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Best bond funds and bond ETFs


Global bond markets are even bigger and deeper than the world’s stock exchanges so how on Earth do you choose the best bond funds or bond ETFs from the bewildering array of products available?

If you’re looking for a bond fund to properly diversify your portfolio beyond equities then we can paint the target quite quickly for UK investors.

High-quality, conventional (often called nominal), government bonds are the best strategic diversifiers for a portfolio with a large amount of equities.

We’ve previously explained the purpose of bonds within a passive investing portfolio.

For UK passive investors, it comes down to investing in UK government bonds (known as gilts) and/or the government bonds of other advanced nations.

We think the best bond fund vehicles are ETFs and index funds because their low fees leave more return in the pockets of investors – as opposed to fat-cat fund managers.

We’ll explain our choices below, but first let’s run through our picks for best bond ETFs and bond index funds.

Best bond funds and ETFs – UK gilts

Fund/ETF Cost = OCF (%) Index Duration Yield-to-maturity (YTM) Credit quality Domicile
Vanguard UK Gilt ETF 0.07 Bloomberg Barclays Sterling Gilt 13.1 0.9 AA Ireland
Vanguard UK Government Bond Index Fund 0.12 Bloomberg Barclays Sterling Gilt 13 0.9 AA Ireland
Lyxor Core UK Government Bond ETF 0.07 FTSE Actuaries UK Conventional Gilts All Stocks 11.8 AA Luxembourg
iShares Core UK Gilts ETF 0.07 FTSE Actuaries UK Conventional Gilts All Stocks 11.7 0.9 AA Ireland
iShares UK Gilts All Stocks Index Fund 0.11 FTSE Actuaries UK Conventional Gilts All Stocks 11.9 0.8 AA UK
Invesco UK Gilts ETF B 0.06 Bloomberg Barclays Sterling Gilt 12.4 0.8 AA Ireland

Source: Fund providers’ data (A dash means data not provided).

These are intermediate gilt ETFs and funds because for most investors intermediates offer a better balance of risk versus reward than long bonds (far more risky) or short bonds (a miserly reward).

Dedicated long or short bond allocations will be right for some, though. You can find a few suggestions in our cheapest trackers guide.

There is little to separate the products in the table, which is as it should be. Competition between index tracker providers is fierce, so most advantages have been eroded away.

You can be confident you’re in the right ballpark so long as you choose a low-cost bond ETF or bond fund, with a good track record among its peers. More on that below.

First, a couple of notes about the bond features picked out in the table.

Duration

Average duration is an approximate guide to how much a bond fund will gain or lose in response to a 1% change in market interest rates. 

For example:

  • A bond fund with a duration of 12 will lose around 12% of its market value for every 1% rise in its interest rate.
  • The fund’s price will similarly jump about 12% if its rate drops by 1%.

The higher a bond’s duration, the greater the capital gain or loss as its market interest rate fluctuates.

The market interest rate of a bond is not the base rate set by the Bank Of England. The market interest rate is a product of supply and demand for each individual bond on the bond market. If the Bank Base Rate hiked by 1% that doesn’t mean that every bond will follow suit.

Yield-to-maturity (YTM)

The expected annual return of your bond fund is its current yield-to-maturity. This number will fluctuate as bond prices move but the main takeaway is that there’s nothing between these products, and that high-quality government bond returns are very low these days.

Credit quality

This is a guesstimate of the financial strength of the bond issuer – the UK Government in the case of the funds in our table.

AAA is top-notch while BBB- sets the floor for investment grade. Below that is ‘junk’.

The higher the credit quality rating, the better. It means there’s less chance the issuer will default on payments, according to the bond rating agencies.

Bond rating systems and verdicts vary slightly by agency but the main message is stick to investment grade.

In other words, don’t touch someone else’s junk.

Bond fund credit quality for a fund is the weighted average of all its bonds ratings.

Domicile

Location matters because funds based in the UK are covered by a better investor compensation scheme than those in Ireland or Luxembourg.

It’s highly unlikely that you’ll ever need to worry about this provision, especially given the scale of the fund providers in the table, but it’s a wrinkle worth knowing about.

Brexit has not proven to be an issue with respect to fund domiciles.

Best bond funds and ETFs – UK gilts results check

Source: Trustnet multi-charting tool

Performance wise it’s neck-and-neck between our field of bond funds over three to ten-year timeframes. Don’t compare funds over a one-year time period – that’s too short to tell you anything meaningful. Longer is better.

Important caveat: we’re mainly checking the results to make sure that our candidates are doing a good job. A fraction of a percentage point in performance makes little odds and doesn’t tell us which fund will nose ahead next year or next decade.

That said, while the two Vanguard funds are not the cheapest (by OCF) they have posted marginally better results than their rivals across all periods over a year.

The headline OCF fund fee doesn’t capture all costs but a performance comparison does. This data is good evidence that the Vanguard funds are the cheapest once hidden costs are exposed.

And that’s ultimately why the Vanguard bond trackers head up the comparison table, although any of the picks would be a fine choice.

Note: Fidelity’s Index UK Gilt Fund P is another potential contender but was excluded from this year’s round-up because of its very short track record.

Best bond funds and ETFs – Global hedged to GBP

Fund/ETF Cost = OCF (%) Index Duration Yield-to-maturity (YTM) Credit quality Domicile
iShares Global Government Bond ETF (IGLH) 0.25 FTSE G7 Government Bond Index 8.5 0.6 Ireland
Vanguard Global Bond Index Fund 0.15 Bloomberg Barclays Global Aggregate 7.5 1 AA- Ireland
SPDR Bloomberg Barclays Global Aggregate Bond ETF (GLAB) 0.1 Bloomberg Barclays Global Aggregate 7.4 1.1 Ireland
iShares Core Global Aggregate Bond ETF (AGBP) 0.1 Bloomberg Barclays Global Aggregate 7.3 1.1 Ireland
Vanguard Global Aggregate Bond ETF (VAGP) 0.1 Bloomberg Barclays Global Aggregate 7.5 1 AA- Ireland

Source: Fund providers’ data (A dash means data not provided).

iShares Global Government Bond ETF is the clear leader in the best bond funds hedged to GBP category.

That’s because it’s the only dedicated government bond fund in our pack.

The other four index trackers are aggregate bond funds. That means they hold corporate bonds and various other bond types too.

This level of diversification means aggregate bond funds are actually less likely to counterbalance the fall of equities than government bonds.

Stock market crash protection is the overriding point of bonds in strategic asset allocation, and so the Global Government Bond ETF tops the table.

The lower risk of high-quality government bonds shows up in the yield-to-maturity numbers in the table.

The aggregate bond funds have higher yields because investors demand more return to take on the risk of holding them.

In my view, a greater capacity to soften the blow in a crisis is worth the higher cost and lower reward of holding government bonds.

  • We’ve previously seen how well the iShares Global Government Bond ETF performed versus the iShares Global Aggregate Bond ETF during the coronavirus crash

Why aggregate bond funds at all?

There isn’t much choice when it comes to global government bonds hedged to GBP, which is why the aggregate bond funds make the table.

They all hold north of 50% in high-quality government bonds and their holdings are investment grade.

If you prefer to trade-off some crash protection for a little extra yield then these products make sense.

Do check their holdings and credit ratings though, so you know what you’re dealing with. Especially as none of the fund managers bar Vanguard have bothered to publish an average credit quality score.

Best bond funds and ETFs – Global results check

Best bond funds and ETFs performance table for global bonds

Source: Trustnet multi-charting tool

Again, the main objective in comparing results here is to make sure there isn’t a weird outlier on the shortlist and to see if any fund is consistently dragged down by hidden costs.

This check already caused me to cross off Xtrackers Global Government Bond ETF because it was bedeviled by volatility, according to Trustnet’s data.

Vanguard’s Global Bond Index fund leads the aggregates on our table by virtue of its long track record and strong showing over three years.

Note, the iShares Global Government Bond ETF lags the pack over three years – which is exactly what you’d expect for a low-risk fund compared to aggregate bonds holding corporate debt.

Currency hedging to GBP

Diversifying across global government bonds came into vogue in the aftermath of the Great Recession as many countries lost their cherished AAA credit ratings – the UK among them.

As government debt continues to balloon, many investors prefer not relying on the full faith and credit of their home country.

If you opt for global bonds then make sure you pick a fund that hedges its return to the pound. That removes currency risk from the defensive side of your portfolio, if you’re a UK-based investor.

While currency risk may sometimes be viewed as a positive, diversifying factor for equities, the same is not true for government bonds.

Currency exchange rate fluctuations add volatility to your returns when the role of government bonds in your portfolio is to lower it.

Some investors leave their global bonds unhedged. Betting on exchange rates is an advanced move, though. It’s only justifiable if you really know what you’re doing.

So, given the diversification benefits of global government bonds why would you go for a 100% gilts tracker?

Mainly because the gilt trackers are one-third less costly to own, offer more yield, and promise marginally more crash protection.

Don’t sweat the small stuff

From a big picture perspective, any of the index trackers gracing these best bond funds (and bond ETFs) tables tick the right boxes.

I’ve touched on the important details but even those differences will likely prove marginal to your results over many years of passive investing.

The most important investing decision is to diversify between equities and government bonds in the first place.

Choose a competitive bond index fund or ETF as the main brace of your defensive asset allocation and you’ll be on the right course.

Take it steady,

The Accumulator





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