I'm confused by a chart of iShares Core UK Gilts UCITS ETF which is supposed to simply expose the customer to returns from UK bonds. Why does it show negative returns over the last 12 months, unless the government has been defaulting on its debt (which I presume it hasn't)? Have I misunderstood what this fund is supposed to do?
In general, when interest rates rise, the value of existing bonds declines. If you hold an existing bond paying, say, 2% and interest rates rise so that new bonds of the same type pay 4%, your existing bond is less valuable.
If you invest in a mutual fund that buys and sells bonds, you'll see the value of the fund decline because the fund's existing holdings all decline in value as rates increase. If you buy an individual government bond and hold that bond to maturity, you won't lose (nominal) money. The same can't be said for bond mutual funds.
As way of illustration, imagine that I have a bond fund. My fund currently has $100,000 in assets and 10,000 shares so each share is worth $10. All the fund's assets are in a 30 year government bond that was issued today. The bond pays 5% and market rates are 5% so the bonds are worth exactly their face amount. You buy 10 shares for a total of $100.
Now, on day 2, market rates increase to 6% due to bad news on inflation. I go to a bond price calculator, plug in the numbers, and find that my $1,000 face value bonds are now worth $924.94 (I'm ignoring the fact that it's one day closer to the next coupon which would have increased the price a few cents). So at the end of day 2, the fund's net asset value is $92,494 and each share is worth $9.25.
Now, since this is a fund, people are free to sell their shares. In which case, I as the fund manager would have to sell some of the bonds to pay out to those customers (a real fund would keep some amount of money in cash to handle expected inflows and outflows but still might be forced to sell assets if there was a large sell-off). I might also choose to sell some of the 5% bonds I currently hold in order to buy some short-term 6% bonds when they're offered in a few months rather than holding those bonds to maturity. In either case, the net asset value of the fund will fluctuate and you may see it remain below the $10 you initially invested for some time.
If you buy a $100 30-year bond yourself and hold that bond for 30 years, you are free to ignore the face that the price of the bond changes over those 30 years. Of course, you might want to sell it before the 30 years are up, in which case you might generate a profit or a loss depending on how interest rates have changed. And you should recognize that if interest rates go up, the bond you own is actually worth less because the $100 you get back in 30 years is expected to be less valuable than you were expecting. You may be able to avoid losing nominal dollars (you'll get back the $100 at the end of the term) but you can't avoid losing real inflation-adjusted dollars if interest rates move against you.
It may be helpful to compare this bond ETF to a stock that pays a dividend.
When you look at a price chart for a stock, the price fluctuates even if the cash dividend is not changed. When you look at a price chart for a bond ETF, the price fluctuates even if the cash distribution is not changed.
As other commented have mentioned, the prices of the bonds in the UK gov't bond ETF can change in response to changes in prevailing interest rates, UK fiscal or monetary policies, investor psychology (greed or fear), the inflation rate, tax policy, etc.