Bond investing

A bond is effectively an I.O.U.

Governments or companies issue bonds (known respectively as sovereign bonds or corporate bonds) when they need to borrow money. 

The investor (bondholder) who buys the bond is lending to the issuer and in return should receive regular interest payments, known as the coupon. After a set period the bond becomes due (matures) and the bondholder is repaid their initial capital (the principal).

Consider the example in Figure 2. Company A wants to raise £10 million to spend on new equipment. It may issue 10,000 five-year bonds for £1,000 each, at an annual coupon of five per cent. This means the company will pay £50 to each investor every 12 months until year five, when the bonds mature and the investors also receive back their £1,000 (the ‘par’ or ‘face value’ of the bond).

The coupon rate, agreed in advance, usually remains constant throughout the life of the bond, which is why bonds are sometimes referred to as ‘fixed ‑income’ investments. The size of the coupon, usually paid annually or semi‑annually, is influenced at the time of issue by several factors. These include current interest rates, the length of time before the bond matures, demand and the perceived risk of ‘default’, which is when the issuer is unable to pay either the interest or the principal.

Bonds with a longer maturity will usually have higher coupons. This is to compensate the holder for the increased risk, as the longer timeframe means there is more uncertainty about interest rates (which can affect the bond’s market value) and other factors relating to the issuer’s ability to make its payments.

Bond issuers are usually given credit ratings by independent agencies, which investors use to get a sense of the risk involved. Issuers with the highest ‘triple ‑A’ ratings are extremely unlikely to default, so the coupon on their bonds is low. US government bonds, known as Treasuries, are considered effectively zero risk, as there is thought to be almost no chance the US government will be unable to pay its debts.

At the other end of the spectrum, bonds from issuers rated below a certain threshold are known as ‘high ‑yield or ‘junk’. Coupons on these ‘sub-investment grade’ bonds tend to be higher.

Figure 2: Life of a bond, from issuance to coupon payments to maturity

Source: Aviva Investors, March 2025.

The markets contain a dizzying variety of bonds. Here are some of the most important categories:

Although investors will sometimes hold bonds to maturity, they can also sell them on in the secondary market.¹ The buyer will then collect the coupon payments from the issuer and (if holding the bond to maturity), the principal when due.

Bonds can be sold for either more than their face value (at a premium) or less than face value (at a discount). Given the coupon payment stays the same, the price paid for the bond will affect the buyer’s overall return. The return is measured using a figure known as ‘yield’.

A simple way to calculate a bond’s current yield is to divide the coupon payments by the current bond price. This means yields and bond prices have an inverse relationship; that is, when prices rise, yields fall, and vice versa. 

Think back to Company A’s £1,000 bonds, with their five per cent annual coupon. When the bonds were first issued (face value of £1000), the yield was the same as the coupon rate – five percent. Imagine that a holder of this bond sells it to another investor later at a premium, say £1,150. For the buyer, the annual coupon of £50 on the bond represents an annual yield of 4.35 per cent (or 50 divided by 1,150).

Because the bond has risen in price, the yield has gone down.

Many factors affect bond prices and yields in the secondary market, including the general state of the economy, inflation and interest rates. For a corporate bond, the yield will also fluctuate to reflect investors’ perception of the company’s credit quality.

This is because most corporates typically have more credit risk (risk of bankruptcy and the consequent risk that you will not receive your interest or your money back at maturity). Hence they have higher yields than government bonds of similar maturity.

The difference in yields creates what is known as a ‘credit spread’, which means the corporate bond investor earns an extra yield by taking on greater risk.

Figure 3 shows how US corporate bond credit spreads have changed over the last two decades or so. Spreads have risen sharply during times of market stress, such as the global financial crisis of 2008‑09 and the early stages of the COVID‑19 pandemic in 2020.

While corporate bond yields reflect a higher risk of default and are sensitive to company-specific and economic risks, government bonds are known for low default risks, given that governments back the bonds. Although, they tend to offer lower interest rates because of the lower risk.

With a market value of around $27 trillion in outstanding debt, the US Treasury market is the biggest, most liquid government bond market in the world.² The yield on US Treasuries is typically much more stable because bondholders are confident the US government will repay regardless of the economic context. In fact, jittery investors often move their money into Treasuries and other highly rated government bonds during times of turmoil, which is why they are sometimes referred to as ‘safe havens’.

As well as the changes in the creditworthiness of the issuer, other factors affecting bond prices include overall levels of supply and demand and inflation. Because rising inflation erodes the value of future interest and principal payments, it tends to result in bonds losing value. (A subcategory of bonds, known as inflation‑linked bonds, offer some protection by connecting the level of interest and principal payments to the inflation rate.)

Related to inflation, is the most important driver of bond prices: ‘base rates’ – the interest rates set by central banks. When interest rates go up, bond prices fall, and yields rise. This is partly because the coupon payments on newer bonds are likely to be higher than those already on the market, and therefore more enticing to investors than those they hold. (The opposite happens when base rates go down: yields fall, and prices rise.)

Let’s return to Company A. Imagine the firm sells a new batch of bonds six months after the first (bond) issuance. The central bank has raised base rates by 100 basis points (or one percentage point) in the interim. All else being equal, the new bonds will require a higher coupon to attract investors, meaning the company’s previous bonds will be less valuable (see Figure 4). If the central bank had cut rates, the opposite would happen, and Company A’s existing bonds would increase in value.

Figure 4: The interplay between interest rates, bond prices and yield

Source: Aviva Investors, March 2025.

To assess a bond’s sensitivity to interest rates, investors use a measurement known as ‘duration’. Duration tells you the extent to which a bond’s value will rise or fall in response to changes in interest rates. When rates fluctuate, the price of a bond with a long duration is likely to move more sharply than one with a short duration. This means bonds with longer duration come with higher interest rate risk.

Expressed in years, duration is a complex calculation that considers the time left until the bond matures and the value of the bond’s coupon. The longer the time to maturity, the higher the duration. Imagine you lent a friend £100: you won’t be concerned about interest rates if they were paying you back in a few days. But if you had lent the money for 20 years, you absolutely would.

The bond’s coupon value also impacts its sensitivity to rates: the higher the coupon, the lower the duration. If you are being paid a low coupon and have to wait until maturity to get the bulk of your returns back, the bond will be much more sensitive to interest rates than if you get most of your returns sooner via the higher coupon payments until maturity.

Duration can be used to gauge the change in a bond’s value in response to a one per cent change in interest rates. In simple terms, if interest rates rise by one per cent, the price of a bond with a duration of three years will fall by three per cent (1% x 3 = 3%); if interest rates fall by one per cent, the same bond’s price will rise by three per cent (see Figure 5).³

The effect becomes more pronounced the longer the maturity of the bonds. So, once again in simple terms, for a bond that has a duration of five years, a one percent rise in interest rates would mean that the price will drop by approximately five per cent.

Figure 5: Duration: Impact of a one per cent rise or fall in interest rates on bond prices

Source: Aviva Investors, March 2025.

Duration can influence investment strategies and it is particularly important to monitor the duration of a bond portfolio when interest rates are rising or falling. For example, if interest rates are rising, the value of a portfolio made up of shorter‑duration bonds is likely to be less affected than one with a longer average duration. When rates are falling, the opposite will be true: portfolios containing bonds with a longer duration are likely to rise in value faster than those with a shorter duration.

Because they offer a reliable income stream, bonds can be preferable to shares for some investors, such as those looking to offset regular liabilities. Although shares can offer income via company dividends, these payments are dependent on the company’s financial performance and are not as predictable.

Bond prices tend to be less volatile – or less likely to experience material changes – than share prices. Unlike shareholders, bond investors can expect to have their capital repaid on a given date and also rank higher in the capital structure (meaning that if a company goes bankrupt, they are ahead in the queue when it comes to repayment). Bonds can therefore be useful for investors whose priority is to preserve their capital.

Bonds can also offer capital appreciation. Investors can realise a profit on a bond if they can sell it at a premium to its face value. The capital appreciation, plus any income derived from the bond, adds up to what is known as the ‘total return’.

On the other hand, corporate bond investors have less control over their investments than shareholders, because they don’t gain an ownership stake in the issuing company. The higher risk an equity holder takes also offers them higher potential returns relative to bonds.

Because of their different characteristics, bonds and equities can complement each other in an investment portfolio. Bonds and equities usually have a low or negative ‘correlation’(at least for the last two decades): this means market events that are good for equities tend to be bad for bonds, and vice versa.

A lower correlation between bonds and equities generally benefits multi-asset investors, because it can reduce the expected volatility of their portfolio as a whole. If the correlation is negative, bonds can, to a degree, offset negative moves in equities.

As a result, investing across both asset classes can help with ‘diversification’, or spreading risk. This is the logic behind the traditional 60/40 portfolio mix, which is based on a 60 per cent allocation to equities and 40 per cent to bonds. However, correlations can sometimes rise under some economic conditions – when this happens, 60/40 portfolios are less effective at mitigating risk.

The COVID‑19 pandemic in 2020 prompted an enormous amount of fiscal and monetary stimulus from policymakers across the globe. Household and corporate balance sheets were supported through the crisis thanks to these measures. However, as life began to return to normal, it became clear that such policies supported demand in the economies even as pandemic-era policies simultaneously reduced supply (for example, by forcing temporary closures of factories). Thus, inflation began to increase, rising from 1.4 per cent at the end of 2020 to 7.0 per cent by the end of 2021.

This was exacerbated by Russia’s invasion of Ukraine in 2022, which resulted in a spike in energy prices that added another leg to the inflationary surge. Inflation peaked at 9.1 per cent in the US, 11.1 per cent in the UK, and 10.6 per cent in Europe in 2022. Central banks raised interest rates aggressively in response. This led to a fall in bond prices and rise in yields, culminating in double-digit losses on fixed income assets over the year.

Good progress was made on tackling inflation in 2023, though underlying inflationary pressures proved ‘stickier’ than expected, particularly in the US. Bond markets continued to fluctuate in 2024 as concerns around economic growth competed with lingering inflationary risk. This was particularly the case in the US, where a temporary spike in inflation in Q1 2024 gave way to fears in Q3 that the labour market was slowing too quickly. This led to a rally in bond markets and prompted the Federal Reserve (Fed, the US central bank) to begin cutting interest rates in September.

However, no sooner had the Fed done than the economic data began to firm. In November 2025, the election of President Trump and his proposed policies was seen as a positive for both growth and inflation. While this initially prompted a rally in stocks, it created a different mood in the bond markets. Worries about increased government spending, inflation and interest rates staying higher, sent US Treasury yields up. The yield on the 10-year US Treasury ended the year around 4.5 per cent, up almost one per cent higher than the level at the start of Q4 2024.

Another consequence of the tough market environment in the last few years is that the correlation between bonds and equities rose, an unusual situation in which both assets lost value at about the same rate at the same time. This created difficulties for investors relying on a mixture of the two assets to spread risk.

Figure 6 shows ‘drawdowns’ – i.e., the drop in value from the highest to lowest point over a rolling period – for 60/40 portfolios and equity portfolios since 1990. It shows that a 60/40 portfolio is usually more resilient during a crisis. But since 2022 both types of portfolios have fallen sharply at the same time, though the 60/40 portfolio shows slight signs of a recovery from late 2024 and into this year.

While the equity/bond correlation has been positive in the last few years, driven largely by high inflation, as inflation has moderated the correlation should shift to a more negative stance, allowing bonds to become more of a diversifier in portfolios.

This is happening currently as the bond/equity correlation has returned to the pre-COVID norm. Going forward, developments on economic growth will become more of a driver for the price of bonds and equities and hence the current negative correlation between the asset classes is likely to become stronger.

So where do we go from here?

The bond market might offer a clue to the future direction of travel through a measurement known as the ‘yield curve’. The yield curve is essentially a line graph that shows the relationship between yields and time to maturity for a number of bonds. The bonds plotted on the curve need to be of the same asset class and credit quality. Thus, the yield curve shows the difference in yield for bonds of different maturities.

Usually, the yield curve looks like the chart on the left in Figure 7: longer-dated maturities offer higher yields. However, the yield curve is occasionally ‘inverted’, as in the chart on the right. This shows that shorter-dated debt yields more, indicating investors expect longer-term interest rates to fall, as would be the anticipated policy response during a recession.

An inverted yield curve has preceded many recessions through history, but not all. The aggressive raising of interest rates to combat inflation by the Fed caused the Treasury yield curve to first invert in October 2022, and it remained inverted until December 2024. However, while this has been the longest inversion in recent history, a recession has yet to materialise.

Figure 7: Normal and inverted yield curve

Source: Aviva Investors, March 2025.

No-one can predict the future. However, bond yields have tracked economic surprises quite well over the last couple of years, making them a useful barometer. The current positive slope of the US Treasury curve suggests optimism about a soft landing – where inflation continues to moderate without a severe economic downturn. While resurgent inflation could slow the process, markets still expect further interest rate cuts in the US and Europe, which would support bond prices. However, the pace and timing of the cuts remain uncertain.

Figure 8 shows that global bond markets generally tend to rise when the Fed cuts interest rates (i.e. loosens monetary policy) and vice versa.

An alternative scenario is that major central banks keep rates high as they try to bring down inflation to their targets, but without causing their economies to fall into recession. This would probably mean bond yields stay higher than they have been over the last decade or so.

While higher rates result in lower bond prices, they can also bring benefits to investors. When interest rates were close to zero, which has been the case for much of the period following global financial crisis, bonds were expensive, and the income they provided was low as a proportion of their cost. But when rates and yields are higher, investors in maturing bonds can reinvest the proceeds in new bonds that offer relatively more attractive levels of income.