Bond funds are among the most widely held investment vehicles in the world. They sit inside pensions, ISAs, and investment portfolios of all kinds. Yet many investors who hold them have only a vague understanding of how they actually work — and specifically why bond funds can lose money in ways that individual bonds, held to maturity, do not.
This matters practically. Understanding what you own helps you react rationally when markets move, rather than being surprised.
What a bond fund is
A bond fund is a pooled investment vehicle — either a unit trust, OEIC, or exchange-traded fund (ETF) — that holds a portfolio of bonds rather than a single bond.
When you invest in a bond fund, you buy units in the fund. Each unit represents a proportionate share of all the bonds the fund holds. Your return comes from two sources: the income distributed by the fund (from the coupon payments the fund receives on its bonds) and any change in the price of your units.
The fund is managed by a fund manager (or, in the case of passive ETFs, by a rules-based process tracking an index). The manager buys and sells bonds according to the fund's objective and mandate.
The fundamental difference from holding an individual bond
When you buy an individual bond and hold it to maturity, you know two things with certainty (assuming the issuer does not default): the stream of coupon payments you will receive, and the principal amount you will get back at maturity.
A bond fund does not work this way.
Bond funds have no fixed maturity date. The fund manager buys and sells bonds continuously, rolling out of bonds as they mature and buying new ones. The fund never reaches maturity — it is a perpetual vehicle.
This means:
- Bond fund investors cannot "hold to maturity" to avoid capital losses. If interest rates rise and bond prices fall, the NAV of the fund falls, and your units are worth less. You have a real capital loss if you sell.
- The fund's duration (interest rate sensitivity) is managed to stay within a target range, not at a fixed level. A "global government bond fund" might target a duration of 7–9 years at all times, replacing maturing bonds with new ones.
This is why bond funds fell sharply in 2022 even though the underlying bonds — had they been held individually to maturity — would have returned their principal. The fund structure forced mark-to-market accounting on every bond, every day.
How NAV is calculated
A bond fund's Net Asset Value (NAV) is the market value of all the bonds in the portfolio, minus any liabilities, divided by the number of units outstanding.
The market value of each bond is calculated daily based on observed market prices (or, for less liquid bonds, model-based prices). When interest rates rise, market prices fall, and the NAV falls. When rates fall, market prices rise, and the NAV rises.
NAV also rises over time as coupons accrue — the income the bonds earn each day adds to the value before it is distributed.
Types of bond funds
Government bond funds: Invest in bonds issued by national governments (UK gilts, US Treasuries, German Bunds, etc.). These are the most interest-rate sensitive category — the credit risk is negligible for highly rated issuers, so duration dominates.
Corporate bond funds (investment grade): Invest in bonds issued by companies with high credit ratings (typically BBB- and above). These carry both interest rate risk and credit risk — the additional yield compensates for the risk of default.
High yield bond funds: Invest in bonds issued by lower-rated companies ("junk bonds"). Higher potential income, but significantly more credit risk and behaviour that correlates with equities in risk-off environments.
Emerging market bond funds: Bonds from developing economies, typically offering higher yields than developed market equivalents. May be denominated in USD (hard currency) or local emerging market currencies — the distinction is important, as local currency funds carry additional FX risk.
Global bond funds: Invest across multiple countries and types, typically hedged back to a base currency for currency-hedged share classes.
Short-dated bond funds: Target the shorter end of the yield curve (1–3 years), with correspondingly lower duration and interest rate sensitivity. Often used as cash alternatives or as a lower-risk allocation within fixed income.
Currency hedged vs unhedged share classes
Many international bond funds offer both hedged and unhedged share classes.
An unhedged share class gives you direct exposure to the bonds' returns in their local currencies. If you buy a USD-denominated bond fund as a GBP investor, your returns in sterling will be affected by USD/GBP exchange rate movements — for better or worse.
A currency hedged share class uses forward contracts to neutralise the impact of currency movements between the fund's currency and your base currency. You receive approximately the bond's return as if it were in your base currency.
Hedging costs money — typically a small drag on returns — but it removes one variable from the equation. For a core bond allocation, most GBP-based investors prefer the hedged share class of an international bond fund, as currency movements can easily overwhelm bond returns over short periods.
Bond fund yield: distribution yield vs yield to maturity
Bond fund literature cites yields in different ways. Two important distinctions:
Distribution yield (also called "historic yield" or "trailing yield"): the income the fund distributed over the last 12 months, expressed as a percentage of the current price. This is backward-looking and may not reflect current conditions.
Yield to maturity (YTM) (or "gross redemption yield"): a forward-looking measure of the total annualised return you would receive if you held the fund and all its bonds ran to maturity at current prices. This is the more meaningful metric for assessing value.
In a rising rate environment, the distribution yield of an existing bond fund may look attractive even as the YTM of new bonds being issued is higher — meaning the fund's income stream may lag current market yields for a period.
Active vs passive: does it matter for bonds?
The active vs passive debate applies to bonds as well as equities.
Passive bond index funds offer low costs and broad diversification. However, bond indices have a structural quirk: they are weighted by debt issuance, meaning the most indebted borrowers have the largest weight. In government bond indices, the countries with the most outstanding debt are most heavily represented.
Active bond managers can add value through credit selection, yield curve positioning, and tactical duration management — and the evidence for active outperformance is somewhat stronger in less efficient bond markets (high yield, emerging market) than in liquid government bond markets. But active management costs more, and the average active bond manager does not consistently outperform after fees.
For most investors, a blend makes sense: low-cost passive for core developed market government bonds, and selective active management for specialist segments where genuine skill can add value.
This article is for general information only and does not constitute investment advice. Bond funds can fall as well as rise in value. Contact us to discuss how fixed income allocations fit within your investment portfolio.
This article is for general information only and does not constitute financial, legal or tax advice. Rules, prices and regulations change; verify current requirements with a qualified adviser before acting.