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Onshore bonds: still going strong

Onshore bonds: still going strong

Onshore bonds are a once-beloved product, now seemingly ignored by many advisers in favour of the supposedly more glamorous international investment bonds or collective investments.

Yes, most onshore bonds don’t have ‘open architecture’ and none deliver exemption from tax on capital gains at fund level or the ability for investors to use their annual exemption from CGT – but does that mean they deserve being dismissed out of hand when it comes to determining the structure of an investment portfolio?

Of course, an ISA, pensions and other tax-advantaged investments should be first port of call – so this article is about clients who have already taken advantage of those products.

The tax-free onshore bond

It is an established fact of the tax legislation that companies get indexation relief on capital gains and it is linked to the RPI (rather than CPI).

This also applies to UK life insurance companies – but not to international life companies or collective investment providers. These, of course, enjoy complete freedom from tax on realised gains at fund level.

But if an onshore bond fund manager disposed of an equity holding in September 2017 having held it for five years, indexation relief of 12.7% is available (source: Office for National Statistics). 

In addition to the dividends received, which are not taxable, if the equity gain had been 12.6% say, the onshore bond return would have been tax-free at fund level as well!

And unlike an ISA or international bond, it would also have a basic rate tax credit for all the underlying growth.

But so much for theory...

...what happened in practice?

So far, we have just based our article on assumptions and expectations. Let’s now look at past performance.

Here’s an historic chart of an OEIC and the same fund as an onshore bond fund link.

There’s not much difference is there? 

This quite remarkable similarity illustrates the effect of fund charges and taxation on the investment return.

We would also suggest that for a basic rate taxpayer, with an annual exemption covering the gain, there is no tax at the end for either a collective investment or an onshore bond.

Better net returns than collective investments

As ever, to demonstrate that an onshore bond can compete on tax grounds with a collective investment, I have to make various assumptions.

These include the split between equities and bond funds, rates of return, the investment term, availability of CGT exemption and other factors. And to be entirely fair, I am using the independent Technical Connection Wrapper Selector to calculate the results.

This ignores charges so, in effect, it assumes charge "neutrality" between the wrappers. The purpose of this tool is to accurately show the tax drag on various investments. In this example, for a basic rate taxpayer, the returns are:

So in this example the onshore bond produces a marginally better return than the collective fund, even taking into account the dividend allowance and capital gains tax annual exempt amount.