Investing in bonds: should you buy funds, trusts, ETFs – or invest directly?

Investors looking to tap into higher bond yields have a wide range of options. Sam Benstead breaks down the choices available.  

Bonds are back on investors’ radar once again, as rising interest rates increase the amount of income on offer.

UK government bonds (gilts) now yield more than 4% across all maturity lengths, with bonds maturing in one and two years paying around 5.5%.

Meanwhile, corporate bonds and those issued by emerging market governments yields even more: the S&P UK Investment Grade Corporate Bond index yields 6.7% and the JP Morgan Emerging Market Bond Index yields 7.5%.

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Bond funds have been one of the most-popular investment areas this year for UK-based investors. In May, the Investment Association (IA), the trade body for the funds industry, reported that government bond funds saw net inflows of £658 million, short-term money market funds added £382 million, and gilt funds took in £344 million.

However, there are many ways to add bonds to a portfolio, all with their own advantages and disadvantages. We break down the four ways of investing: funds, investment trusts, exchange-traded funds (ETFs) – and direct bonds.

Open-ended funds

Open-ended bond funds, like open-ended equity funds, grow and shrink as money flows in and out. This means that new money gives fund managers capital to invest, but outflows mean that the fund manager has to sell bonds (or use its cash position) to return money to investors.

This makes them suitable for investing in highly liquid parts of the bond market, but less suitable for investing in illiquid bonds. The most liquid bonds are developed market government and investment grade corporate bonds, but global high-yield bonds is also a large and commonly traded market.

On the other hand, investment trusts are better suited to hard-to-sell parts of the bond market, such as specialist bonds that not frequently traded.

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Kelly Prior, a bond fund buyer at investment firm Columbia Threadneedle, explains: “The differences in the structure of a bond is key when thinking about funds versus investment trusts, as liquidity can vary greatly.”

She gives the example of asset-backed bonds, where the income comes from a pool of assets such as mortgages, that are “far from a liquid area of investment”.

“Having a fund offering daily liquidity that invests solely in thin tranches of ‘the stack’ would be a challenge in matching the daily flows in any size in or out without compromising on the price you pay – and price is very important in the bond world as it is a binary asset class,” she said.

A number of open-ended bond funds make it on to interactive investor’s Super 60 investment ideas list. Most invest in highly liquid areas, meaning assets are easy to buy and sell.

They include M&G Global Macro Bond and Jupiter Strategic Bond, which take a go-anywhere approach to bond investing and currently have distribution yields of 4.1% and 4.8%.

For investors looking for a sustainable option Rathbone Ethical Bond has a distribution yield of 4.8%.

Two Super-60 rated bond funds that have exposure to more illiquid areas of the market – unrated bonds – are Royal London Global Bond Opportunities and Royal London Sterling Extra Yield. Unrated bonds are an under-researched part of the market, which Royal London fixed-income strategies have a particular specialism in. These bonds offer potential greater rewards, but the trade-off is during times of market stress such bonds could be more difficult to sell. Investors looking for passive exposure to bond markets can also look at open-ended funds, which price their assets daily and do not have a spread between the buying and selling price.

Interactive investor’s Super 60 investment ideas includes the Vanguard Global Bond Index and Vanguard UK Government Bond index. 

Closed-ended funds (investment trusts)

In contrast with open-ended funds, investment trusts have a permanent pool of capital, meaning they are not required to sell assets when investors withdraw money. Instead, the trust share price moves when investors buy or sell, leading to bigger discounts or  declines in the premium to the net asset value (NAV) of a strategy.

Prior says: “The disadvantage of closed-ended structures is the impact that sentiment and trading can have on the price of the trust itself. This is troublesome as you need bonds to work in your favour during periods of risk-off. The discount to NAV could work against you, just at the time you need it most.”

However, she says this can also work in an investor’s favour as there may be “fabulous buying opportunities” when trusts trade at discounts.

She adds: “If the investment trust is trading at a discount, the manager cannot raise capital to take advantage of these, whereas the opened-ended manager can court the flows of clients who too may wish to lock in great returns for the future.”

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Prior says a great example of the nuances of bond funds and trusts comes from specialist fixed income manager TwentyFour Asset Management.

Its Monument Bond fund is open-ended but invests in higher-quality, larger tranche and more liquid areas of asset-back securities, whereas TwentyFour Income Fund, the closed-ended vehicle, fishes down the balance sheet for greater returns in less liquid areas.

The largest investment trusts in the Association of Investment Companies (AIC) debt sector are BioPharma Credit (£1.3 billion in assets, 7.8% yield); Pollen Street (£846 million, 10.3% yield) and TwentyFour Income (£757 million, 8.4% yield).

Emma Bird, head of investment trust research at Winterflood, recommends BioPharma Credit, which provides venture debt to biotechnology firms, guaranteed by royalty streams from approved drugs, devices and diagnostics.

She said: “Given the frequency of prepayments and the specialist nature of counterparties, the fund relies on the expertise of the investment adviser to assess credit risk, royalty valuation and ongoing deal sourcing.

“We rate the managers highly, and the quality of credit selection is illustrated by the fact that the fund has experienced no defaults since its launch in 2017. The fund targets a NAV total return of 8% to 9% a year over the medium term, including a target dividend of 7 cents a year, equivalent to a 9.8% yield at the moment.”

Exchange-traded funds (ETFs)

ETFs are stock market-listed vehicles that own a basket of securities. They allow investors access to many assets by just making one trade.

For example, the Vanguard Global Aggregate Bond ETF owns 8,879 bonds from companies and governments around the world, and trades on the London stock market with the ticker VAGP.

Another popular ETF is the iShares Core £ Corp Bond ETF , ticker SLXX. Managed by BlackRock, it owns 489 bonds issued in sterling by large “investment grade” companies.

Because they are on the stock market, where buyers and sellers are connected, there will be “spread” between the bid (selling) and offer (buying) price. The more widely traded an ETF, the lower this spread will be.

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The complexities of the bond market make bond ETFs different from stock market ETFs. While stock market ETFs generally copy exactly the shares in their benchmark index, bond ETFs tend to “sample” the index in an attempt to replicate its performance without having to copy it exactly.

This is a more cost-efficient and practical method than owning thousands of bonds physically, as some will be difficult to trade cheaply and costs would have to be passed on to investors.

Vanguard says its global bond ETF “invests in a representative sample of bonds included in the index in order to closely match the index’s capital and income return” and “to a lesser extent the fund may invest in similar types of bonds outside the index”.

While the price of a bond ETF should normally match the value of its assets, during times of market stress when there are more buyers than sellers, or sellers than buyers, the price of an ETF can diverge from its net asset value (NAV). This means that investors can end up overpaying or underpaying for a bond ETF.

To counter this risk, “authorised participants”, typically large financial institutions such as banks, can improve liquidity by creating or redeeming extra shares in ETFs on behalf of market makers, which broker ETF deals. This process means that in most scenarios the price of an ETF is very close to its underlying value.

However, because bonds are less liquid than stocks, issues sometimes arise. For example, during the March 2020 stock market crash, some ETFs traded at 5% discounts to their NAVs. 

Despite brief periods where bond ETF NAVs and share prices diverged, bond ETFs have proved to be an efficient and cheap way of owning large baskets of bonds.

Advantages and disadvantages of bond funds

Bonds, like stocks and shares, are traded by investors. The big factor that impacts bond prices is interest rates, which is the risk-free lending rate set by each country’s central bank. When rates go up, it means that investors can get a better deal from newly issued bonds. They may choose to sell old bonds and lock in a better rate by buying a new bond.

When rates go down, this has the opposite effect. The old bonds that have higher interest rates become relatively more valuable.

Longer maturity bonds are more sensitive to interest rate changes, and therefore their prices rise more when interest rates fall, but their prices also drop more when rates rise. The sensitivity to interest rates is known as “duration”.

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Bond funds are constantly buying and selling new bonds, or holding them to maturity and reinvesting the capital that’s returned. This means changes in the price of bonds will impact the value of a bond fund.

As interest rates have been rising in the UK over the past 18 months or so, bond funds that pay investors in pounds are falling in value. This means that even though yields are higher, the total return of many bond funds (which includes income and capital gains/losses) has been negative given this rising interest rate backdrop.

Direct bonds

Investors can avoid the risk that bond prices fall, therefore eating into their total returns, if they buy and hold direct bonds to maturity. Investors can ignore price changes as they do not need to sell the bond, and instead can wait for it to mature.

The Order Book for Retail bonds, from the London Stock Exchange, allows retail investors access to fixed income, such as bonds issued by companies or the UK government.

The most popular direct bonds being bought at the moment by interactive investor customers are gilts.

They are buying up gilts set to mature in the next couple of years, with bonds maturing in 2024, 2025, and 2023 as the three most-popular choices. This suggests investors are holding the gilts to maturity, locking in yields of more than 5%.

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Given that UNITED KINGDOM 0.125 31/01/2024 (LSE:TN24) and UNITED KINGDOM 0.75 22/07/2023 (LSE:TG23) are low coupon bonds trading below par, most of the returns will come when the gilt pays back its £100 principal on maturity.

This capital gain is tax free, making these gilts especially attractive for investors who have used up their ISA allowance. In addition, cuts to the tax-free capital gains allowance are making gilts an even more effective way of reducing tax bills.

Income from gilts is taxed at income tax rates if held outside an ISA or a SIPP.