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

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

UK government bonds (gilts) now yield more than 4% across most maturity lengths, with bonds maturing 10 years paying about 4.5% a year. Meanwhile, corporate bonds yield even more, at about 5.5%. 

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Bond funds have seen a resurgence among UK-based investors due to higher yields following the sharp rise in interest rates in 2022.

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. We also look at the key sectors and how they are likely to perform under different market conditions. 

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. We explain why below in the investment trust section. 

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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 Invesco Sterling Bond and Jupiter Strategic Bond, which take a go-anywhere approach to bond investing and currently have distribution yields of 4.7% and 5.2%.

For investors looking for a sustainable option Rathbone Ethical Bond has a distribution yield of 5.1%.

The distribution yields reflects what investors are currently getting as income from the fund, while a "gross redemption yield" on a factsheet shows the total return of holding its portfolio of bonds to maturity, including the return of any capital. 

One Super-60 rated bond funds that has exposure to more illiquid areas of the market is Royal London Global Bond Opportunities. 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.

Three key bond fund sectors

The Investment Association's Sterling Corporate Bond sector is the most common hunting ground for UK-based bond investors. It contains nearly 100 funds, all investing most their assets in sterling bonds issued by highly rated companies. They also typically allocate a proportion to gilts and higher risk bond, depending on the rules for the individual fund. 

Sterling Strategic Bond is another important sector. Bonds classified as "strategic" take a go-anywhere approach to fixed income investing, allowing them to access bonds that could be higher risk, such as emerging market and high yield bonds. Due to this flexibility, they are more likely to be taking big macroeconomic bets on the direction of interest rates and currencies around the world. They can also use derivates to dial up or down risk. 

There are 31 funds in the Sterling High Yield sector. Here, fund managers are free to select higher yielding "junk" bonds from around the world, with foreign currencies often hedged back to sterling to avoid currency risk. Returns can be far higher than what gilts can return, sometimes as much as three or four percentage points greater. The FTSE  World High-Yield Bond Index has a yield to maturity of 7.4%. 

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Investment trusts (closed-ended funds)

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. This adds volatility but can lead to bargains appearing. 

This permanent pool of capital means that investment trusts can buy more illiquid parts of the fixed income world, such as direct loans to companies. 

For example, the Loans & Debt trust sector has average yields of 8%. The trusts all follow distinct investment styles, but the common thread is that they can buy company debt that is not publicly tradable, as regular bonds are. This means that they have access to more specialist, but potentially higher-yielding and therefore generally riskier, parts of the debt world.

This includes “floating rate” bonds, where coupons are linked to interest rates, which means that returns rise and fall as interest rates do. This type of debt is really useful when interest rates are rising, as they are more resilient than fixed-interest bonds, which see their value eroded when rates rise.

The best-performing fund in this sector over the past decade is CVC Income & Growth GBP, which has more than doubled investors’ money. It has about 80% invested in floating-rate debt and splits it portfolio roughly half and half between higher-risk “credit opportunities” and more stable “performing credit”.

Other options are M&G Credit Income Investment , TwentyFour Select Monthly Income and Invesco Bond Income Plus. They yield 8.94%, 8.5% and 7.1% respectively. 

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 close to 9,000 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 nearly 500 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.

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. This suggests investors are holding the gilts to maturity, locking in yields of around 4%. Two very popular options are: UNITED KINGDOM 0.125 31/01/2028 (LSE:TN28)and UNITED KINGDOM 0.25 31/07/2031 (LSE:TG31). Given that are low coupon bonds trading below par, most of the returns will come when the gilt pays back its £100 principal on maturity.

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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.