Bond ETFs: start with the job bonds do in a portfolio, not the yield
Bond ETFs are easiest to misunderstand when they are judged on yield alone. The more useful question is what the bond holding is for: steadying a mixed portfolio, matching spending in sterling, or holding a specific slice of the government-bond market.
A bond ETF is usually there to make a portfolio steadier, simpler, or easier to match against future spending. Judging one on its yield alone leaves out duration, credit quality and currency hedging, which decide how it behaves.
AGBP or VAGP: global bonds hedged to sterling
Both hold investment-grade government and corporate bonds from around the world in one fund, with the currency exposure hedged back to sterling.
Global aggregate
Designed as one diversified bond holding rather than a source of high income.
The sterling hedge aims to reduce the effect of exchange-rate moves for a sterling investor. AGGU, another class of the same iShares fund, is hedged to US dollars instead.
Bond prices still fall when interest rates rise, and credit risk remains; the hedge deals with currency only.
VGOV — plain gilt exposure
Holds UK government bonds (gilts) only, so what the bond holding is made of is easy to see.
UK gilts
No currency risk, and simpler to follow than a global mix of government and corporate bonds.
Still rate-sensitive; “government bond” does not mean “price never moves”.
Concentrated in one government’s bonds, so less diversified than a global fund.
Which bond ETF route fits which problem?
Investor problem
Examples
What to know
I want one broad bond sleeve inside a mixed portfolio.
AGBP or VAGP
One fund holds a wide spread of government and corporate bonds, so separate holdings for each are not needed.
I want explicit UK government-bond exposure.
VGOV
A gilt fund holds UK government bonds only, rather than a global mix of government and corporate bonds.
I mainly care about income.
Look at what the income is for
A higher yield usually means longer duration or more credit risk, which may not suit a goal of stability, cash-flow planning or matching inflation.
Common mistake: mixing “defensive” and “income” goals without realising they can point to different bond structures and different duration risk.
The framework: what "best bond ETF" means for UK investors
Bond ETFs sit in a different decision space from equity ETFs. Which kind of bond fund fits depends mostly on why bonds are being held. Three reasons cover most holdings:
Steadying a portfolio: something that tends to hold its value better than shares when share prices fall. This usually points to high credit quality, short-to-intermediate duration, and sterling or sterling-hedged bonds.
Income: regular distributions to help fund spending. Higher yields usually come with longer duration, more credit risk, or both.
Holding money for the near term: money needed within a few years. This points to very short duration, such as short-dated gilts or money market funds.
One fund may not do all three jobs well, so it helps to be clear which one it is there for.
The five dimensions that actually differentiate bond ETFs
Duration: a measure of how sensitive a bond fund’s price is to interest rates. A duration of 7 years means a 1 percentage point rise in yields produces roughly a 7% fall in price. A long-duration fund can fall sharply over a short period, which matters if the money is needed soon. See the page on duration and hedging.
Credit quality: government bonds (gilts, US Treasuries, Bunds), investment-grade corporate bonds and high-yield bonds. Higher yields come with more credit risk, and lower-quality bonds tend to fall alongside shares in a crisis, so they do less to steady a portfolio.
Currency hedging: an unhedged global bond fund’s value in sterling also moves with exchange rates, and those moves can be larger than the moves in the bonds themselves. A sterling-hedged share class aims to remove most of that. The share class name says which currency it is hedged to: AGBP is the sterling-hedged class of the iShares Core Global Aggregate Bond UCITS ETF, while AGGU is the same fund hedged to US dollars. The cost or gain from hedging depends mainly on the difference between interest rates in the two currencies, and it shows up in the fund’s return rather than as a separate charge.
Replication and trading costs: most broad bond ETFs hold a representative sample of the index rather than every bond in it. The bid-ask spread on the ETF itself is a cost each time it is bought or sold, and on some bond ETFs it is wide enough to matter for small, frequent purchases.
Income and tax: see the wrapper tax page. In a general account, income from a bond fund is taxed as savings interest rather than as dividends (below), at up to 45% for additional-rate taxpayers. Because savings rates are higher than dividend rates, the tax difference between holding a bond fund inside or outside an ISA or SIPP tends to be larger than for an equity fund.
UK-specific bond-ETF tax issues
A point that US-focused material misses: distributions from an offshore fund that holds more than 60% of its assets in bonds and similar investments are treated as interest, not dividends (section 378A, Income Tax (Trading and Other Income) Act 2005). Most bond ETFs are in that position. That means:
Above the allowance, the interest is taxed at the taxpayer’s savings rate: 20%, 40% or 45%.
Inside an ISA or SIPP, none of this applies. For a higher-rate taxpayer whose allowance is already used, tax takes 40% of the income: on a fund yielding 4%, that is 1.6% of the amount invested each year.
Four common bond-ETF mistakes
Holding an unhedged foreign-currency bond fund for stability. If the spending it supports is in sterling, exchange-rate moves add a second source of ups and downs. Sterling-hedged classes exist for many major bond indices.
Assuming a global aggregate fund is all government bonds. A global aggregate index holds corporate and other bonds alongside government bonds. Corporate bonds pay more because they carry credit risk, and they tend to hold up less well than government bonds when shares fall. A fund holding only government bonds, such as a gilt fund, removes most of that credit risk but is less diversified.
Underestimating duration. Long-dated gilt funds fell sharply in 2022 as interest rates rose. The longer the duration, the larger the fall for a given rise in yields.
Not thinking about which holdings sit inside the ISA or SIPP. Bond funds pay taxable income every year, while much of an equity fund’s return may come as capital gains, taxed only when the holding is sold and only above the annual exempt amount. That difference is why the choice of which holdings go inside a tax wrapper can change the total tax paid.
Worked example: bond fund income in a general account
A higher-rate (40%) taxpayer with the full £500 Personal Savings Allowance available holds £10,000 in a general investment account. The yields below are round numbers chosen for the arithmetic, not the current yield of any fund:
Fund yielding 4%: £400 of interest, all within the £500 allowance. Tax £0.
Fund yielding 5%: £500 of interest, exactly the allowance. Tax £0.
Fund yielding 6%: £600 of interest; £100 is above the allowance and taxed at 40%. Tax £40.
The allowance matters less as the amount grows. On £100,000 in a fund yielding 5%, the interest is £5,000; after the £500 allowance, £4,500 is taxed at 40%, which is £1,800 a year. Held inside an ISA or SIPP, none of it is taxed. The allowance covers all of a person’s savings interest, including bank and building society interest, so other savings reduce what is left for fund income.
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