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Do you need international bonds?

Posted: Mon May 26, 2014 11:44 am
by Rick Ferri
I agree with much of what Larry wrote on this often asked question: Do you need international bond exposure?

My answer is no. Larry may not agree. I based my conclusions on the cost for retail investors to access this market. It may make sense if your a gigantic institution that trades for extremely low cost and can hedge currencies extremely cheaply.

Should You Include International Bonds In Your Portfolio? - Part I

Rick Ferri

Re: Do you need international bonds?

Posted: Mon May 26, 2014 1:00 pm
by larryswedroe
Rick
If don't have access to the lowest cost trading I agree. In fact the only international bonds we buy direct are dollar bonds of governments or government agencies.
Otherwise if want benefits need to own a fund, in that case I would look for funds like DFA's global bond funds --no call risk, super high credit quality, and they also shift maturities as yield curves shifts.
But of course you do pay for the funds while if buying individual bonds on own and avoid fund fees you can save that fee, offsetting some of the benefits of the global bond diversification

Best wishes
Larry

Re: Do you need international bonds?

Posted: Mon May 26, 2014 1:52 pm
by G-Money
Thanks Rick and Larry.

I'm struggling to figure out if anyone can hedge cheaply. The Vanguard fund has over $23 billion in assets, which seems like a lot to me. So I would figure if anyone could hedge cheaply, Vanguard could. But I look at the difference in SEC yield between Total International Bond (VTABX) and Vanguard's Intermediate-Term Index (VBILX), which has similar duration and credit risk. VBILX's SEC yield is 114 bp higher. Some of that is the spread in ER (10 bp). Perhaps wrongly, I attribute the remaining spread (104 bp) to the costs of hedging. That seems like an awfully high price to pay. Another point of comparison: Total Bond has lower credit risk and shorter duration (so less risky), and its yield is still 69 bp higher, only 12 bp of which is attributable to the spread in ERs.

My questions are:

1. Am I correct in attributing the difference in yields to the cost of hedging? If not, what else explains the difference in yield?

2. If I'm correct about the costs of hedging, isn't that a high price to pay for diversification? Who can do it cheaper, and how?

Re: Do you need international bonds?

Posted: Mon May 26, 2014 2:29 pm
by Rick Ferri
G-Money

The hedging cost for Vanguard is only about 0.15% per year (take it on my word that I have a good source). The difference in yield is because the yields of the bonds in the fund are lower. Pretty straight forward. But this doesn't mean the expected total return is lower in local currency.

Under the Fisher Effect, when equal quality foreign bonds are yielding less than US bonds, it's supposed to mean that the dollar is expected to depreciate against other currencies, thus an investor in the foreign bond will see appreciation in value due to a better currency exchange rate - leading to a parity of return.

"The currency of the country with the higher nominal interest rate (US) is expected to depreciate against the currency of the country with the lower nominal interest rate, as higher nominal interest rates reflect an expectation of inflation."

But, since the Vanguard fund is currency hedged to the dollar, if the dollar declines, investors in the fund won't get the extra appreciation in return.

It's as clear as mud, right?

Rick Ferri

Re: Do you need international bonds?

Posted: Mon May 26, 2014 2:34 pm
by scotbogle
What's your opinion about international bond exposure for European investors ? The Barclays Euro Aggregate Bond constituents are : 22% France, 19% Germany, 16% Italy, 11% Spain .....

Should European investors combine Euro Aggregate with, for example, Vanguard Global Bond Index Fund Euro Hedged ?

Thanks
Mark

Re: Do you need international bonds?

Posted: Mon May 26, 2014 2:45 pm
by G-Money
Thank you, Rick. I had a feeling I was missing something.

If I understand your post correctly, there's very little advantage to invest in international bonds now, at least hedged funds. Foreign bonds are yielding significantly less than domestic bonds of similar duration and credit risk. As you note, the spread is supposed to be compensated by the expected depreciation of the dollar. But if Vanguard investors will get no benefit because VTABX is hedged, there seems little reason to invest in it now. Perhaps when the converse is true would be a time to jump in?

Re: Do you need international bonds?

Posted: Mon May 26, 2014 2:56 pm
by gkaplan
If I remember correctly from one of his earlier books, Larry recommends unhedged funds for foreign equity funds and hedged funds for foreign fixed income funds.

Larry, please correct me if I am mistaken in your beliefs.

Re: Do you need international bonds?

Posted: Mon May 26, 2014 4:43 pm
by Rick Ferri
gkaplan wrote:If I remember correctly from one of his earlier books, Larry recommends unhedged funds for foreign equity funds and hedged funds for foreign fixed income funds.

Larry, please correct me if I am mistaken in your beliefs.
For the record, my view is to get your currency exposure through unhedged foreign equity funds and forget about foreign bond funds whether hedged or unhedged.

Rick Ferri

Re: Do you need international bonds?

Posted: Mon May 26, 2014 4:51 pm
by Electron
Would it be worth reevaluating international bonds in the future if there was a yield advantage?

I'm talking about a case where Vanguard's International Bond Index fund had an SEC yield somewhat greater than the domestic bond index fund.

Re: Do you need international bonds?

Posted: Tue May 27, 2014 9:46 am
by columbia
What's the expected correlation between BND and BNDX?

Re: Do you need international bonds?

Posted: Tue May 27, 2014 10:44 am
by chicagobear
I can see owning unhedged foreign bonds to protect against US dollar debasement (although I personally prefer gold bullion) but don't see the point of owning hedged foreign bonds. Aren't those effectively dollar bonds due to the hedging?

Re: Do you need international bonds?

Posted: Tue May 27, 2014 11:42 am
by larryswedroe
Few things
Re Fisher Effect
Problem is that it's wrong. The evidence is very clear it doesn't hold. Hence we have the carry trade. Basically another form of the value trade. Currencies with higher interest rates on average earn higher returns AFTER currency effect. One might argue it's a risk premium (extra risk for investing in a high interest rate currency--though the higher rate could simply be a higher REAL rate based on faster economic growth, not a risk premium). There are funds that play this strategy, but it is subject to big crashes during financial crises (hence IMO the risk story holds at least partially as the reason, if not full reason).
DFA plays this with it's partially hedged global bond strategy, hedges investments in lower yielding currencies but not higher.

As to costs, Rick's estimate certainly in ballpark if not bit high. But hedging costs should be very low in major currencies.

And yes I recommend not hedging equities (only defeats one of main purposes which is low correlation, hedging increases it).
And not owning international bonds is perfectly fine, can own safe bonds in US and that saves fund costs. But if in fund and it holds high quality, no call bonds and low cost you will get likely some diversification benefit (yield curves all don't mean in same way). But in scheme of things, a minor issue

Finally, for those willing to accept higher volatility of their portfolios unhedged does provide some diversification of economic and geopolitical risks.

Larry

Re: Do you need international bonds?

Posted: Tue May 27, 2014 11:48 am
by abuss368
Rick Ferri wrote: For the record, my view is to get your currency exposure through unhedged foreign equity funds and forget about foreign bond funds whether hedged or unhedged.

Rick Ferri
Great advice from Rick once again. I always enjoy Rick's post because they are very clear and common sense.

Thank you Rick!

Re: Do you need international bonds?

Posted: Tue May 27, 2014 11:52 am
by abuss368
The timing of this post is excellent. To think I had started another "Jack Bogle - International Bonds" post earlier today.

Thanks Rick!

Re: Do you need international bonds?

Posted: Wed May 28, 2014 7:51 am
by abuss368
Rick Ferri wrote: For the record, my view is to get your currency exposure through unhedged foreign equity funds and forget about foreign bond funds whether hedged or unhedged.

Rick Ferri
I believe this is exactly what David Swensen advised in his excellent book "Unconventional Success".

Thank you for the excellent advise Rick!

Re: Do you need international bonds?

Posted: Wed May 28, 2014 12:18 pm
by NoRoboGuy
abuss368 wrote:
Rick Ferri wrote: For the record, my view is to get your currency exposure through unhedged foreign equity funds and forget about foreign bond funds whether hedged or unhedged.

Rick Ferri
I believe this is exactly what David Swensen advised in his excellent book "Unconventional Success".

Thank you for the excellent advise Rick!
This is exactly what I did. I increased the percentage of foreign relative to domestic within the equity side to provide a dollar hedge, and kept bonds domestic-only (though a small percentage of US TBM has dollar-based foreign bonds).

Re: Do you need international bonds?

Posted: Wed May 28, 2014 12:29 pm
by scotbogle
Rick,

What's your advise for a European investor ? Vanguard Global Bond Index Fund Euro Hedged, Ishares Euro Aggregate Bond ETF or a combination ?

Thanks
Mark

Re: Do you need international bonds?

Posted: Thu May 29, 2014 10:08 am
by abuss368
louis c wrote:
abuss368 wrote:
Rick Ferri wrote: For the record, my view is to get your currency exposure through unhedged foreign equity funds and forget about foreign bond funds whether hedged or unhedged.

Rick Ferri
I believe this is exactly what David Swensen advised in his excellent book "Unconventional Success".

Thank you for the excellent advise Rick!
This is exactly what I did. I increased the percentage of foreign relative to domestic within the equity side to provide a dollar hedge, and kept bonds domestic-only (though a small percentage of US TBM has dollar-based foreign bonds).
I was fortunate enough to attend a lecture of David Swensen's. During the excellent presentation, he advised that the individual investor should allocate to international equities to obtain diversification. He went on to provide an excellent analysis on why international debt should be avoided due to many of the risks involved that were not present with US debt and bonds. His one line "debt is an entirely different from equity" was perfect.

Re: Do you need international bonds?

Posted: Thu May 29, 2014 11:12 am
by dl7848
It's harder to fit international bonds in when you have a traditional stock/bonds portfolio. But some investors, especially retirees, rely on an 80-100% allocation to bonds, in which case, they diversify with emerging market, developed world, and domestic, within the government and corporate sectors. This gives them income and also greater capital appreciation than they would get just using domestic bonds. It also, of course, adds credit risk, but as long as the allocations are well-balanced, the risk is well balanced.

Re: Do you need international bonds?

Posted: Thu May 29, 2014 12:17 pm
by 209south
Monetary issues confuse me, and I'm not smart enough to understand the hedging programs within some international bond funds. Having said that, as an American investor with a fairly defensive portfolio (60% fixed income + 5% bullion), and with some concerns about the growth in government spending (under both parties), I have 20% of my fixed income (12% overall) in three international funds (Vanguard's international and emerging market, and DFA's global bond) - understand this is a modestly higher cost approach but helps me sleep at night. I don't know how to post charts but it has been interesting to see how BNDX and VWOB have been somewhat more volatile than BND since inception.

Re: Do you need international bonds?

Posted: Thu May 29, 2014 12:52 pm
by abuss368
One item that David Swensen discussed, and perhaps Rick Ferri or anyone else may expand on, is the fact that we live in the U.S., are impacted by U.S. fiscal and monetary policy. Dr. Swensen noted that U.S. inflation will impact us more than the rate of inflation in other countries, which may be higher or lower than the U.S.

Re: Do you need international bonds?

Posted: Thu May 29, 2014 8:25 pm
by Johno
Though this partially repeats points that have been made, my summary would be:
-Foreign sovereign bonds are a way of holding 'safe money outside the country', for when things go to hell inside the investor's country, and/or for the value of its currency (the vehicle for such an investment would probably be a fund domiciled inside the investor's country, but that doesn't negate the basic point). Well to do people in most other countries for most of modern history have and still do seek to do this with part of their wealth. Historically the US has been a country where this was not necessary. The question for US investors is therefore whether 'past performance is a guarantee of future results' in this respect. I don't currently have a high grade foreign bond allocation. But this IMO is the best rationale for one, rather than to improve return/variance-of-return performance under normal circumstances. It's to hedge against a crisis in confidence in the USD and/or US treasuries.

-under this rationale it makes no sense to hedge the currency risk of the foreign bonds. Diversifying away from the USD is part of the basic idea.

-as was stated, debt and equity are different animals, and more so for foreign debt and equity from a USD POV because the currency risk is different. The USD value of foreign equities often correlates weakly with the USD value of the currency of the country of domicile of the company issuing the stock. The correlation of USD value of foreign currency bonds with their home currency OTOH is 100% at maturity, and not that much lower for bonds with years to maturity even considering the variations of interest rates with currency values.

-therefore while hedging out currency in foreign bond funds partly defeats the purpose (as I see it) of holding them, it's hard to see any consistent purpose in currency hedged foreign equity funds. In some cases that will actually magnify price swings; indeed in some cases that seems to be the intention (for example hedged Japanese stock funds; often the Nikkei 225's Yen value is negatively correlated with the Yen's value in USD, 'stunting' unhedged USD investor gains when the Nikkei rises in Yen terms; the currency hedged funds seem intended to remove this cushioning negative correlation effect and give more potential short term upside, though of course also downside).

-on the side issue of the relative yields of bonds in various developed countries, the currency of the country with higher yielding bonds* must trade at a forward discount to the currency with the lower rates, an arbitrage condition of *today's* market for forward currency trades. It is not 'the market's prediction of future FX rates'. As was mentioned, history shows no strong correlation between the interest rate differential on date A which determines the discount/premium of the FX rate for settlement date B (transacted on date A), and the actual movement of the spot FX rate between dates A and B.

*it's actually a function of the borrowing/lending rates of the predominant entities trading currency forwards, large financial institutions, rather than government bond rates, but the relative answer is usually around the same.

Re: Do you need international bonds?

Posted: Thu May 29, 2014 9:09 pm
by steve_14
Johno wrote:Though this partially repeats points that have been made, my summary would be:
-Foreign sovereign bonds are a way of holding 'safe money outside the country', for when things go to hell inside the investor's country, and/or for the value of its currency (the vehicle for such an investment would probably be a fund domiciled inside the investor's country, but that doesn't negate the basic point). Well to do people in most other countries for most of modern history have and still do seek to do this with part of their wealth. Historically the US has been a country where this was not necessary. The question for US investors is therefore whether 'past performance is a guarantee of future results' in this respect.
Yes, or more specifically, what is the chance of an event so cataclysmic that the US govt, which can easily print money to cover its debts (and cover those with insured CDs) decides not to do so, and allows permanent default, while the rest of the world is doing just fine? I'm putting the odds so close to zero over my time horizon that I'm just not worried about it.

Re: Do you need international bonds?

Posted: Thu May 29, 2014 9:31 pm
by JamesSFO
Rick Ferri wrote:The hedging cost for Vanguard is only about 0.15% per year (take it on my word that I have a good source).
Rick I fundamentally believe you but just wonder, the BNDX ETF (https://personal.vanguard.com/us/funds/ ... IntExt=INT) has an expense ratio of 0.20%. If 0.15% is hedging then that would mean the expenses are 0.05%? That would be less than the expenses for running the US bond fund, BND which is 0.08%?

Am I mis-parsing your statement or were you saying that of the expenses of the int'l bond fund, the hedging expenses are nominal, e.g. <1%?

Best.

Re: Do you need international bonds?

Posted: Thu May 29, 2014 9:47 pm
by Boglenaut
Hedging cost are not included in the ER.

Re: Do you need international bonds?

Posted: Thu May 29, 2014 10:27 pm
by JamesSFO
Boglenaut wrote:Hedging cost are not included in the ER.
Thanks for clarifying. I know better, but keep forgetting that the ER isn't the TOTAL expenses.

Re: Do you need international bonds?

Posted: Fri May 30, 2014 9:39 am
by Johno
steve_14 wrote:
Johno wrote:Though this partially repeats points that have been made, my summary would be:
-Foreign sovereign bonds are a way of holding 'safe money outside the country', for when things go to hell inside the investor's country, and/or for the value of its currency (the vehicle for such an investment would probably be a fund domiciled inside the investor's country, but that doesn't negate the basic point). Well to do people in most other countries for most of modern history have and still do seek to do this with part of their wealth. Historically the US has been a country where this was not necessary. The question for US investors is therefore whether 'past performance is a guarantee of future results' in this respect.
Yes, or more specifically, what is the chance of an event so cataclysmic that the US govt, which can easily print money to cover its debts (and cover those with insured CDs) decides not to do so, and allows permanent default, while the rest of the world is doing just fine? I'm putting the odds so close to zero over my time horizon that I'm just not worried about it.
This is indeed a judgement call, but the scenario you give is not the only possible one. It could be a situation where the very policy of 'easily printing money' creates a crisis of confidence in the USD and/or very high inflation in the US*. It doesn't require a formal US default, and by the same token benefit from high grade foreign sovereign bonds does not require 'the rest of the world is doing just fine'. High grade foreign sovereigns are simply a hedge against a scenario where foreign government bonds become the preferred safe haven in crisis, not US treasuries as has been the case. It's not a hedge just against a formal default of the US govt. I don't see how you (or I) can know if the probability of the USD and treasuries generally losing their preferred safe haven status in times of crisis is close to zero.

*though there are of course other hedges if inflation alone is the problem.

Re: Do you need international bonds?

Posted: Fri May 30, 2014 11:20 am
by ogd
Johno wrote:This is indeed a judgement call, but the scenario you give is not the only possible one. It could be a situation where the very policy of 'easily printing money' creates a crisis of confidence in the USD and/or very high inflation in the US*. It doesn't require a formal US default, and by the same token benefit from high grade foreign sovereign bonds does not require 'the rest of the world is doing just fine'. High grade foreign sovereigns are simply a hedge against a scenario where foreign government bonds become the preferred safe haven in crisis, not US treasuries as has been the case. It's not a hedge just against a formal default of the US govt. I don't see how you (or I) can know if the probability of the USD and treasuries generally losing their preferred safe haven status in times of crisis is close to zero.
Johno: well, let's think about this. The problem with Treasuries could be:
1) confidence / safe haven status: who cares? They still get paid.
2) USD devaluation to pay them: hedged foreign bonds don't protect you there. Vanguard argues that unhedged bonds are too volatile and you lose too much in risk adjusted returns to currency fluctuations. I too think unhedged equities are enough here. Also, the US economy is so huge that the amount of printing necessary to pay the entire debt, if it came to that, isn't that large in the grand scheme of things (think total assets, not just yearly GDP) and terms like "soft default" are entirely overblown.
3) outright default: it's my strong belief that this can't happen, even in moments of extreme political stupidity. The market agreed in summer 2011, when the debt ceiling shenaningans and famed S&P downgrade lead to a flight into Treasuries.

Bottom line is, I need a safe instrument and have one readily available. There's no reason for me to replace [even some of] it with the combination of a foreign government paying less and either currency currency fluctuation or hedges with expenses and counterparties.

Re: Do you need international bonds?

Posted: Fri May 30, 2014 1:16 pm
by Johno
ogd wrote:
Johno wrote:This is indeed a judgement call, but the scenario you give is not the only possible one. It could be a situation where the very policy of 'easily printing money' creates a crisis of confidence in the USD and/or very high inflation in the US*. It doesn't require a formal US default, and by the same token benefit from high grade foreign sovereign bonds does not require 'the rest of the world is doing just fine'. High grade foreign sovereigns are simply a hedge against a scenario where foreign government bonds become the preferred safe haven in crisis, not US treasuries as has been the case. It's not a hedge just against a formal default of the US govt. I don't see how you (or I) can know if the probability of the USD and treasuries generally losing their preferred safe haven status in times of crisis is close to zero.
Johno: well, let's think about this. The problem with Treasuries could be:
1) confidence / safe haven status: who cares? They still get paid.
2) USD devaluation to pay them: hedged foreign bonds don't protect you there. Vanguard argues that unhedged bonds are too volatile and you lose too much in risk adjusted returns to currency fluctuations. I too think unhedged equities are enough here. Also, the US economy is so huge that the amount of printing necessary to pay the entire debt, if it came to that, isn't that large in the grand scheme of things (think total assets, not just yearly GDP) and terms like "soft default" are entirely overblown.
3) outright default: it's my strong belief that this can't happen, even in moments of extreme political stupidity. The market agreed in summer 2011, when the debt ceiling shenaningans and famed S&P downgrade lead to a flight into Treasuries.

Bottom line is, I need a safe instrument and have one readily available. There's no reason for me to replace [even some of] it with the combination of a foreign government paying less and either currency currency fluctuation or hedges with expenses and counterparties.
1) I don't agree. The market to market value of the instrument during a crisis certainly matters. Even a 'stay the course and rebalance no matter what' strategy rebalances according to...current market value. And unless one would rule out US bond funds also, they don't have any date of certain payment, even for US treasuries. And the only (relatively certain) guarantee of an individual nominal treasury is a nominal $ payoff, not preservation of purchasing power. TIPS at least theoretically address the latter concern (assuming honest official inflation figures) but suffered in price performance in comparison to nominal treasuries in 2008-09 even with the US still being the perceived safe haven, the natural question being, what if it's not?
2) I thought I was clear in stating that currency hedging a foreign government bond allocation makes no sense IMO. As to your judgement about the future credit worthiness of the US, by definition if you're sure it will never come into question, there's no need to worry. The only problem I see with basing your investments on a market prognostication like that is confusing it with some fundamental investment strategy argument about simplicity and expenses.
3) I agree a true (not just technical) formal US government default is unlikely, but as I've already said it's not the main scenario one would be hedging against by making some allocation to foreign bonds. As to 2001 case it's history: do past results guarantee future results?

And therefore I believe my point stands. The goal of a foreign government bond allocation is not to get superior return/variance of return in normal circumstances. And I think the hole in your argument is mainly your point 1, that it somehow doesn't matter if in a future crisis long US bonds (and bond funds) go to 80 cents on soft default fear, USD suddenly goes to 80% (not necessarily the same %, just for example), and the money fleeing the US and piling into other countries' government bond markets makes their bonds go to 120. The person who has an allocation in foreign govt bond will be glad he or she did in that case and not regret the lower return previously. And that's really the same argument we (validly) use to buy US treasuries either rather than just stocks. If we could see ahead and rule out various types of crisis, or characterize all future market panics as having only temporary effects, as you you basically do in point 1, we'd put 100% in stocks. We buy some US treasuries because the crystal ball is cloudy. The same rationale holds IMO for buying some foreign bonds, subject to individual predictions, risk tolerance and personal situation.

Re: Do you need international bonds?

Posted: Fri May 30, 2014 2:31 pm
by abuss368
Boglenaut wrote:Hedging cost are not included in the ER.
This was my understanding as well.