Foreign bonds

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RoboFan
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Foreign bonds

Post by RoboFan » Wed Oct 10, 2018 4:39 pm

The 3-fund portfolio consisting of domestic equity, foreign equity, and domestic bonds seems to receive a lot of press together with positive comments. However, it’s never clear to me why foreign bonds aignored. Vanguard’s portfolio analysis tool allows you to set any AA allocation but recommending between 30-50% of the equity holdings be foreign. However, it only complains when the foreign bond allocation drops below 20%. This means it does not care if the foreign and domestic AA is equal.

I read posts and new articles arguing for and against holding any foreign equities. However, what I have not found is a logical explanation as to why, if you chose to buy foreign equity, you would not keep the domestic and foreign AA the same. Say, for example, you want a 60/40 AA with 30% of the equities being foreign. What’s the logic behind having foreign equities but not foreign bonds?

Valuethinker
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Re: Foreign bonds

Post by Valuethinker » Wed Oct 10, 2018 5:03 pm

RoboFan wrote:
Wed Oct 10, 2018 4:39 pm
The 3-fund portfolio consisting of domestic equity, foreign equity, and domestic bonds seems to receive a lot of press together with positive comments. However, it’s never clear to me why foreign bonds aignored. Vanguard’s portfolio analysis tool allows you to set any AA allocation but recommending between 30-50% of the equity holdings be foreign. However, it only complains when the foreign bond allocation drops below 20%. This means it does not care if the foreign and domestic AA is equal.

I read posts and new articles arguing for and against holding any foreign equities. However, what I have not found is a logical explanation as to why, if you chose to buy foreign equity, you would not keep the domestic and foreign AA the same. Say, for example, you want a 60/40 AA with 30% of the equities being foreign. What’s the logic behind having foreign equities but not foreign bonds?
If you search for threads about Vanguard's foreign bond fund you will find quite a bit about the debate.

Also William F Sharpe's Financial Engines company has a "world portfolio" and we have discussed that here as well. From memory it is about 25% global bonds.

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nisiprius
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Re: Foreign bonds

Post by nisiprius » Wed Oct 10, 2018 5:04 pm

The logic is that stocks and bonds are different, and there isn't a whole awful lot of diversification to be obtained in high-quality international bonds. An investment-grade bond that promises to pay 2% is almost certain to pay 2%, regardless of whether the promise is made by an American or a German. And you are exposing yourself to significant currency risk in an unhedged fund, while hedging currency (as Vanguard does) is going to cost something.

The main reason I have not chosen to invest in international bonds is... Vanguard's own white paper on them! It's quite a good paper with a lot of data in it; if you haven't read it, you should: Global fixed income: Considerations for U.S. investors. And--what is the opposite of a "clincher?"--for me was figure 7:

Image

If we take absolutely everything at face value, then Vanguard is setting our expectations that if we consider 60/40 with 40% of stocks international, if we move from 100% of the bond allocation being US to 30% international, we will reduce our volatility from 9.5% to 9.4%.

I mean, that's a joke. I posted a challenge, based an older version of the paper, to see whether people could even tell the difference visually between 9.5% and 9.6%. One of the curves has a volatility of 9.5%, the other has 9.6%. Can you tell which is which?

Image

Morningstar critiqued the Vanguard Total International Bond Fund in an article, Diversification for the Sake of Diversification and, among other things, said:
I don’t know why Vanguard bothered to launch Vanguard Total International Bond ETF (BNDX), a currency-hedged developed-markets bond fund. When you hedge foreign sovereign bonds, you end up with something that looks a lot like U.S. Treasuries. Vanguard points to some modest historical diversification benefits...
So my personal opinion is that there's absolutely nothing good or bad about Vanguard's international bond fund. I don't use it and I wouldn't lift a finger to add it; if I used one of their LifeStrategy or Target Retirement funds, I wouldn't be the least bit bothered by holding it and I wouldn't lift a finger to avoid it.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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galeno
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Re: Foreign bonds

Post by galeno » Wed Oct 10, 2018 5:18 pm

USD bonds have higher yields, lower average durations, better credit quality. No currency risk (or hedging costs) compared to non-USD bonds from developed countries other than the USA.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

patrick
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Re: Foreign bonds

Post by patrick » Wed Oct 10, 2018 5:26 pm

Currency hedged foreign bonds ought to have pretty much the same return as domestic bonds, but with extra trading costs to maintain the currency hedge. Unhedged foreign bonds will be much more volatile than domestic bonds due to currency risk (which being more or less symmetrical wouldn't be expected to earn much of a risk premium).

Foreign stocks will likely have a very different return than domestic stocks due to factors related to individual companies, sectors, or countries, so they' provide more diversification. Furthermore, currency risk is a much smaller component of their volatility.

Elysium
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Re: Foreign bonds

Post by Elysium » Wed Oct 10, 2018 5:28 pm

I hold about 5% of my portfolio in Vanguard Total Intl Bond, and my reasons for holding it is not at all related to efficient frontier or anything like that. It's purely out of fear of US treasuries blowing up and I am left with no money other than this 5% in foreign debt issued by several countries spread out geographically. May be it is a far fetched idea, and of course I wish it may never come to pass.

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Gort
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Re: Foreign bonds

Post by Gort » Wed Oct 10, 2018 7:19 pm

Elysium wrote:
Wed Oct 10, 2018 5:28 pm
I hold about 5% of my portfolio in Vanguard Total Intl Bond, and my reasons for holding it is not at all related to efficient frontier or anything like that. It's purely out of fear of US treasuries blowing up and I am left with no money other than this 5% in foreign debt issued by several countries spread out geographically. May be it is a far fetched idea, and of course I wish it may never come to pass.
An egg laying hen will be worth more than your remaining 5% foreign debt if US Treasuries blow up and that is all you are left with.

Elysium
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Re: Foreign bonds

Post by Elysium » Wed Oct 10, 2018 7:34 pm

Gort wrote:
Wed Oct 10, 2018 7:19 pm
Elysium wrote:
Wed Oct 10, 2018 5:28 pm
I hold about 5% of my portfolio in Vanguard Total Intl Bond, and my reasons for holding it is not at all related to efficient frontier or anything like that. It's purely out of fear of US treasuries blowing up and I am left with no money other than this 5% in foreign debt issued by several countries spread out geographically. May be it is a far fetched idea, and of course I wish it may never come to pass.
An egg laying hen will be worth more than your remaining 5% foreign debt if US Treasuries blow up and that is all you are left with.
This is the counter argument you hear, but beyond those one liners I wouldn't for so sure of what will happen in a black swan event.

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galeno
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Re: Foreign bonds

Post by galeno » Thu Oct 11, 2018 3:21 pm

As long as the USD continues as the MAIN reserve currency the SCARED money will always run to USD and US treasury bills, notes, and bonds.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.13%. Term = 34 yr. FI Duration = 6.2 yr. Portfolio survival probability = 95%.

alex_686
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Re: Foreign bonds

Post by alex_686 » Thu Oct 11, 2018 3:27 pm

patrick wrote:
Wed Oct 10, 2018 5:26 pm
...but with extra trading costs to maintain the currency hedge.
FYI, there are no explicit trading costs to FX hedging. Extra hedging costs are about under 5 bps per year for a small fund. And that is for hiring a 3rd party, indirect trading costs, drag, the extra tax preparation. etc. Honestly, not that much.

KJVanguard
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Re: Foreign bonds

Post by KJVanguard » Thu Oct 11, 2018 4:05 pm

patrick wrote:
Wed Oct 10, 2018 5:26 pm
Currency hedged foreign bonds ought to have pretty much the same return as domestic bonds, but with extra trading costs to maintain the currency hedge.
I know hedging costs money, but I have no idea how much. Can any of the experts here help me out with a ball park figure in basis points? If Vanguard has taught us anything it's that costs matter, and they matter a lot.

This higher cost would be one reason I use to justify not buying international bonds. Interest rate parity is the other big reason -- same expected returns from bonds in all nations (assuming same credit quality). Paying extra to get the same expected return fails to excite me. Yes, international stocks have higher expenses too, but I expect to get greater diversification out of that deal (and more attractive valuations at this point in time as well).

The main reason I refuse to buy Vanguard's international bond funds is that I don't want the interest rate risk of intermediate term bonds. I would have to reconsider if they offered a short-term international choice to kill that argument.

alex_686
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Re: Foreign bonds

Post by alex_686 » Thu Oct 11, 2018 4:14 pm

KJVanguard wrote:
Thu Oct 11, 2018 4:05 pm
I know hedging costs money, but I have no idea how much. Can any of the experts here help me out with a ball park figure in basis points? If Vanguard has taught us anything it's that costs matter, and they matter a lot.
The cost in hedging is the difference of yields between the government bonds in local currency. That is, if a 1 US Treasuries yield 3%, and a 1 year German Budn is 1%, then the cost is 2%. 2 points here. First, I am really simplifying the math here.

Second, the short term government bond yields tend to be a good proxy for inflation. So the cost of hedging is about the difference in inflation rates. So the economic cost of hedging is basically zero. Then see my above post, where the actually direct trading cost is zero, and the indirect costs are less than 5 bps.

Cost is not really a factor here.

KJVanguard
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Re: Foreign bonds

Post by KJVanguard » Thu Oct 11, 2018 9:58 pm

Thanks for the clarification that currency hedging is only around a mere 5 basis points. Can't really complain about that.

Guess I will stick with my fine excuse of how I'm waiting for a short-term international bond fund choice. (I don't know if any such creature exists at any cost anywhere, though I know it would be too costly till Vanguard provides it.)

I remember interest rate parity from my college days so long ago, so I know currency movements make up for foreign bonds that yield more or less than US bonds, such that all bonds should give an investor the same return (assuming equal quality). I have noticed that with other nations having even lower interest rates than the US, the yield listed for their international bond fund is VERY low (just over 1%). They obviously do not take into account these fully expected currency moves, which makes for an unrealistic return expectation for US investors.

Question: if someone owns a significant amount of international stock (as I do) do they have less need for the diversification of international bonds, or is that irrelevant?

alex_686
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Re: Foreign bonds

Post by alex_686 » Thu Oct 11, 2018 10:04 pm

KJVanguard wrote:
Thu Oct 11, 2018 9:58 pm
I remember interest rate parity from my college days so long ago, so I know currency movements make up for foreign bonds that yield more or less than US bonds, such that all bonds should give an investor the same return (assuming equal quality). I have noticed that with other nations having even lower interest rates than the US, the yield listed for their international bond fund is VERY low (just over 1%). They obviously do not take into account these fully expected currency moves, which makes for an unrealistic return expectation for US investors.

Question: if someone owns a significant amount of international stock (as I do) do they have less need for the diversification of international bonds, or is that irrelevant?
I am not following you point. Can you lay out a example. Are you factoring in inflation expectations? Interest rate parity gets you the same real returns, not nominal. At least in theory. Real world issues intervene - such as the USD being the world's reserve currency.

I don't see much linkage between international equity and international bonds. International equity has low FX risk. Historically, international equity has a 1% standard deviation per year for inflation adjusted FX risk.

RoboFan
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Re: Foreign bonds

Post by RoboFan » Sat Oct 13, 2018 1:11 pm

Thanks for all the comments. I’ll end with one of own observations. I’ve been tracking 4 vanguard funds:

1. VFIAX (domestic equity)
2. VTIAX (foreign equity)
3. VBTLX (domestic bonds)
4. VTABX (foreign bonds)

By way of disclosure I own all 4 amount others. I’m using Vanguards Portfolio analysis tool with 60/40 asset allocation. The analysis tool indicates everything is fine; i.e., I’m close to my desired AA, not overweighted in large, mid, or small cap fund, no bias towards growth v value, not overweighted in long v short term bonds etc. etc. As such, i have just over 20% of my total bonds outside the US and the analysis tool gives me a warnings whenever the foreign bond allocation drops below this number. I’ve been following the RoboAdvisor advice for a number of years and like it.

So, back to the 4 funds. Yahoo’s financial app allows you to compare funds over different intervals. YTD for these 4 funds is:


1. VFIAX +2.7%
2. VTIAX -11.6%
3. VBTLX -4.1%
4. VTABX +0.1

My apologies for not posting the YTD plots but I cannot see a way to insert these. Still they should be easy for anyone to look at using any number of apps. The point that I’m driving at here is that the Vanguard’s recommendation to have 20% of bond outside the US has, in retrospect, helped me a lot as domestic bonds have fallen 4.1% and foreign bonds have held steady (up 0.1%). The above numbers do not, of course, reflect dividend or interest as most app’s are notoriously deficient in this regard. Still, my sense looking at past numbers is that the yield on foreign bonds has been substantially higher than domestic, which would be reflected in there higher risk. I’m staying with Robo advice.

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