How to invest in bond ETFs

The return you get when buying a bond and holding it to maturity is set at the outset: it’s the yield to maturity when you buy. Yet the market value of the bond between now and maturity can vary greatly as short-term and long-term interest rates change. Investing in a bond fund, which holds a portfolio of bonds of different maturities, makes this even more complicated since the value of the fund will depend on how the value of all the bonds it holds is shifting.

To see this in practice, consider an exchange-traded fund (ETF) such as iShares Core UK Gilts compared to a 10-year government bond. The ETF doesn’t just hold 10-year bonds, but its average maturity is roughly that – 11.5 years now – so it should be a fair comparison (although the exact composition of its portfolio and the way that this has changed over time will affect whether it’s really a good match).

If you bought a 10-year gilt in November 2014, you would have got a yield of around 2.1%, and so your annualised return would have been 2.1%. On the other hand, the 10-year total return from buying the ETF and holding it until now – including interest payments – is around -0.5% per year. The fall in the ETF’s market value is because it holds many bonds that were bought on much lower yields and are now worth less than they were because interest rates have risen.

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This works the other way as well. If you bought a 10-year gilt in July 2010, your yield was around 3.5%. If you had bought the ETF and held it until July 2020, when yields bottomed, you earned about 7.7% per year (because it held bonds bought at higher yields that had risen in value).

As you go through a full interest-rate cycle, and as bonds mature at face value and are replaced, this slowly works its way through, and the return should become much closer to the yield at which you bought.

The chart above, which shows the 10-year gilt yield against the market price of the ETF (ie, ignoring all interest payments) broadly indicates how this works. But that takes time.

Consider bond ETFs with a fixed maturity date

There is another kind of bond ETF that has been available in the US for a while and is finally starting to arrive here. These have a fixed maturity: they hold bonds maturing at around the same time, and when the entire portfolio matures, the ETF liquidates and makes a final payment. So the ETF will behave much more like owning an individual bond of a given maturity.

iShares now lists 38 of these in the UK (it calls them iBonds), covering US Treasuries maturing every December from 2025 to 2029, as well as some dollar and euro corporate bonds and – oddly – Italian government bonds. DWS has 12 euro corporate trackers in its Xtrackers range, Amundi has four euro government bond funds, and Invesco has 25 dollar and euro funds, branded as Bulletshares. The only ones that look very useful to me so far are the iShares Treasury iBonds and it would be good to have some longer maturities (the range in the US is much greater). Still, they could be a useful tool for fine-tuning the bond exposure in an ETF portfolio.

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