If you’re investing in bonds – either directly or through bond funds – it makes sense to consider holding them in an Isa. Here are five of the best Isas for bonds.
It used to be rare for individual investors to put money directly into bonds other than holding some UK government bonds (gilts) for income or a safe haven during turbulent times, perhaps.
That was partly because bonds trade in a very different way to shares. Whereas shares are listed on the stock exchange, corporate bonds are traded by arrangement between dealers and brokers (known as off-exchange or over-the-counter (OTC) trading). Trades in shares can be as small as you like even just a single share but corporate bonds change hands in blocks of £50,000, or more in some cases. That makes them too large for most individual investors.
However, that's been slowly changing since the London Stock Exchange launched a new market called the order book for retail bonds (ORB) five years ago. ORB was intended to change bond trading in two ways that make it easier for individual investors to buy bonds directly.
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First, ORB-listed bonds trade in much smaller blocks: the minimum size is £1,000 or less. Second, having bonds trade on-exchange improves transparency and liquidity. That means investors can be more confident they will be able to buy and sell when they want to, and they also have more assurance that the price they are being quoted is a fair market price.
Retail bonds remain a niche investment compared to shares, but ORB has grown strongly since its inception. There are now around 110 corporate bonds from companies in a wide range of sectors trading on ORB, as well as 70 different gilt issues.
Holding bonds in an Isa
If you're investing in bonds either directly or through bond funds it makes sense to consider holding them in an Isa. That's because unlike dividends from shares, which are subject to favourable income-tax rules, the interest from bonds is taxed at normal income-tax rates.
So if you're a basic-rate taxpayer, you'd pay no tax on dividends, but 20% on your bond coupons. A higher-rate taxpayer would pay 25% and 40% respectively, while a top-rate taxpayer would pay 30.56% and 45%. That means the income-tax break on bonds is greater than that for shares, so if you need to prioritise which part of your portfolio you should use your Isa allowance for, bonds will often be the best choice.
Most UK stockbrokers now offer bond trading services, but these are frequently telephone-only. As such, they are usually charged at higher rates than online trades in stocks. Many bond investors say that Selftrade offers the best bond-trading service, in terms of the number of issues available for online dealing.
Selftrade was recently taken over after being closed to new customers for almost two years and its new owner, Equiniti, is promising further improvements. However, because it's unclear what Selftrade's charges are likely to be in the future under Equiniti's ownership, investors may want to wait to see how these changes pan out before deciding whether the firm suits their needs. In the meantime, we've listed details of five other brokers in the box below.
Bonds are riskier than savings
If you're contemplating investing in bonds for the first time, it is important to understand that they are not the same as putting money into a savings account. The value of bonds can rise and fall, meaning that if you need to sell, you may get back less than you invested.
What's more, companies may default on their bonds ie, not pay all the interest or repay all the capital that they owe. So far, no company has defaulted on an ORB issue. However, with a growing number of bonds listed on the market some riskier than others it's almost certain that one will do so sooner or later. If that happened, you would not be protected by any compensation scheme, as you would be with a savings account. So you need to make sure that you understand the risks before investing.
0.45% of portfolio value per year (capped at £45). £11.95 per trade online. 1% (min £20, max £50) by telephone
Hargreaves Lansdown is by no means the cheapest provider, but it offers a number of popular corporate bonds for online dealing. So if online availability is important to you, the firm may be worth considering.
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Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.
Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.
He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.
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