured in years, but it's easier to think of it as a sensitivity score: the higher the duration, the more a bond's price will drop when interest rates rise. A bond or fund with a duration of 7 will be roughly twice as sensitive to rate changes as one with a duration of 3.5. It is the single most important metric for gauging interest rate risk.
Real Yield: The nominal yield is the headline rate, but what truly matters is the real yield—the yield after subtracting inflation. If your bond yields 5% but inflation is running at 3%, your real yield is only 2%. In today's environment, focusing on real yields is critical to ensure your income is actually increasing your purchasing power.
Part 2: The Key Risks of Bond Investing
While bonds are generally less volatile than equities, they are not risk-free. Understanding these risks is crucial for making informed decisions.
Interest Rate Risk: This is the risk that rising interest rates will cause the value of your existing bonds to fall. As we saw with the seesaw example, if new bonds are issued with higher coupons, your older, lower-coupon bond becomes less attractive and its market price will drop. Longer-maturity bonds are most sensitive, and duration is the key metric to watch here.
Inflation Risk: This is the risk that inflation will rise faster than your bond's coupon, eroding the purchasing power of your income. A 4% yield is great when inflation is 2%, but not when it's 6%. This is a major risk for all fixed-coupon bonds.
Credit (or Default) Risk: This is the risk that the issuer will fail to make its interest payments or repay your principal. For UK government bonds, this risk is negligible. For corporate bonds, it varies hugely, from low for corporate giants to very high for smaller, more indebted "junk" bond issuers.
Liquidity Risk: This is the risk of not being able to sell your bond quickly at a fair price. While popular government bonds are very liquid, this is a significant issue in the corporate bond market, where many bonds trade infrequently, especially in the smaller sizes typical for retail investors.
Reinvestment Risk: This is the risk that when your bond matures, you'll have to reinvest your capital at a lower interest rate, reducing your future income. This is most relevant for investors who rely on a steady income stream and for those holding shorter-term bonds in a falling-rate environment.
Call Risk (or Prepayment Risk): Some bonds are "callable," meaning the issuer can choose to repay them early. They typically do this if interest rates have fallen, allowing them to borrow again more cheaply. This is bad for the investor, who is forced to take their money back and reinvest it at the new, lower rates.
Part 3: The UK Bond Universe
For a UK-based investor, the bond market can be broken down into two key areas.
1. UK Government Bonds (Gilts): The Lowest-Risk Benchmark
Gilts are bonds issued by the UK government to fund its spending. They are considered the benchmark for UK credit because the UK government is considered to have virtually no risk of default on debt issued in its own currency (sterling). For this reason, their credit risk is considered negligible. However, this does not make them risk-free, as they are still exposed to significant interest rate risk and inflation risk.
There are two main types of gilt:
Conventional Gilts: Pay a fixed coupon twice a year and repay the principal at maturity. They are the backbone of the UK bond market.
Index-Linked Gilts: Both the coupon payments and the final principal are adjusted in line with an official measure of UK inflation (historically the Retail Price Index, or RPI). This makes them popular during inflationary periods, but they typically offer a lower starting yield to reflect this protection.
2. Sterling Corporate Bonds: The Engine of Corporate Finance
These are bonds issued by UK companies to raise capital. They always offer higher yields than gilts to compensate investors for taking on more risk. The market is broadly split by credit quality:
Investment-Grade Corporate Bonds: Issued by large, stable UK companies (think FTSE 100 giants). They offer a modest yield premium over gilts and are a core holding for many income investors.
High-Yield Corporate Bonds (or "Junk" Bonds): Issued by smaller or more indebted companies. The risk of default is significantly higher, but so are the potential returns. This is a specialist area requiring careful research.
It's worth noting that the corporate bond market is incredibly diverse. Beyond the standard fixed-coupon bonds, investors can also find Floating Rate Notes (FRNs), where the coupon payment adjusts with interest rates, and more complex hybrid securities like Preference Shares and Convertible Bonds. We may explore these more specialist areas in a future article.
Part 4: The Practical Guide for UK Investors
The Core Benefits for a UK Investor's Portfolio
Structurally Safer than Equities: Due to their seniority in a company's capital structure, bonds must be repaid before shareholders in the event of bankruptcy.
Contractual Income Stream: Coupon payments are a contractual obligation, unlike discretionary equity dividends which can be cut at any time.
Portfolio Diversification: Government bonds (Gilts) have historically provided strong diversification against equities. However, this relationship can change. Corporate bonds often fall in value for the same reasons shares do (like a bad economy), meaning they don't always provide the diversification you might expect.
Significant Tax Advantages: A huge advantage for UK investors is that any capital gain from selling Gilts is exempt from Capital Gains Tax (CGT). Furthermore, most sterling corporate bonds are Qualifying Corporate Bonds (QCBs), meaning any capital gain you make on them is also completely exempt from CGT. Crucially, the income (coupon) from these bonds is still subject to Income Tax unless they are held in a tax-efficient wrapper like an ISA or SIPP.
Sourcing and Buying Individual Bonds: The Reality for Retail Investors
While it's possible to buy individual bonds via platforms like the LSE's Order Book for Retail Bonds (ORB), this represents only a tiny fraction of the market. The reality is that most high-quality corporate bonds are issued in large denominations (often £100,000 or more) to place them out of reach for most individuals. Liquidity can also be very low.
The Fund Route: A Gateway to Diversification
This is why, for the vast majority of retail investors, a fund-based approach is not just more practical, it's often the only viable route. It provides instant diversification, professional management, and easy access, even with a small amount of capital.
Illustrative Examples: A Spectrum of Bond Funds and ETFs
Bond funds and ETFs cater to a wide range of risk appetites. To illustrate this, here are a few examples of fund types, moving from lower-risk strategies to those targeting higher income.
For Capital Preservation & Cash-Like Returns (e.g., a Sterling Money Market Fund): These funds aim to preserve capital by investing in cash and very short-term debt. They are designed to be a low-volatility option for cash holdings, seeking a higher income than a typical savings account.
For Core Diversification (e.g., a Global Aggregate Bond ETF): These passive exchange-traded funds (ETFs) offer broad, low-cost diversification. They track a global index of thousands of investment-grade government and corporate bonds, making them a common core holding.
For Higher Income (Illustrative Investment Trusts): For investors willing to take on more credit and complexity risk, specialist investment trusts offer access to professionally managed portfolios of higher-yielding assets. The following are examples to illustrate different strategies in this space:
Invesco Bond Income Plus (BIPS): Primarily invests in higher-yielding European corporate bonds and the subordinated debt of financial institutions.
CQS New City High Yield Fund (NCYF): Its strategy is anchored in UK high-yield bonds, supplemented with other income-producing assets like preference shares.
TwentyFour Income Fund (TFIF): Invests in a specialist area: European Asset-Backed Securities (ABS), which are bonds backed by pools of financial assets like mortgages or car loans.
Note: The yields on these funds are variable and not guaranteed. Before investing, always check the fund's official factsheet or Key Information Document (KID) for the most up-to-date information on its yield, duration, holdings, and risk profile.
The Power of ISAs and SIPPs
The most effective way for most people to invest is through a tax-efficient wrapper. If you hold bonds or bond funds within a Stocks and Shares ISA or a SIPP, all income and capital gains are completely free of UK tax.
Part 5: How Professionals Analyse Bonds (And Why Funds Are Useful)
To truly understand the value a fund manager provides, it's helpful to see the analysis they perform.
Credit Spread: This is the difference in yield between a corporate bond and a government bond (a Gilt) with a similar maturity. It is the extra yield you receive as compensation for taking on credit risk. Professionals focus intensely on whether spreads are "widening" (risk increasing) or "tightening" (risk decreasing) to judge value.
Credit Ratings: The starting point is the rating agencies: Moody's, S&P, and Fitch. They assign a rating from AAA (highest quality) down to D (in default). Bonds rated BBB- or higher are "Investment Grade".
Seniority and Security: This refers to the bondholder's place in the queue if a company goes bankrupt. Senior bondholders must be legally repaid before subordinated bondholders and equity holders. However, this is no guarantee of getting all your money back.
The Prospectus and Covenants: Every bond is issued with a prospectus outlining its terms, including covenants—rules the issuer must abide by. These legal documents are long, complex, and impractical for a retail investor to analyse.
This rigorous due diligence is a key benefit of using a professional fund manager.
Part 6: Conclusion and Actionable Next Steps
By understanding the journey from a simple loan to the interplay of credit spreads and duration, you equip yourself with a powerful new lens through which to view the market. This knowledge is about more than just income; it's about understanding a company's financial health at a deeper level.
To continue your journey, consider these steps:
Do Your Fund Homework: When looking at a bond fund or trust, always read the factsheet and Key Information Document. Pay close attention to its objective, duration, credit quality, and top holdings.
Link Debt to Equity: Use bond market signals as an equity investor. If a company's credit spread is widening sharply, it's a red flag about its financial health that shareholders should not ignore.
See the Big Picture: Consider how fixed income fits your personal risk tolerance and long-term goals. If you are unsure, it is always best to seek independent financial advice.
Disclaimer
The fund types mentioned are for illustrative purposes only and are not recommendations. Yields are variable, not guaranteed, and past performance is not an indicator of future results. This article is for informational purposes only and does not constitute financial advice. Readers should conduct their own thorough due diligence and consult with a qualified financial advisor before making any investment decisions. Please also refer to the full disclaimer available on the 'About' page, which applies to all content published here.