Benstead on Bonds: direct gilts or a bond fund?

Investors can access bonds in two main ways – via a collective vehicle such as an open-ended fund or exchange-traded fund (ETF), or by buying an individual bond directly.

The arguments for holding bonds can be boiled down to two things: reliable income and diversification benefits. Income, as yields for UK government bonds range from around 4% to 5.5%, with corporate bonds paying more; and diversification as bonds rise in value generally when interest rates fall, which may be a result of a shaky economy or falling stock market.

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But this oversimplifies how bonds behave, particularly the differences between how individual bonds move in value, and how a fund’s price might change.

The big difference is that a bond fund never matures – it is a living portfolio where bonds are constantly exiting (either because they are sold or mature) and being added (such as if a new bond enters an index or a fund manager decides to make a purchase). This means that it isn’t possible to hold a regular bond fund to maturity.

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The consequence is that a portfolio value will always move as the prices of the bonds change.

Bonds, like stocks and shares, are traded by investors. The big factor that impacts bond prices is interest rates, which is the risk-free deposit rate for commercial banks 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.

Therefore, if we enter an economic environment where interest rates fall and inflation is falling, this would be good news for bond prices.

On the other hand, barring a default, an individual gilt held to maturity offers a fixed “yield to maturity” return for the investor which is not possible with a fund.

While the price of the gilt will change with market conditions, investors know that it will return to its redemption value (£100) when it matures, meaning that they can ignore market moves so long as they are able to hold on to the gilt.

The yield to maturity calculation takes into account the coupons being reinvested and the return of the bond’s redemption value on maturity.

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Longer maturity bonds (those with lifespans of over 15 years) 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.

This applies to individual bonds as well as bond funds, so owning gilts maturing way out into the future, such as the popular UNITED KINGDOM 0.5 22/10/2061 (LSE:TG61) gilt maturing in 2061, will lead to big price swings.

It is also less realistic to hold on to a gilt for more than 30 years, so it’s likely that investors in these longer gilts are doing so to benefit from a rally in bond prices, rather than to lock in a fixed return.

A fund or a gilt – which to buy?

For those looking for a short-term savings tool, similar to a fixed-rate bond your bank might offer, then a direct gilt, maturing soon, is likely the best option.

The most popular gilts on our platform are those maturing in the next five years, giving investors an achievable holding period that they can stick to.

They include UNITED KINGDOM 0.125 30/01/2026 (LSE:T26), UNITED KINGDOM 0.125 31/01/2028 (LSE:TN28), UNITED KINGDOM 0.25 31/07/2031 (LSE:TG31) and UNITED KINGDOM 0.5 31/01/2029 (LSE:TG29). Yield to maturities are around 4%.

For investors looking for the diversification benefits of bonds, where values could rise when equities are falling, then a bond fund might be more suitable. This is because its price will rise and fall with market conditions, and holding to maturity is not an option.

A diversified bond fund will own a mix of maturity dates, but the overall sensitivity to interest rates, know as “duration”, will likely be higher than a gilt maturing soon.

For example, over the past five years, the Vanguard UK Government Bond Index has delivered a total return of –31.2%, while the T26 gilt has moved from around £100 to £98, hitting a low of £88 at the end of 2022.

The bond funds our fund research team recommend on our Super 60 list of investment ideas include: Vanguard Glb Corp Bd Idx £ H Acc (BDFB5M5), Vanguard UK Government Bond Index, Invesco Sterling Bond, Royal London Corporate Bond, and Jupiter Strategic Bond.

Tax on direct gilts vs funds

Tax is also an important consideration. Income from gilts, coming from the coupon paid twice a year, is subject to income tax if not held inside an ISA or a SIPP.

However, capital gains from selling a gilt, or when it redeems, are not subject to capital gains tax. This makes them a useful tax-planning tool for investors who have used up their ISA and SIPP allowances.

For some gilts, such as those issued with low coupons, most of the total return is when the gilt redeems at £100, meaning that the capital gains tax savings are significant.

On the other hand, funds do not have the same tax benefits, even if they are invested in gilts. This means that income and capital gains are both taxed, if the fund is not in an ISA or SIPP.

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The tax break on low coupon gilts has not gone unnoticed by investors. This has caused demand to spike for low-coupon gilts compared to higher coupon gilts with similar maturity dates.

For example, T26, with a 0.125% coupon, has a yield of 3.3%. Meanwhile, UNITED KINGDOM 3.5 22/10/2025 (LSE:TY25), with a 3.5% coupon, yields 4.2%.

If someone is investing in an ISA or a SIPP, they may be better off with TY25. But if they are buying gilts outside tax wrappers, then T26 may offer a better tax-adjusted return.