Why invest in BNDX's when 30 day SEC yield = 0.76%.

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Ketawa
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Ketawa »

I haven't been following this discussion very closely, but the idea that the SEC yield does not include a hedge return is interesting to me. Why should the hedge return be expected to be 0%? I could see it being expected to be 0% over the very long term, but not under current circumstances.

Code: Select all

                 % of BNDX  10 Year Yield
Japan                21.9%       0.41%
France               11.6%       1.05%
Germany               9.8%       0.74%
United Kingdom        9.1%       2.03%
Italy                 8.3%       1.93%
Canada                5.5%       1.54%
Spain                 5.4%       1.98%
Netherlands           3.4%       0.92%

Total                75.0%
Weighted Average                 0.85%

USA                              2.35%
10 year bond yields are from here: http://www.bloomberg.com/markets/rates-bonds

Yields for 10 year bonds from the countries with the top 75% of holdings in BNDX are all lower than for 10 year Treasuries. To some extent, differences in yields for governments that have similar credit quality should reflect inflation expectations, i.e. the USD is expected to weaken against the yen, euro, Canadian dollar, and pound sterling.

You should expect to make similar returns in the unhedged foreign bonds when they are converted to USD. However, there can be some wild swings associated with currency movements. You don't want that in bonds, so you pay a small amount to hedge the difference upfront and remove the future volatility. You should still expect to make some from the hedge return when the foreign currencies appreciate relative to the USD, just not all of what you might in an unhedged fund.

I don't understand why hedging should remove all the potential upside from currencies appreciating. Maybe someone can explain it in simple terms?
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

Thebigc wrote:Well according to Vanguard, http://www.vanguard.com/pdf/icrifi.pdf
...
Thebigc, in all the quotes you copied, there seem to be an implicit assumption that currency-hedging derivatives are risk-free. We know that this is not true; there's a note about it in the prospectus. The problem that I and some others have is we don't know how to quantify this risk. We suspect that it is not likely to show up during our lifetime, but if it was to show, what's the damage it could do?
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Thebigc »

ogd wrote:
jalbert wrote:
The structure doesn't allay my fears that much. What if the USD rallies, Toyota can't pay, and as a result of many Toyotas the "organization implementing the hedge" can't pay Vanguard
These are fair value hedges not cash flow hedges so the counterparties own the assets being hedged. There won't be many Toyotas and 1 Vanguard because the hedging bank only implements thd hedge if they are matching counterparties each owning aasets in the currencies the other wants to hedge to.
...The currency hedging reduces risk, rather than enhances it.
There could be many Vanguards as well; that's not the point. The point is that the hedge middleman could be overwhelmed by multiple failures to pay (or indeed its troubles in unrelated areas), leaving it unable to cover a potential Toyota shortfall. The same way that insured bonds are risk-less until the day AIG croaks.

I can accept that a hedge with Toyota on the other side can be made safer than a plain Toyota bond. But it's hard to accept that it's zero risk, as if the Japanese govt owed me USD directly (which btw would still leave open the possibility that Japan can't pay USD even if they can pay all the yen they owe to anybody). The hedging reduces risk in USD as compared to not having it, but it does not make it identical to the (IMHO zero) risk in yen. So I can trust Japan's credit in yen while still being suspicious of a (Japan + hedge) instrument.
I thought most of the bonds in the Total Int, were government bonds at least that is what Vanguard says, in that case wouldn't the middle man be said government so not really a middleman? While the country of Japan or any other country could see debt failure, so can the US. And while Japan could see failure, does that mean France will? You know more about bonds then I do, but I can't really find these middlemen who are doing all the foriegn hedged government bond currency exchanges? I thought it was the government of said countries. Vanguard uses 1 month forward hedged, I have looked but I can't find anything that answers your question. There is this

https://personal.vanguard.com/us/insigh ... dex-062013

But it does not answer what happens if someone can't pay there debt. I would guess the same thing that happens when anyone can't pay there debt. I would "hedge" a guess that Vanguard follows there traditional very conservative approach to buying any bonds, and there ideal of stay the course. No matter what you do you find some risk, intresting enough while you feel international bonds are a higher risk, Vanguard seems to think they are less volatile in the long term and I linked there report on that in my first post. Though they say they can be more volatile, but less and it depends and all that. Less yield and longer durration bothers me more than what risk this fund may have as I don't see it as being much more risky than US backed. A little more yes, but not a lot more. I don't really know if there is an answer to the hypothetical question that is any different from what happens if there is a government credit default. In which case the word "depends" comes to mind. The amount of variables is really impossible to guess at. What happens if the US defaults on their government bonds? Is it actually less likely to happen? Maybe Germany defaults 20 years from now and Greece gives them a loan who knows.

My only answer is that I hope Vanguard has done what they have always done and tried to keep credit risk down. I mean even in there risky Bond funds they are pretty much less risky than everyone else. They rate the risk as 2 which is the same ballpark as Total US, do you think they are lying to you? I think there is a little more risk not a lot more. I guess you have to trust that they know what they are doing, why else would you invest in there funds if you did not trust them? Nothing wrong with questioning it, and it's a good queston, I am just not sure it is an accurate portrayal of what is actually happening or what the actual risk is. It seems you feel this is a rather large risk, with these middle men defaulting and the bonds being risky.

I can't say the BNDX will ever be a world beater, but it isn't meant to do that. It is suppose to be low risk, low volatility and pretty much no reward in the short term but higher rewards in the long term. Given the charts in the previous report it would seem it is very low volatility and pretty good diversification. But nothing predicts the future either so? I said in a previous post this is above my pay grade, I hope you get an answer to your question.
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Ketawa
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Ketawa »

Here's another example. Consider two countries with similar credit quality and different currencies.

Country A has 2% inflation expectations, 1% real return expectations -> 3% yield on nominal bonds
Country B has 4% inflation expectations, 1% real return expectations -> 5% yield on nominal bonds

Here is how hedging should work:

It doesn't matter whether I invest in Country A's or Country B's bonds in terms of my expected real return. However, I do want to remove currency fluctuations from the bond returns. Vanguard's own words are that currency hedging is very cheap. It shouldn't cost nearly the entire 2% difference in inflation expectations.

So a mutual fund in Country A that invests in Country B's bonds should have an expected return of approximately:
(5% yield in Country B's bonds) + (-2% hedge return) - (cost of hedging) = slightly under 3% in Country A's currency

A mutual fund in Country B that invests in Country A's bonds should have an expected return of approximately:
(3% yield in Country A's bonds) + (2% hedge return) - (cost of hedging ) = slightly under 5% in Country B's currency

If I had a mutual fund in Country A that invested in Country B's bonds, it seems like the SEC yield of this mutual fund would be reported as 5%. If I took the general premise of this thread, why would I ever invest in my own country's bonds? (This is the opposite side of argument being made in the OP.) However, this doesn't represent what is actually happening. I don't think the hedge return is 0% over the near term, so I think looking at the SEC yield is pretty much useless.

Is there something wrong with this analysis?
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by ogd »

Thebigc wrote: I thought most of the bonds in the Total Int, were government bonds at least that is what Vanguard says, in that case wouldn't the middle man be said government so not really a middleman? While the country of Japan or any other country could see debt failure, so can the US. And while Japan could see failure, does that mean France will? You know more about bonds then I do, but I can't really find these middlemen who are doing all the foriegn hedged government bond currency exchanges? I thought it was the government of said countries.
No, this is about the currency hedge rather than the credit risk. Japan pays yen. I get USD. Someone has to cover the difference between yen and USD. It's not the Japanese government; nevermind the fact that I wouldn't be nearly as confident about the ability of Japan to pay USD as I am about its ability to pay yen, or the US' ability to pay USD. The troubling fact is that I'm expected to accept yields as low or lower I can get from the USD issuer, from this combination of parties.
Ketawa wrote:You should expect to make similar returns in the unhedged foreign bonds when they are converted to USD. However, there can be some wild swings associated with currency movements. You don't want that in bonds, so you pay a small amount to hedge the difference upfront and remove the future volatility. You should still expect to make some from the hedge return when the foreign currencies appreciate relative to the USD, just not all of what you might in an unhedged fund.
I think the answer to this conundrum is that the hedge return is something you get on an ongoing basis while the yield differential exists, rather than an expected return "when/if the foreign currency appreciates". The latter would be what you get with unhedged bonds.

I freely state my ignorance as to the effect of differing durations between the hedges and the bonds. Perhaps it is precisely what you say, to transfer some return from "ongoing" to "expected currency movement".
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Kevin M »

abuss368 wrote:We are all learning about this asset class and the nature of the derivative (which I do not understand completely) is causing me to not invest in the fund at this time.
To be fair, Vanguard's domestic bond funds also use derivatives, and I don't understand them completely either.

Total Bond fund had some very strange performance a few years ago (large drop then large increase over about 2-3 months), which we discussed in one of the threads on the relationship between SEC yield and price for bond funds. I asked Vanguard about this, and was told that it had to do with the derivatives they were using.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Kevin M »

Ketawa wrote:Why should the hedge return be expected to be 0%?
Not working hard enough to understand it myself, but one reason is that Vanguard said so--at least about a year ago they did--as I quoted in this post earlier in the thread.

So on the one hand they say that one should account for hedge return (which can be positive or negative) in addition to yield to determine expected value, and on the other hand they say the expected hedge return currently is about zero. If the latter is true, then why isn't it yield currently as good an expected return predictor for an international bond fund as for a domestic bond fund?

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

Kevin M wrote:
abuss368 wrote:We are all learning about this asset class and the nature of the derivative (which I do not understand completely) is causing me to not invest in the fund at this time.
To be fair, Vanguard's domestic bond funds also use derivatives, and I don't understand them completely either.

Total Bond fund had some very strange performance a few years ago (large drop then large increase over about 2-3 months), which we discussed in one of the threads on the relationship between SEC yield and price for bond funds. I asked Vanguard about this, and was told that it had to do with the derivatives they were using.

Kevin
Yes, all Vanguard's domestic bond and stock index funds occasionally use derivatives to reduce market impact (and side-step front-runners), but in considerably lower proportion than the ongoing use of derivatives in currency-hedged funds.

In Canada, there is some history of currency hedging in stock index ETFs. The following article is quite revealing about another risk of currency hedges, that of failing to deliver an effective hedge!
https://www.pwlcapital.com/en/Advisor/T ... g-Decision
From January 2006 to December 2011, the U.S. dollar depreciated against the Canadian dollar by 12.8% (or 2.3% annualized). Over this same period, the S&P 500 Index (in USD) returned 2.3% annualized, while the S&P 500 Index (in CAD) returned -0.1%.

In theory, this time period would have been ideal for investing in U.S. currency-hedged ETFs. If we had made the decision six years ago to purchase the iShares S&P 500 Index Fund (CAD-Hedged) (XSP), we would have expected to see an annualized return before fees of 2.3%, similar to the returns of the S&P 500 Index (in USD). If we had instead decided to remain unhedged and purchased the iShares S&P 500 Index Fund (IVV), we would have expected a return before fees of -0.1%. [...]

Contrary to what we had expected, XSP did not outperform an unhedged strategy – it actually lagged the S&P 500 Index (in USD) by 2.4% annually. Although a portion of this underperformance could be attributed to management fees and withholding taxes, approximately 2.0% of the tracking error is still unaccounted for. If this 2.0% tracking error is an implicit cost of insurance for hedging away currency fluctuations between the U.S. dollar and the Canadian dollar, the additional drag may make it highly unlikely that a currency-hedged U.S. ETF will outperform an unhedged U.S. ETF over the long term.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by lack_ey »

Kevin M wrote:
Ketawa wrote:Why should the hedge return be expected to be 0%?
Not working hard enough to understand it myself, but one reason is that Vanguard said so--at least about a year ago they did--as I quoted in this post earlier in the thread.

So on the one hand they say that one should account for hedge return (which can be positive or negative) in addition to yield to determine expected value, and on the other hand they say the expected hedge return currently is about zero. If the latter is true, then why isn't it yield currently as good an expected return predictor for an international bond fund as for a domestic bond fund?

Kevin
If I understand it correctly (ha ha, like I understand this :wink:), the low historical predictability of returns from yield is based on periods in which short-term rates everywhere weren't low. Vanguard likes to talk about strategic allocations and the long term. They're giving long-term advice while occasionally making points about the present, like current hedge return being about zero.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Thebigc »

ogd wrote:
Thebigc wrote: I thought most of the bonds in the Total Int, were government bonds at least that is what Vanguard says, in that case wouldn't the middle man be said government so not really a middleman? While the country of Japan or any other country could see debt failure, so can the US. And while Japan could see failure, does that mean France will? You know more about bonds then I do, but I can't really find these middlemen who are doing all the foriegn hedged government bond currency exchanges? I thought it was the government of said countries.
No, this is about the currency hedge rather than the credit risk. Japan pays yen. I get USD. Someone has to cover the difference between yen and USD. It's not the Japanese government; nevermind the fact that I wouldn't be nearly as confident about the ability of Japan to pay USD as I am about its ability to pay yen, or the US' ability to pay USD. The troubling fact is that I'm expected to accept yields as low or lower I can get from the USD issuer, from this combination of parties.
Ketawa wrote:You should expect to make similar returns in the unhedged foreign bonds when they are converted to USD. However, there can be some wild swings associated with currency movements. You don't want that in bonds, so you pay a small amount to hedge the difference upfront and remove the future volatility. You should still expect to make some from the hedge return when the foreign currencies appreciate relative to the USD, just not all of what you might in an unhedged fund.
I think the answer to this conundrum is that the hedge return is something you get on an ongoing basis while the yield differential exists, rather than an expected return "when/if the foreign currency appreciates". The latter would be what you get with unhedged bonds.

I freely state my ignorance as to the effect of differing durations between the hedges and the bonds. Perhaps it is precisely what you say, to transfer some return from "ongoing" to "expected currency movement".
Yeah this seems to be right, from what I understand hedging is done to mitigate the risk of fluctuations on foriegn currency, and you pay for it. Rick Ferri mentioned this as well, and said it was hard to pin down the actual cost as it does not show up in the ER. Consider it a hidden cost that is hard to track.


"Currency hedging isn't free, and it's "a cost not shown in the expense ratio," says Rick Ferri, founder of investment-management firm Portfolio Solutions. While the exact cost of these hedges can be hard to pin down, the additional expense makes it all the more important to minimize other fees. Consider new low-cost foreign-bond offerings such as the exchange-traded fund version of the Vanguard fund (BNDX)."

It is actually considered much safer for a retiree exposed to international bonds to have said bonds hedged. That does not actually mean it is a good idea to own them as you can hedge wrong. Vanguard uses 1 month forward contracts agreed upon by the two parties involved. This assigns a fixed rate over that period of time for an agreed upon currency swap and thus removes the currency volatility risk. The cost for the hedge according to Vanguard is about .20% on average. This cost is not depicted in the ER, or the yeild. You can gain money or lose money on the hedge, and this cost or boon is also not depicted in the funds Yield.

Vanguard does answer the question about what to make of this funds Yeied though. Well it answers the question of what to make of hedged bond fund yields really. Your're in luck it's on the very first page. Basically the yeild of hedged bond funds does not represent the return. As for currency exchange

https://personal.vanguard.com/pdf/ISGHC.pdf

As for who handles the exchange, the FOREX is the largest most liquid market in the world and trades nearly 2 trillion daily, banks, usually large banks handle the exchanges between currencies. Depending on the contract, and many other veriables within. But basically you have a giant decentralized entity made up of the major financial institutions of the world who decide on the value of of a given currency on a given day. They basically handle all of the exchanges. So that is the middle man usually, giant international banks. Not all banks take part in the Forex as it is known, just the really big ones.

That is all I could find. There are tons of articles on it, if you want a middleman look for the mystery men known as the dealers. So whoever you purchased a bond from the hedge is in the contract and the banks handle the exchange. You pay for the hedge, and the hedge can make or lose you money. Though I am guessing with bonds they don't take large risks on either side, and are just looking for a way to protect the bond from currency risk so it can hold a stable value.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Thebigc »

"Investors should thus avoid making allocation decisions based on yield differentials between a domestic and international investment and, rather, should focus on the potential for a diversification benefit."

This is why they want you to buy it.

And this is what they want you to do after you buy it.


Earlier research has established that hedging an international bond portfolio is an important way to reduce the risk of currency movements. However, hedging introduces an additional return stream that
a domestic bond investment does not have, namely
a hedge return, which can be measured and estimated over the short term. This paper’s discussion has highlighted four observations about the return impact of hedging:
• Hedging does not merely produce an investment without currency return; rather, it represents an alternative return stream to replace currency return.
• Over the short term, the contribution to return from hedging has tended to be much less than the contribution to return from foreign currency that is unhedged.
• The relative volatility of the hedge return has been small compared with the price movement of international bonds, meaning that the diversification benefits of international bonds should not be weakened by hedging activity.
• Over the medium to long term, hedging has the effect of adjusting for differences in market fundamentals, mainly differences in interest rates and inflation. This has tended to equalize returns across markets and has detracted from the usefulness of yield to maturity as a long-term return predictor.
Based on these observations, Vanguard urges investors to be aware of the impact that hedging can have on their international bond portfolios. It is likely that a reduced focus on the yield of a hedged international portfolio is warranted. Also of note: Comparisons between yields across domestic and international markets are not valid, and we discourage the use of yield differentials in setting bond allocations. Rather, investors should focus on the diversification benefits that international bonds can bring to a balanced, low-cost portfolio.

So in short you don't have a great metric like domestic bond yields to project future performance, you don't know how much your fund actually costs, or what it can earn. International hedged bonds have similar performance to domestic bonds over the long term, hedging can act as an extra sourse of revenue, but can also act as a negative. So since we can't tell you what the fund will do, we have no solid metric for performance, and it does contain extra risk as well as extra reward, ignore the yield, ignore the hidden fees because both are wrong and just focus on diversification and hope we get this right.

In hindsight the risk level of 2 seems a bit misleading, there are no good metrics to measure or project performance, it has hidden fees, we may be taking a gamble with hedging, so basically just ignore everything written down and know that your heavily diversified portfolio is now more diversified not because of international bonds, but because of hedging which adds a new demension to your funds.

PS. We have no way of measuring this thing so we are calling the risk level a 2 because we don't know if the hedging will workout, and we can't give you an accurate yield, nor can we show you the hidden expense of hedging. :beer
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

Thebigc wrote: It is actually considered much safer for a retiree exposed to international bonds to have said bonds hedged. That does not actually mean it is a good idea to own them as you can hedge wrong. Vanguard uses 1 month forward contracts agreed upon by the two parties involved. This assigns a fixed rate over that period of time for an agreed upon currency swap and thus removes the currency volatility risk. The cost for the hedge according to Vanguard is about .20% on average. This cost is not depicted in the ER, or the yeild. You can gain money or lose money on the hedge, and this cost or boon is also not depicted in the funds Yield.
I suspect that this is only the direct cost, e.g. the cost of hedging instruments. It certainly does not include the hedging tracking error due to the 1-month delay to reset the hedge.

As I've cited in my previous post, the total currency hedging cost (tracking error) has been of an annualized 2% for a major S&P 500 index ETF hedged to the Canadian dollar, between 2006 and 2011. This is significant. All this during a time when, as far as I know, the ETF didn't have to deal with any default on its hedges.

Maybe such tracking errors are lower in hedged bonds funds due to lower volatility, but an important problem is that this tracking error cannot be observed by comparing a fund to its index; the "hedged S&P 500" index included most of the tracking error! (In other words, XSP tracked its index pretty well, even though it trailed the US S&P 500 by 2%). One has to manually look at the S&P return in US dollars, then look at CAD/US currency exchange rates at buy and sell times to construct a proper benchmark and reveal the huge tracking error! Doing the same calculations for a hedged bond fund invested in bonds of many countries is beyond the reach of most investors. So, one better trust the "hedged" benchmark not to hide a big "effective" tracking error when investing in the fund.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

Thebigc wrote:PS. We have no way of measuring this thing so we are calling the risk level a 2 because we don't know if the hedging will workout, and we can't give you an accurate yield, nor can we show you the hidden expense of hedging. :beer
+1 :thumbsup

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Thebigc »

longinvest wrote:
Thebigc wrote: It is actually considered much safer for a retiree exposed to international bonds to have said bonds hedged. That does not actually mean it is a good idea to own them as you can hedge wrong. Vanguard uses 1 month forward contracts agreed upon by the two parties involved. This assigns a fixed rate over that period of time for an agreed upon currency swap and thus removes the currency volatility risk. The cost for the hedge according to Vanguard is about .20% on average. This cost is not depicted in the ER, or the yeild. You can gain money or lose money on the hedge, and this cost or boon is also not depicted in the funds Yield.
I suspect that this is only the direct cost, e.g. the cost of hedging instruments. It certainly does not include the hedging tracking error due to the 1-month delay to reset the hedge.

As I've cited in my previous post, the total currency hedging cost (tracking error) has been of an annualized 2% for a major S&P 500 index ETF hedged to the Canadian dollar, between 2006 and 2011. This is significant. All this during a time when, as far as I know, the ETF didn't have to deal with any default on its hedges.

Maybe such tracking errors are lower in hedged bonds funds due to lower volatility, but an important problem is that this tracking error cannot be observed by comparing a fund to its index; the "hedged S&P 500" index included most of the tracking error! (In other words, XSP tracked its index pretty well, even though it trailed the US S&P 500 by 2%). One has to manually look at the S&P return in US dollars, then look at CAD/US currency exchange rates at buy and sell times to construct a proper benchmark and reveal the huge tracking error! Doing the same calculations for a hedged bond fund invested in bonds of many countries is beyond the reach of most investors. So, one better trust the "hedged" benchmark not to hide a big "effective" tracking error when investing in the fund.
Moringstar has cited minimal tracking errors with BNDX and only a minor .05% hedge drag on the fund. The hidden fee does not help and I can't say I am a fan of the debt to GDP ratio the fund favors explaing why Japan is the largest holding because of the higher debt. The fund does offer good diversification and low volatility beating out it peers, but the problem as I see it and as I mentioned before is the duration. Vanguard is stretching out the duration in order to find higher yields, and thus taking on more risk. And while the credit risk is not bad, it's not great either. If I do not have a reliable yield to track and what yield I do have is dropping even with increased duration do to historically low intrest rates what reason do I have to purchase a fund that is more expensive than it looks, and has increasing credit risk and duration with falling yeilds. Hedge or no hedge it is a bad play in the short term and possibly the intermidiate term.

I have the same concern with US bonds but at least there I have lower credit risk, higher yields and no hidden fees like a hedge fee, it's also has a reliable metric to follow the yield because it is not hedged. I also can expect an increase in intrest rates which will eventually pay off in the itermediate term.

I am not saying you are wrong it's just not the biggest problem for me compared to falling already low yields, increased credit risk and duration. Long term I am less concerned with international, for me it's the short to intermidiate term that bothers me. Wy push a fund that is nose diving? I don't get the logic here, and I find it very curious they want people in on this and are increasing there holdings. I also don't get why they are putting it in Target Retirment, it's pretty much what a retiree would want to avoid, long term if intrest rates go up in these countries you will get higher yield and can by lower credit risk. But there is really no reason to take on the current added risk for such a low yeild when you can pretty much get it in an ultra secure short term bond fund. I am ok with the bond currency hedging because it generally does not have a huge impact on bond funds, it's not a new idea and has been going on for a long time. I am ok with Vanguard doing that and they seem good at doing. Sure it is different than US bonds and adds some minor risk, but the increased credit risk, duration and yield should be enough for anyone to stay clear of it for now. It'ss not a bad fund, it's just a bad fund right now. Long term it could become great diversification, a low credit risk and have decent yield if intrest rates go up in a lot of countries. But when is that going to happen? It may happen on it's own, it may happen if the US does it and you get global contagion from it causing other rates to rise. Inflation could do it, but I have know idea when that will happen or if raising our rates would cause that in the global market.

Vanguard must want people to own this fund for a reason, I don't know what they think they see coming but I can't imagine they think hey you will lose money but you will be diversified. But when they take on more credit risk and extend duration to try to slow a falling yield and then say I should own this I get a little perplexed. Diversification = good, and the other stuff is bad so I am in the confused with the mixed signals camp right now.

From what I have read they have actually run the fund well, it's just intrest rates and credit risk around the world right now are bad. I am not sure why Vanguard wants people in it now, but I understand in the future it may be a pretty good fund.

So just looked at my VTABX and it was up again today. Sure is doing a lot better than total international stock which seems like another bad call on their part, that is another fund of theirs that is not all that great at least not now or since it's inception. But they are pushing international like a lot of other people. If there is one fund I hate it's not BNDX, it's VTIAX, I hate it, if it was crossing the street I would run it over. People seem to be hoping that Europe has a recovery like the US, but I think they will screw it up, I mean they already have screwed it up, but I am guessing they will screw it up more.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

Thebigc wrote: Moringstar has cited minimal tracking errors with BNDX and only a minor .05% hedge drag on the fund.
I tried to explain that this can be quite misleading. BNDX follows a "hedged index", which means that the index tracks the performance of a hypothetical portfolio that buys both (1) foreign bonds and (2) 1-month forward currency contracts. As a result, any anticipated gain/loss due to the use of derivatives is included in the index, hiding potentially significant tracking errors relative to a proper index.

In my opinion, a proper index would look at the value of foreign bonds today, in local currencies. In one month, the index would do the same (including the value of reinvested coupons, of course). The difference would determine the monthly growth of the index.

I am sure that most investors think that BNDX is using what I call a proper index, but it is not!

Maybe that's what one wants; maybe one doesn't want to experience Japan's local bond returns in US dollars, but the gains and losses due to derivative instruments are far from transparent.

Do you know whether it easy is or not to front-run currency contracts? Unlike bonds which can be held for decades, these contracts have to be renewed monthly. There is a lot of opaqueness in BNDX on top of difficult to quantify derivative risks.

I don't doubt that BNDX behaves as expected from a broad bond index fund. I am sure that Vanguard made in depth studies before proposing this fund to investors. All I am expressing is my personal inability to fully appreciate the risks embedded in hedged foreign bond funds.

In other words, currency hedging adds a whole layer of complexity to a fund. I do not understand this layer well enough to feel at ease investing in it.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by abuss368 »

Kevin M wrote:
abuss368 wrote:We are all learning about this asset class and the nature of the derivative (which I do not understand completely) is causing me to not invest in the fund at this time.
To be fair, Vanguard's domestic bond funds also use derivatives, and I don't understand them completely either.

Total Bond fund had some very strange performance a few years ago (large drop then large increase over about 2-3 months), which we discussed in one of the threads on the relationship between SEC yield and price for bond funds. I asked Vanguard about this, and was told that it had to do with the derivatives they were using.

Kevin
Hi Kevin,

I went back and reviewed the Notes to the Financial Statements of the annual report for Vanguard Total Bond Index Fund. There is a small note but it appears that any derivatives utilized are far different from Vanguard Total International Bond Index Fund.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

An interesting blog entry from Vanguard Canada:

https://www.vanguardcanada.ca/individua ... tivity.htm
Comparing U.S. Treasury yields to, say, German bund yields is like comparing apples to oranges—both are a round fruit, but there are important differences between the two. A yield on a foreign bond always carries with it the currency effects accruing to the home-based investor. This is where we need to bring in the financial math: The currency effect should offset the yield differential between the domestic and the international bond. [...]

Where does this currency return come from? Basically, from the currency hedging. Technically, the hedge return arises from the current and expected short-term interest rates (1- or 3-month yields, depending on the hedge contract). When you add these hedge returns to each bund yield, the resulting expected return is almost exactly equal to the corresponding U.S. Treasury yield.

While expected currency returns depend on what markets are pricing in ex ante, that relationship may not hold ex post since currency and bond markets fluctuate, and no one can predict exactly how they may drift from the ex ante equilibrium. These duration and currency risks should be similar for both domestic and international bonds, and they could go either way, positive or negative, which is why I believe that global diversification in an investor's bond portfolio is important.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Ketawa »

longinvest wrote:An interesting blog entry from Vanguard Canada:

https://www.vanguardcanada.ca/individua ... tivity.htm
Comparing U.S. Treasury yields to, say, German bund yields is like comparing apples to oranges—both are a round fruit, but there are important differences between the two. A yield on a foreign bond always carries with it the currency effects accruing to the home-based investor. This is where we need to bring in the financial math: The currency effect should offset the yield differential between the domestic and the international bond. [...]

Where does this currency return come from? Basically, from the currency hedging. Technically, the hedge return arises from the current and expected short-term interest rates (1- or 3-month yields, depending on the hedge contract). When you add these hedge returns to each bund yield, the resulting expected return is almost exactly equal to the corresponding U.S. Treasury yield.

While expected currency returns depend on what markets are pricing in ex ante, that relationship may not hold ex post since currency and bond markets fluctuate, and no one can predict exactly how they may drift from the ex ante equilibrium. These duration and currency risks should be similar for both domestic and international bonds, and they could go either way, positive or negative, which is why I believe that global diversification in an investor's bond portfolio is important.
This is very similar to what I wrote earlier! More from the conclusion:
In either situation, the logic holds. Regardless of negative yields, when doing the right financial math, an investor should be indifferent between local and foreign bonds. Don't just compare yields; keep in mind that the hedge return will bring your clients back to parity.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

jalbert wrote: If you get the inappropriately named "Statement of Additional Information" for the fund, which is the real description of the fund (the prospectus is matketing fluff), you likely can find the precise instruments used instead of speculating about the risks of some hypothetical. scenario, and then evaluate the actual risks of the actual instruments.
Instead of looking at BNDX, I propose to look at the simpler VBU, as a single foreign currency is involved, and the internal structure of the ETF is simple as it only invests in BND and currency contracts.

OK. Here's an excerpt from Vanguard Canada's "U.S. Aggregate Bond Index ETF (CAD-hedged)" (VBU) financial statement:

Image

We see that the investment in BND has a fair value of CAD $4M.

If we look at Schedule 1 for the currency contracts:

Image

We see one huge currency contract:
- sold CAD $4.1M
- bought US $3.5M
- Credit rating: AA-

To me, the credit rating indicates that the currency contract has some default risk.

If we go back to basics:

BND contains thousands of bonds. Each bond has its own credit rating; each bond has some default risk (low to almost none; they're investment-grade bonds, after all). Some bonds have the highest credit rating (U.S. Government), others have lower ratings. But, each bond is independent. If it defaults, BND's exposure is limited to the value of this bond. This is the principle of diversification.

Now, we add the currency hedge:

We have a single CAD $4.1M currency contract for hedging an investment in BND valued at CAD $4M. The currency contract has a lower rating than the Treasuries contained in BND.

Question: What is the effective credit rating of the treasuries in BND, when hedged in VBU?
Question: If the $4.1 currency contract defaults, how much can be lost on that single contract?
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Thebigc »

longinvest wrote:
Thebigc wrote: Moringstar has cited minimal tracking errors with BNDX and only a minor .05% hedge drag on the fund.
I tried to explain that this can be quite misleading. BNDX follows a "hedged index", which means that the index tracks the performance of a hypothetical portfolio that buys both (1) foreign bonds and (2) 1-month forward currency contracts. As a result, any anticipated gain/loss due to the use of derivatives is included in the index, hiding potentially significant tracking errors relative to a proper index.

In my opinion, a proper index would look at the value of foreign bonds today, in local currencies. In one month, the index would do the same (including the value of reinvested coupons, of course). The difference would determine the monthly growth of the index.

I am sure that most investors think that BNDX is using what I call a proper index, but it is not!

Maybe that's what one wants; maybe one doesn't want to experience Japan's local bond returns in US dollars, but the gains and losses due to derivative instruments are far from transparent.

Do you know whether it easy is or not to front-run currency contracts? Unlike bonds which can be held for decades, these contracts have to be renewed monthly. There is a lot of opaqueness in BNDX on top of difficult to quantify derivative risks.

I don't doubt that BNDX behaves as expected from a broad bond index fund. I am sure that Vanguard made in depth studies before proposing this fund to investors. All I am expressing is my personal inability to fully appreciate the risks embedded in hedged foreign bond funds.

In other words, currency hedging adds a whole layer of complexity to a fund. I do not understand this layer well enough to feel at ease investing in it.
Ok I see what is going on, so you are concerned about the derivative and the currency hedging that takes place within. Yes it iis layer of complexity, but in this specific case I don't think it is the risk that you think it is. A dirivative can be very risky, but it can also be very simple and safe, it depends on what it is written in it, it's just a contract based on a specific asset, in this scase bonds. Now in the contract Vanguard wishes to hedge us currency, simply because that is what we us and this is a international trade agreement.

So in order for both parties to add stability to the contract so neither gets screwed Vanguard uses a currency hedge. This actually benifits both sides. Vanguard is just seeking a balances exchange rate, and the .05% drag would seem to suggest they are rather good at it and are very close to hiting the mark on average. Vanguard is agreeing to buy these bonds one month ahead at a given exchange rate, price, intrest rate etc. There is a level of speculation involved but I doubt they are doing heavy currency speculation in order to gain a profit. One month contracts also work against this, they are constantly buying and selling every month from different markets with different currency risks and fluctuations. They talked about it in one of the links I posted. They have graphs and all that stuff addressing it. This is very common and happens every day hundreds of thousands of times a day. Someone from China wants to buy grain from the US, well you need a derivative and a hedge so that the exchange will be eqitable.

They are not trying to use derivatives for debt financing and options to gain leverage and all that. There is not really a reason for them to do anything crazy. The reason they can't give you an exact yield is because because it's a floating rate do to the monthly contract price and fluctuating currency. Every month in this case it is probably going to be different. You yourself would need to look at thousands of contracts every month. You would probably see that there is a range to the currency hedge, stable is between such and such, high is between such and such. Chances are that it's a stable hedge within a nominal range. Chances are you don't really make much or lose much.

The hedge is not what is making the bonds expensive and the intrest rates low, neither is the derivative. Also you need to remember Vanguard does not have to buy or agree to something unfavorable. Such and such does not want to give us a decent deal so we will by more France, Britian and Sweden who are offering sweet deals. We have been doing forex trades for a very long time and the US is really good at getting a proper exchange rate on standard trades. People can make it really complex and gamble doing it, but that is really not what is going on here as far as I can tell, I can't even think of a reason why they would do it.

In my opinion it's what they say it is, they use a hedge in there contract to purchase bonds at a fair price reguardless of what happens in either country. It takes a lot of volatility out, and the entire idea is based on a fair exitiable exchange of an asset. After that the hedge might create minor boon or a minor bust. Or .05% drag in this case. If in that one month window the bonds gain value your set price guarantees you a boon, if it loses some value a bust. If the dollar is a little stronger or weaker in that period compared to the given currency you gain or lose a little. Vanguard is not really hiding anything but on a month to month basis it is just to much information for most people to go through.

It can get really complex, because a dirivative is a contract and as we all know contracts can be very complex. In this case these are probably pretty standard trade contracts with fair exchange rates. No matter what you do with international bonds you will have an exchange rates or rates really, this just minamalizes that to create lower volatility.

The reason the rates are low and the bonds are expensive, has little to do with those contracts, or the hedge fee. People are always in search of safe haven assets, weather it's in the US or over seas. The reason the rates are low and the bonds are expensive is because us investors have been flooding that market driving the prices up which is lowering the yield, when China just had it's flash crash, a lot of investors rushed to bonds over seas and here and again bond prices up and rates go down, and finally Greece sent many international investors rushing towards bonds and again the same thing happened. Both over seas and here intrest rates are at historic lows in many countries, people have been flooding out of 20 and 30 year treasuries because they are higher risk do to duration and have been flooding into corporate high yeild bonds to try and capture yield which is why many say there is a high yield bubble. Stocks are expensive right now, and people want safe assets but bonds are also expensive judging by the yields. Note that the BNDX intrest rate took a dive around the Greek debt crises because people were seeking refuge.

I guess in the case of BNDX you need to be comfortable with the idea that Vanguard is paying fair value in the current market and not doing heavy speculation, that it is more likely a simple stabalizing mechanism for a international exchange which is done all the time by lots lots of people every day. It's not a great time for any bonds so bonds don't look that great. There is a lot of weight on the bond market right now. The derivative and the hedge are not a big concern for me, unhedged bond funds have taken a beating with the rising dollar. Like I said for me I can except those factors as a pretty common practice in Forex, and that an over weight bond market low intrest rates international, rising intrest rates US, people scrambaling for yeild in risky bond assets, extended duration in search of yield, higher credit risks in search of yield etc... All concern me more. In the stock market I am ready for a correction, I am ready for a slow down, that is all logical to me. Bonds are different story right now, they are riskier and more expensive than they normally are. I am not saying they are as risky as stocks right now, just that for bonds they are riskier than normal. I see long term positives for the bond market, but I can't give you a good reason to buy anything you are not comfortable with and I am not trying to, I just don't see it the exact same way, I see some risk, a little more complexity with hedging, but nothing with Vanguard that really makes me uncomfortable.

I think Vanguard has explained it well enough and gone out of their way to explain hedging and international bonds. I am not going to tell you any bonds are a good buy right now domestic or international, because I don't think they are and there is more safety in CD's and savings, and given current yields I see them as very exceptable options. Most of the money I want to spend on bonds in the future are in CD's and savings, and that money will stay there until I feel comfortable with the bond market. Just took a little money out of riskier assets yesterday, because I wanted to and it made me feel more comfortable. I can put that where I want in the future when I feel comfortable with certain things. I am not against bonds I am just not for them right now with these yields and prices, and people constantly in search of higher yields through increased risk. Does not matter which fund you point too, I only have about 7-8 percent in bonds.

Conclusion, I think you are a little to worried about the hedge and the derivative contract, and that other factors in the bond market are more concerning. Not end of the world concerning but just not a great time for the bond market in the near term. I also can't give a good reason for Vanguard to be pushing international at this time, maybe they know something I don't which would not be a surprise but nothing looks great enough to warrant 40 percent of my equity portfolio, 30 percent international bonds is like 2-3% of my portfolio right now, I can deal with that for a long time. But that is my portfolio. I am pretty much ok with this fund, and everything Vanguard has written about it, I don't see anything that risky or fishy other than it seems a poor time to own bonds at current yields and prices in the short term and possibly intermediate term market. Things will probably improve but who knows when and how much? Not this guy. I get it this is a different type of fund for you, you don't fully get it, I don't either most people probably don't and we always fear what we don't understand. But with all the reading and discussion, it does not really seem risky when compared to other Bond funds in the same class. Bonds in general really.

I am spent, I feel I learned a lot today which is always good, good discussion, good reading, thank you. Maybe you might want to have beer or 12. I am going to have one... after another, until I am no longer thinking about international bond fund and hedging. If you want safety you can always buy silver bullion, sure you probably lose money in the short term, but at least the werewolves won't be a problem. I carry a silver coin with me every where, and I have never been attacked by a werewolf... so totally works. I also may be way ahead of you on the beer.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by ogd »

jalbert wrote: With counterparty hedging, it is a zero sum gane between counterparties. If a currency rises, 1 side has more than they are entitled to receive by exactly the amount of loss that needs to be covered on the other side.

The hedge bank just has to contractually collateralize the assets being hedged so that the side with the windfall can't bug out on the deal even if they wish to.
Zero sum does not mean zero risk. I can play a zero-sum coin flip game in which the other side is unable to pay me (i.e. heads they win, tails I don't get paid).

The collateral assets are not likely to be pure cash. I mean, look at Vanguard's side (or BNDX rather, as a separate entity): it doesn't hold short duration yen, it holds yen bonds, the value of which can become quite diminished if yen yields increase sharply. Similarly, in a financial collapse the assets of the other party might simply not be enough; let alone the possibility that a bankruptcy court does not award Vanguard a good enough place in line.

Ultimately, the gap between the credit risk of Japan in yen (which I consider negligible) and USD-denominated returns cannot be bridged at zero risk, like you seemed to argue earlier. The only actor that has that kind of certainty in USD is the US government. So I can be confident in Japan's ability to pay, yet be more suspicious of my USD returns. It's a problem if I'm being asked to accept the same kind of low returns from this arrangement as from US Treasuries.
jalbert wrote:If you get the inappropriately named "Statement of Additional Information" for the fund, which is the real description of the fund (the prospectus is matketing fluff), you likely can find the precise instruments used instead of speculating about the risks of some hypothetical. scenario, and then evaluate the actual risks of the actual instruments.
I did, and it's quite nonspecific. The little that's relevant to the present discussion is worded with far less certainty than your posts:
VTABX SAI wrote:The forecasting of currency market movement is extremely difficult, and whether any hedging strategy will be
successful is highly uncertain. Moreover, it is impossible to forecast with precision the market value of portfolio
securities at the expiration of a forward currency contract. ... snip ... Because forward currency contracts are privately negotiated transactions, there can be no assurance that a
fund will have flexibility to roll over a forward currency contract upon its expiration if it desires to do so. Additionally,
there can be no assurance that the other party to the contract will perform its services thereunder.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Kevin M »

One thing that must be acknowledged is that in its short history, the fund has provided some diversification with respect to US Total Bond fund. YTD VTABX (international, admiral shares) had returned -0.83% as of 6/30, while VBTLX (US total bond, admiral shares) had returned -0.17%. One year returns were +3.53% and +1.73% respectively.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by ogd »

jalbert wrote: Don't underestimate the benefit of having a 3rd party to implement the hedge, creating a separation of currency risk from credit risk. USD-denominated emerging market sovereign bonds have an opaque, de facto uncollateralized currency hedge builtin. Deterioration of credit quality usually causes outflows of capital from the country, which lowers currency value, and lower currency values make it more burdensome for the govt to pay the bonds, which lowers credit quality, a potential feedback loop.
This paragraph contains the essence of my objection to treating hedged bonds as subject only to the credit risk of the sovereign-currency issuer. Emerging market or not, we all understand the difference in risk between USD-denominated and local-denominated. If this difference could be bridged at negligible additional risk by third parties, USD-denominated bonds would have no reason to exist. It must be the case that currency hedging is somewhat risky, somewhat costly, or both.
jalbert wrote:Equities from a country in such a situation will not fare well either, the currency fluctuation just making it worse. That's an opaque currency hedging risk I think worthy of attention.
I would call that simply "currency risk". I think that equities are much less exposed than bonds because they have some built-in hedges: foreign currency sales that aren't subject to it at all, higher local sales if inflation, exports more competitive, even local sales more competitive against imports. Whereas with bonds all you get is "X local currency at time Y", so the local currency better be good.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by abuss368 »

jalbert wrote:
Emerging market or not, we all understand the difference in risk between USD-denominated and local-denominated. If this difference could be bridged at negligible additional risk by third parties, USD-denominated bonds would have no reason to exist. It must be the case that currency hedging is somewhat risky, somewhat costly, or both.
When one or both currencies are unstable, you will indeed pay alot more for the hedge, and there may not even be enough counterparties to make it happen.

Investors who want to avoid currency hedging completely probably should avoid investing in equities. Companies routinely hedge future expected revenue back to their home currency using cash flow hedges.

-jalbert
Indeed.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

jalbert wrote: Investors who want to avoid currency hedging completely probably should avoid investing in equities. Companies routinely hedge future expected revenue back to their home currency using cash flow hedges.
Stocks make up the riskier part of my portfolio. I don't mind them doing all kind of stuff; I actually expect them to leverage and use derivatives, so that I don't have to leverage.

Bonds are the less risky part of my portfolio. I have trouble including riskier stuff there, unless I better understand the risk and its size.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by dc81584 »

mpt follower wrote:In the April semi annual report of the Vanguard Total International Bond Index Fund, the 30 day SEC yield was reported to be 0.76%. My question is why would anyone invest in a fund that does not even expect to return anything close to inflation. By the way, the average duration of the fund is 7.3 years.
I won't need the money for 35+ years, so I'm not concerned in the least. It will most likely match or beat inflation over said time period.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

jalbert wrote:
Bonds are the less risky part of my portfolio. I have trouble including riskier stuff there, unless I better understand the risk and its size.
You mean like unhedged international bonds? Without currency hedging, currency volatility would dominate the comparatively lower volatility of the bonds themselves, significantly increasing volatility of the fund, and increasing correlation to (unhedged) int'l developed market stocks. I don't invest in this fund becsuse of the low yield, but wouldn't even consider it without the currency hedging.

And USD-denominated sovereign bonds of emerging and frontier markets countries do not have the same risk profile, as suggested in a different post above.

-jalbert
I do not equate risk and volatility. Volatility is only one form of risk, to me.

I was trying to say that I am unable to quantify the impact of derivative default (in a really bad scenario) in the hedged international bond fund. So, I'll avoid it until someone actually explains it to me like if I was not a derivatives trader (which I am not).
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by ogd »

jalbert wrote:
Bonds are the less risky part of my portfolio. I have trouble including riskier stuff there, unless I better understand the risk and its size.
You mean like unhedged international bonds? Without currency hedging, currency volatility would dominate the comparatively lower volatility of the bonds themselves, significantly increasing volatility of the fund, and increasing correlation to (unhedged) int'l developed market stocks. I don't invest in this fund becsuse of the low yield, but wouldn't even consider it without the currency hedging.

And USD-denominated sovereign bonds of emerging and frontier markets countries do not have the same risk profile, as suggested in a different post above.
The obvious alternative is US Treasuries, which do not need currency hedging to have zero currency risk, and they also don't need it to (supposedly) bridge the yield gaps that currently exist.

I fully agree with longinvest that things that I would be okay with in stocks, I'm not so okay in bonds. The bonds are supposed to be reliable in the direst of market circumstances. Whereas in stocks there's already a million things going on (most importantly, the pricing of long-term earnings) so the currency hedging is not a big one. Or unhedged currency risk, for that matter. The deal is that stocks reward me for all those things. I'm not sure hedged safe international bonds currently do.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Northern Flicker »

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

jalbert wrote:
So, I'll avoid it until someone actually explains it to me like if I was not a derivatives trader (which I am not).
Theoretical maximum risk is paying the currency hedge premiums, but still having the entire currency exposure unhedged due to zero payout from the hedge contract. I think VG was claiming the hedges cost 39 basis points per year. There is no added risk to the underlying bond principal or their coupon stream. Relative to the unhedged portfolio, that would cap the risk to investors of hedging the fund at 39 basis points per year.

I think the more pertinent issue is whether or not one is comfortable with the currency risk of the portfolio, since that is the real risk associated with currency hedge failure.
Jalbert,

Thanks for your answers.

I hope that you can spare some additional patience to help me check that I really understand you clearly.

Let me build a simplified hypothetical example and try to explain what I understand, so that you can correct me:

I want to buy and currency-hedge a 1,000 Euro zero-coupon bond (let's ignore its yield, for now). Let's also assume that short term yields are 0% for both US and Euro cash.

Assuming a currency exchange rate of 1 Euro = $1.10 US, this bond will cost me $1,100.

I buy a currency-hedging contract so that if the Euro significantly moves, relative to the US dollar, I don't experience a loss or gain. Let say that the cost of the hedge is $0.01. I guess that it will be in the form of a 1-month forward contract with some counterparty that I'll call Bank CP.

So, as of now, I've spend $1,100.01 and I possess 2 things:
  1. A zero-coupon 1,000 Euro bond.
  2. A 1-month forward contract to buy $1,100 using $1,000 Euro.
Did I get the forward contract right? My reasoning: I will want to convert my $1,000 Euro back into $1,100 US dollars without being affected by a change in the exchange rate during the month.

The way this 1-month forward contract works is that it says that in one month, if the currency exchange rate moves, one of the two parties will owe the other:
  • If the exchange rate changes to 1 Euro = $1.00 US, Bank CP will owe me $100 [ = $1,100 - (1,000 Euro X ($1.00 / 1 Euro)) = $1,100 - $1,000 ].
  • If the exchange rate changes to 1 Euro = $1.20 US, I will owe Bank CP $100 [ = $1,100 - (1,000 Euro X ($1.20 / 1 Euro)) = $1,100 - $1,200 ].
The above illustrates an approximate 10% currency exchange rate change in a single month.

In other words, if the US dollar loses value, I will owe Bank CP the profit I would have made by holding an unhedged Euro bond. If the US dollar gains value, Bank CP will owe me the money I would have lost by holding an unhedged Euro bond.

Question: What would I lose if the dollar gained value and Bank CP defaulted on its obligation?

Answer: For the above increase of 10% in value of the US dollar, I would lose (in the worst case) $100, on my $1,100 investment. So, in the worst case, I lose the value of the hedge.

OK, I think that I'm starting to understand, now. Please let me know if I made any mistake in my reasoning.

(If this was all correct, I'll have to go back and read all the previous posts based on my new understanding).
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by lee1026 »

As I've cited in my previous post, the total currency hedging cost (tracking error) has been of an annualized 2% for a major S&P 500 index ETF hedged to the Canadian dollar, between 2006 and 2011. This is significant. All this during a time when, as far as I know, the ETF didn't have to deal with any default on its hedges.
That sounds more like the US withholding tax on Dividends rather then any cost in hedging. Hedging USD and CAD is dirt cheap.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

lee1026 wrote:
As I've cited in my previous post, the total currency hedging cost (tracking error) has been of an annualized 2% for a major S&P 500 index ETF hedged to the Canadian dollar, between 2006 and 2011. This is significant. All this during a time when, as far as I know, the ETF didn't have to deal with any default on its hedges.
That sounds more like the US withholding tax on Dividends rather then any cost in hedging. Hedging USD and CAD is dirt cheap.
No, before withholding tax, the loss was 2.4%. See the link to the PWL Capital article in my previous post: viewtopic.php?f=1&t=169828&p=2566593#p2562788.

But, I increasingly think that this article just did not understand how currency hedging works using forward contracts.

If I understand correctly what I read on this thread, the currency hedge does not try to completely eliminate the impact of currency movements on monthly gains/losses; it aims at eliminating the impact of currency movement on the main invested capital during the month, while keeping the currency impact on gains and losses.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by lee1026 »

Yep, doesn't look like they took into account that overnight interest rates are considerably higher in Canada then in the US.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Northern Flicker »

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by longinvest »

jalbert wrote:
I hope that you can spare some additional patience to help me check that I really understand you clearly.
Generally correct. A refinement is that your real counterparty in the hedge is another customer of Bank CP who wishes to hedge $1100 back to euros at the current exchange rate, but the bank encapsulates that for you so you don't have to enter into a relationship with the counterparty, or even know who they are. In this model, none of the three parties are really taking any currency risk.

That payments required to be made are actually made is wrapped into contractual obligations and capitalization/collaterization of the contracts. I won't claim to be knowledgeable about the legal structure and protections builtin to these international business contracts.

I do think if a currency collapses, you will be much better off if your position were hedged, even if the hedge contract doesn't pay out 100%.
Jalbert,

I'm finally seeing, now, how the risk related to the forward contract is really low. The real risk is that of the complete collapse of a foreign currency, in which case the loss would not really be due to a forward contract default but to having decided, in the first place, to invest in bonds of a foreign country whose currency eventually collapsed.

I must admit, after getting the answers I was seeking, that I am now more comfortable with how a currency-hedged international bond fund works.

As long as Vanguard restricts TIBM to invest into investment-grade bonds of investment-grade countries, it should obviously remain much safer than a stock fund.

Thanks for your help.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Ketawa »

jalbert wrote:Back to the OP's original question of why someone would want to hold a nominal bond fund with a 0.76% yield and 7.5 year duration, I have no clue. I'm not touching it at the current yield and duration.
Vanguard (or at least, a senior Vanguard official) has pointed out that the yield is not an accurate measure of this fund's expected return. It seems like the SEC yield does not include the expected hedge return.

On Wednesday, I pointed out that 10-year bonds for the top 75% of countries in the fund had a weighted average of 0.85%. At the time, the fund's SEC yield was 1.09%. That almost certainly does not include the hedge return, since the fund includes some bonds from countries that are a higher credit risk as well as some corporate bonds, even though the duration is less than 10 years.

I don't actually have any interest in holding this fund because I have access to the G Fund.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Ketawa »

Also of note is that the SEC yield has risen 0.33% in 3 months. By my back of the envelope calculation, you would expect a loss of approximately 2.4% from the change in interest rates with a 7.3 year duration and a gain of about 0.2% from interest payments, for a total loss of 2.2%.

Meanwhile, the fund is only down 1.1% over that time period. Perhaps the hedge return is part of the reason for that?

This type of calculation happens to work almost perfectly for BND. Over the same time period, SEC yield is up 0.26%. You would expect a loss of approximately 1.5% with the 5.7 year duration and gain about 0.5% from interest payments, for a total loss of 1.0%. The fund is down 0.97%.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by Ketawa »

Apparently, Vanguard also has a lot of experience with hedging currencies before they opened this fund. They have a Global Bond Index Fund domiciled in Ireland with USD hedged shares. It's date of inception was March 31, 2008, so this fund survived the Great Recession.

According to its annual report, it returned 4.48% since inception through 2014 while its index returned 4.74%. With an ER of 0.15% on Institutional shares, my guess would be that hedging has cost the fund an average of 11 bp per year.

More info on the fund.
jalbert wrote:I don't know the reason, but it is also possible for some bonds in the fund to mature and be reinvested at a higher yield, or for new deposits to be invested at a higher yield based on the country whose bonds are purchased, etc. You would have to look at changes in interest rates for the countries, not changes in yield for the fund to apply the duration measure. A 33 basis point change in yield could be lots of things other than a rise in interest rates, although from your calculation it appears about half of it was an increase in rates.
New deposits shouldn't matter since they should be purchasing baskets of all the fund's bonds, and the amount of rollover in 3 months (3% of the fund's bonds) is hardly enough to account for a 1.1% difference in what you would expect the fund's performance to be based on changes in interest rates, the fund's SEC yield, and its duration.

My calculation didn't show that half the rise in yield was from rising interest rates; rather, it showed that the fund dropped about half of what you would expect if SEC yield and duration were useful measures for this fund.

SEC yield seems basically useless for this fund. People in this thread are making a lot of conclusions about whether to invest in it based on its lower SEC yield and longer duration than Total Bond Market. Maybe I should start a new thread to get some more attention.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by abuss368 »

Bogleheads,

I recently read a study regarding the TSP plan and the consideration of additional investments for the plan. My understanding is the TSP plan is a simple plan of either Target Funds of individual funds such as US Stock, International Stock, US Bond, a bond fund that resets interest rates daily (close to TIPS), and a cash alternative.

REITs appear to have the strongest consideration for possibly being included in the future.

The section on international bonds and debt was less than ideal with no perceived benefit to the individual investor. This is counter to Vanguard's research.

Best.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by ogd »

Ketawa wrote:SEC yield seems basically useless for this fund. People in this thread are making a lot of conclusions about whether to invest in it based on its lower SEC yield and longer duration than Total Bond Market. Maybe I should start a new thread to get some more attention.
I wouldn't call it useless because it does in fact measure the underlying instruments in their currencies.

It's true that the hedging may introduce a lot of variability, but there's no way that this could be incorporated into a linear duration/yield framework. One possible way in which the SEC yield helps is if you take the very conservative view that you cannot expect any particular returns from hedging, then you don't want this fund because Treasuries are clearly better. From that extreme, one can start allowing for some positive expected returns, etc. All very nebulous to me.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by lee1026 »

It's true that the hedging may introduce a lot of variability, but there's no way that this could be incorporated into a linear duration/yield framework. One possible way in which the SEC yield helps is if you take the very conservative view that you cannot expect any particular returns from hedging, then you don't want this fund because Treasuries are clearly better. From that extreme, one can start allowing for some positive expected returns, etc. All very nebulous to me.
Even if you take the view that you don't expect any particular returns from hedging, it isn't obvious that treasuries are always better. Treasuries would get crushed if US interest rates went up but Europeans ones didn't. This would not. Not taking treasury risks and not getting treasury returns seems reasonable to me.
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Re: Why invest in BNDX's when 30 day SEC yield = 0.76%.

Post by ogd »

lee1026 wrote:
It's true that the hedging may introduce a lot of variability, but there's no way that this could be incorporated into a linear duration/yield framework. One possible way in which the SEC yield helps is if you take the very conservative view that you cannot expect any particular returns from hedging, then you don't want this fund because Treasuries are clearly better. From that extreme, one can start allowing for some positive expected returns, etc. All very nebulous to me.
Even if you take the view that you don't expect any particular returns from hedging, it isn't obvious that treasuries are always better. Treasuries would get crushed if US interest rates went up but Europeans ones didn't. This would not. Not taking treasury risks and not getting treasury returns seems reasonable to me.
"Crushed" only temporarily. Returns commensurate with SEC yield can only get delayed with safe bonds, not taken away. If I get less for a given period, I will get that much more going forward through high yields.

Now obviously the market is saying something with the yield difference, but I have a hard time understanding how that isn't just a currency thing.
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