international bonds a good idea?

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dlefton
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international bonds a good idea?

Post by dlefton »

I invest with Vanguard and their investment advisors suggest diversifying a large chunk of my bonds into international bonds. Doing some initial research, I discovered the current SEC yield for the Vanguard Total International Bond Index Fund Investor Shares (VTIBX) is 0.72%. However, Vanguard's money market fund pays about the same yield: 0.80% (Vanguard Prime Money Market Fund (VMMXX)).
So--why would I want to invest in a bond fund with an interest rate no better than a risk-free money market fund? Are they expecting price appreciation on the international bonds? Isn't it just as likely international bond prices will decline?
As another question, this international bond fund is currency hedged. Does anyone know what the cost is for this? In other words, what percent of my investment am I paying for the currency hedge?
Thanks--
lack_ey
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Re: international bonds a good idea?

Post by lack_ey »

The SEC yield reflects the local-currency yield of the underlying bonds.

What you may be missing is that the fund earns a hedge return on its currency forward contracts (it usually uses 1-month forwards for hedging FX rate movements) depending on the differences in short-term rates in the two currencies. This can in general be positive or negative. The USD short-term rate is higher than in the currencies most of the bonds are denominated in (EUR by a good bit, JPY by a good bit, etc.) so this is a net positive overall now, adding to return. This helps to somewhat or mostly equalize the rate differential most of the time.

However, there are some costs for hedging related to the bid/ask spreads that you see. This varies over time but should probably be under 0.2% a year or so for hedging the major currencies back to USD. Vanguard's fund has tracked typically some 0.29% behind its index with an ER of 0.12%. (Don't forget that the fund incurs costs trading the bonds themselves.)

Some concepts are explained in the fund company's own docs, though you may want to consult other sources as well.
https://advisors.vanguard.com/iwe/pdf/ISGHC.pdf
http://www.vanguard.com/pdf/icrifi.pdf

Their advice is not tactical, looking at current rates, but a long-term position.
Fundhunter
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Re: international bonds a good idea?

Post by Fundhunter »

Larry Swedroe, who wrote a book about fixed income investing ("The Only Guide To A Winning Bond Strategy You'll Ever Need"), says to stick to short and intermediate high quality bonds only. He doesn't like the VG Total Bond Market Index fund, which includes long bonds. He thinks that you should stick to short and intermediate term bonds if you go international as well. You can buy short and intermediate term US bond funds from VG, including index funds, which is what I do. However, unless you have an advisor who has access to DFA mutual funds, there are no low expense short and/or intermediate international bond funds available.

Just because VG offers a fund, doesn't always mean that it should be in your portfolio. From what I have gleaned from earlier threads about this, I think international bond investing is not really necessary to be well diversified.
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randomizer
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Re: international bonds a good idea?

Post by randomizer »

Fundhunter wrote:Larry Swedroe, who wrote a book about fixed income investing ("The Only Guide To A Winning Bond Strategy You'll Ever Need"), says to stick to short and intermediate high quality bonds only.
Amazing book, BTW. I think it's about time I read it again.
87.5:12.5, EM tilt — HODL the course!
herpfinance
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Re: international bonds a good idea?

Post by herpfinance »

At current rates, I do not see the appeal in investing in international bonds. You take more credit risk for less yield.

However, if you wish to take a truly a long term approach, it can be sensible. There's no telling how the yields are going to be a few years from now.
"The intelligent investor is a realist who sells to optimists and buys from pessimists" - Benjamin Graham
Fundhunter
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Re: international bonds a good idea?

Post by Fundhunter »

randomizer wrote:
Fundhunter wrote:Larry Swedroe, who wrote a book about fixed income investing ("The Only Guide To A Winning Bond Strategy You'll Ever Need"), says to stick to short and intermediate high quality bonds only.
Amazing book, BTW. I think it's about time I read it again.
During the last recent thread I was involved in regarding bond investing (and that Larry also participated in), the discussion prompted me to read his whole book again. Glad I did, because I had forgotten some things. He is not always 100% in tune with Vanguard on everything (like not recommending the Total Bond Index Fund that they use in all their Target Date retirement portfolios), but I generally side with him, as his explanations for why he recommends something make sense to me. (No, I am NOT his brother-in-law and get zero from his book sales!)
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ruralavalon
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Re: international bonds a good idea?

Post by ruralavalon »

The Google search box, upper right, will locate many forum discussions about international bonds.

In my inexpert opinion adding an international bond fund to a portfolio adds unnecessary complexity and extra expense, with little or no readily apparent benefit.
"Everything should be as simple as it is, but not simpler." - Albert Einstein | Wiki article link:Getting Started
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Noobvestor
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Re: international bonds a good idea?

Post by Noobvestor »

No benefit I can see but I also would accept them if I were trying to simplify with a fund-of-funds (like a Target Date fund).
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe
Dandy
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Re: international bonds a good idea?

Post by Dandy »

If the primary purpose of your allocation to fixed income is safety/stability so you can take most of your risk on the equity side -- I think the value of international bonds is marginal. You have an array of domestic fixed income choices that seem to fit almost any portfolio.

Muni bonds for tax advantage, US government bonds for almost zero default exposure, inflation protected bonds for protection for the inflation that you might actually experience in the U.S., CDs, money markets, savings accounts, Stable Value Funds for preservation of principal, High Yield bonds for higher yield/higher risk, Corporate bonds for moderate yields/moderate risks, and all sorts of combination of most of these products inside mutual funds/EFTs for about 10 basis points.

I think most people can find a mix of the above products to get the risk/reward/stability/diversification/safety they seek without adding international bonds. I don't think anywhere close to global weighting of international bonds is needed if the goal of your fixed income is basically safety/stability. Currently, and for quite some time, no fixed income products have been safer than those backed by the U.S. government. If that changes that it is a whole different story.
lazyday
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Re: international bonds a good idea?

Post by lazyday »

I suspect that if one just followed Vanguard's advice without questioning it, they would be in pretty good shape. I assume that their advice is based on decent research. And the interests of Vanguard align pretty well with the investor's interests, so there is little motivation for them to intentionally place you in bad investments.

That said, I like the idea of using only US bonds, CDs, etc for fixed income. David Swenson made a good case in Unconventional Success, though it's been too long since I've read it to try to summarize.
Swelfie
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Re: international bonds a good idea?

Post by Swelfie »

lack_ey wrote:The SEC yield reflects the local-currency yield of the underlying bonds.

What you may be missing is that the fund earns a hedge return on its currency forward contracts (it usually uses 1-month forwards for hedging FX rate movements) depending on the differences in short-term rates in the two currencies. This can in general be positive or negative. The USD short-term rate is higher than in the currencies most of the bonds are denominated in (EUR by a good bit, JPY by a good bit, etc.) so this is a net positive overall now, adding to return. This helps to somewhat or mostly equalize the rate differential most of the time.

However, there are some costs for hedging related to the bid/ask spreads that you see. This varies over time but should probably be under 0.2% a year or so for hedging the major currencies back to USD. Vanguard's fund has tracked typically some 0.29% behind its index with an ER of 0.12%. (Don't forget that the fund incurs costs trading the bonds themselves.)

Some concepts are explained in the fund company's own docs, though you may want to consult other sources as well.
https://advisors.vanguard.com/iwe/pdf/ISGHC.pdf
http://www.vanguard.com/pdf/icrifi.pdf

Their advice is not tactical, looking at current rates, but a long-term position.
Isn't this just the currency carry trade though? And I believe that is one of the first things that becomes highly correlated with equities is a market downturn, which would indicate that your returns could take a much bigger hit in a downturn than domestic bonds, particularly when US rates are high.
chicagobear
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Re: international bonds a good idea?

Post by chicagobear »

I certainly could see having foreign currency bonds as a partial hedge to US dollar holdings, but I don't see any point in having hedged bonds.
lack_ey
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Re: international bonds a good idea?

Post by lack_ey »

Swelfie wrote:Isn't this just the currency carry trade though? And I believe that is one of the first things that becomes highly correlated with equities is a market downturn, which would indicate that your returns could take a much bigger hit in a downturn than domestic bonds, particularly when US rates are high.
No, currency carry is uncovered (not currency hedged), for starters. The risk is in the exchange rate fluctuations, that the higher-yielding currency will become significantly less valuable relative to the lower-yielding currency.

Here we're talking about hedging foreign currency exposure by locking in rates with forward currency contracts. The return comes from the difference between the spot exchange rate and the forward rate. If there weren't a discrepancy, then you could do the same thing as the currency carry trade except hedge your currency exposure and get the excess return for free.
VaR
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Re: international bonds a good idea?

Post by VaR »

Does interest rate parity still hold nowadays? If so, then the currency-hedged return of international bonds should be equal to the return of USD bonds. And thus currency-hedged international bonds are a decent portfolio diversifier with no dilution of return.

OTOH, I have read that a number of U.S. companies are issuing Euro reverse-Yankees to take advantage of the arbitrage opportunities. Specifically they are also swapping Euro payments back into USD. And you wouldn't want to be the investor on the other side of this trade.

Conclusion: I recommend international bonds but I'm personally staying out of them for few years due to market timing. I hate it when this happens to me!

Note: I don't think EM bonds have this problem, but I don't think that EM Bonds are appropriate to overweight in one's fixed income portfolio. I might recommend them to "replace" some equity allocation, though.
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convert949
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Re: international bonds a good idea?

Post by convert949 »

Another aspect that I have NOT seen discussed is how to compare duration of the US fund vs. the hedged International fund. Current international rates are low if not negative. The Vanguard International Bond fund has a duration of 7.66 years, considered "extensive" by M*. Ignoring the hedging question for now, how would the inevitable rising rate scenario affect pricing on the underlying bonds? Will it behave the same as US bonds or differently due to the hedging activity?

I add this to the mix of questions as it seems to be ignored in most discussions I have seen. The Vanguard advisor I spoke with did not answer my question directly but rather referred to the diversification achieved by possibile differences in the yield curve.

Anyone able to weigh in?
Valuethinker
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Re: international bonds a good idea?

Post by Valuethinker »

convert949 wrote:Another aspect that I have NOT seen discussed is how to compare duration of the US fund vs. the hedged International fund. Current international rates are low if not negative. The Vanguard International Bond fund has a duration of 7.66 years, considered "extensive" by M*. Ignoring the hedging question for now, how would the inevitable rising rate scenario affect pricing on the underlying bonds? Will it behave the same as US bonds or differently due to the hedging activity?

I add this to the mix of questions as it seems to be ignored in most discussions I have seen. The Vanguard advisor I spoke with did not answer my question directly but rather referred to the diversification achieved by possibile differences in the yield curve.

Anyone able to weigh in?
Because the cost of the hedge is a function of the interest rate differential, I suspect in the long run it would even out, that +1% on the US yield curve (across the curve) would have similar effects on a currency hedged into USD foreign bond fund.

That said, this is a classic CFA exam type question, and I am too far away from those to be able to give you an answer I am sure is correct ;-).
Valuethinker
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Re: international bonds a good idea?

Post by Valuethinker »

VaR wrote:Does interest rate parity still hold nowadays? If so, then the currency-hedged return of international bonds should be equal to the return of USD bonds. And thus currency-hedged international bonds are a decent portfolio diversifier with no dilution of return.

Covered Interest Rate Parity holds, generally, I believe-- markets are efficient. Uncovered Interest Rate Parity there is the carry trade, but I am not sure how successful it is right now.

The cost of hedging will dilute your returns. Also almost by definition, you are embracing bonds with lower credit quality than the US Treasury bonds.
OTOH, I have read that a number of U.S. companies are issuing Euro reverse-Yankees to take advantage of the arbitrage opportunities. Specifically they are also swapping Euro payments back into USD. And you wouldn't want to be the investor on the other side of this trade.
I don't know enough of the jargon to understand your point?

US companies borrowing overseas is a Eurobond? A Yankee is a foreign company borrowing in the US market?
Conclusion: I recommend international bonds but I'm personally staying out of them for few years due to market timing. I hate it when this happens to me!

Note: I don't think EM bonds have this problem, but I don't think that EM Bonds are appropriate to overweight in one's fixed income portfolio. I might recommend them to "replace" some equity allocation, though.
To me it would seem better to own EM equities, with their theoretically infinite upside? Because there are generic/ systemic risks to EMs (ie one crisis in one country starts a rout) EM debt always struck me as adding volatility to an excessive degree.
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convert949
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Re: international bonds a good idea?

Post by convert949 »

Valuethinker wrote:
convert949 wrote:Another aspect that I have NOT seen discussed is how to compare duration of the US fund vs. the hedged International fund. Current international rates are low if not negative. The Vanguard International Bond fund has a duration of 7.66 years, considered "extensive" by M*. Ignoring the hedging question for now, how would the inevitable rising rate scenario affect pricing on the underlying bonds? Will it behave the same as US bonds or differently due to the hedging activity?

I add this to the mix of questions as it seems to be ignored in most discussions I have seen. The Vanguard advisor I spoke with did not answer my question directly but rather referred to the diversification achieved by possibile differences in the yield curve.

Anyone able to weigh in?
Because the cost of the hedge is a function of the interest rate differential, I suspect in the long run it would even out, that +1% on the US yield curve (across the curve) would have similar effects on a currency hedged into USD foreign bond fund.

That said, this is a classic CFA exam type question, and I am too far away from those to be able to give you an answer I am sure is correct ;-).
Thanks... So, if I understand you correctly interest rate parity is assumed due to hedging. Therefore, if interest rates were to increase in local currency, the value of the bond would decrease based on the same rules of duration we assume for US Bonds, but by an amount of that local currency? Or, is that hedged out as well...
lack_ey
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Re: international bonds a good idea?

Post by lack_ey »

The hedging doesn't do anything about the term risk. These are still longish-intermediate term bonds. If the prices of those bonds drop (the rates of bonds in those countries increases), that's a loss, no matter if the currency exposure is hedged or not.

That said, adding a 7.6 duration ex-US bond fund to a 6 duration US bond portfolio doesn't really add the same amount of rate-related risk as adding a 7.6 duration US bond fund to a 6 duration US bond portfolio. The ex-US bonds respond to the movements of different yield curves than the US bonds and as such the mid-to-high (rather than 1) correlation between the yield curves results in some modest diversification benefit relative to having more US bonds.

Note that virtually every portfolio you see discussed here is dominated by equity risk, not term risk (even if 40% stocks or some low number, unless really reaching out in duration), and given the correlation between those two, there's consequently little portfolio benefit from diversifying the term risk taken. If you're going to do anything fancy, you can get better rates and lower term risk from direct bank CDs anyway.


By the way, checking the forward rates, given that the fund uses 1-month forwards generally, do you see getting parity of returns in the base case? You get say 1.0575 EUR for 1 USD now, with a 1-month forward of 1.05918. So currently, that's what, 1.92% annualized hedge return? (Is it really that high or did I screw something up?) A 10-year German bund is at 0.343% and the 10-year Treasury is at 2.511%. Huh, that's actually not so bad at all, given that short-term rates could diverge further later in the year.
VaR
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Re: international bonds a good idea?

Post by VaR »

Valuethinker wrote:
VaR wrote:OTOH, I have read that a number of U.S. companies are issuing Euro reverse-Yankees to take advantage of the arbitrage opportunities. Specifically they are also swapping Euro payments back into USD. And you wouldn't want to be the investor on the other side of this trade.
I don't know enough of the jargon to understand your point?

US companies borrowing overseas is a Eurobond? A Yankee is a foreign company borrowing in the US market?
No and yes.

Yes, a Yankee bond is a USD denominated bond issued by a non-US entity in the US market.
A reverse-Yankee bond is a foreign currency denominated bond issued by a US entity in a foreign market.
A Eurobond is a bond where the currency of the bond is mismatched from the place of issue. So a USD bond issued in London is a Eurobond.

Example deals:
Fedex 3bn EUR in April 2016 - not a great example since they are probably using the funds to buy TNT Express
Berkeshire Hathaway 1.1bn EUR issued January 2017 - this one replaces a 1bn USD bond that matured in late January. So for whatever reason, Berkeshire Hathaway decided to issue EUR debt instead of USD debt. Let's go over two possible reasons. First, they could be taking the view that when they have to repay the 1.1bn EUR in 2019 and 2020, it will be worth less because they expect the dollar to get stronger. In this case they would not swap their EUR payments and principal into USD. OR if they are swapping the payments back to USD, they are not taking a view on FX and are instead issuing in EUR because AA-rated companies can issue debt at a lower spread than in USD, even after taking into account the extra spread from the forward FX to USD.

As a U.S. based investor, in the latter scenario I would do better to buy Berkeshire Hathaway's USD bonds instead of their EUR bonds. Generalizing, I would do better to stick with USD corporate bonds compared to EUR corporate bonds.
Valuethinker
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Re: international bonds a good idea?

Post by Valuethinker »

VaR wrote:
Valuethinker wrote:
VaR wrote:OTOH, I have read that a number of U.S. companies are issuing Euro reverse-Yankees to take advantage of the arbitrage opportunities. Specifically they are also swapping Euro payments back into USD. And you wouldn't want to be the investor on the other side of this trade.
I don't know enough of the jargon to understand your point?

US companies borrowing overseas is a Eurobond? A Yankee is a foreign company borrowing in the US market?
No and yes.

Yes, a Yankee bond is a USD denominated bond issued by a non-US entity in the US market.
A reverse-Yankee bond is a foreign currency denominated bond issued by a US entity in a foreign market.
A Eurobond is a bond where the currency of the bond is mismatched from the place of issue. So a USD bond issued in London is a Eurobond.

Example deals:
Fedex 3bn EUR in April 2016 - not a great example since they are probably using the funds to buy TNT Express
Berkeshire Hathaway 1.1bn EUR issued January 2017 - this one replaces a 1bn USD bond that matured in late January. So for whatever reason, Berkeshire Hathaway decided to issue EUR debt instead of USD debt. Let's go over two possible reasons. First, they could be taking the view that when they have to repay the 1.1bn EUR in 2019 and 2020, it will be worth less because they expect the dollar to get stronger. In this case they would not swap their EUR payments and principal into USD. OR if they are swapping the payments back to USD, they are not taking a view on FX and are instead issuing in EUR because AA-rated companies can issue debt at a lower spread than in USD, even after taking into account the extra spread from the forward FX to USD.

As a U.S. based investor, in the latter scenario I would do better to buy Berkeshire Hathaway's USD bonds instead of their EUR bonds. Generalizing, I would do better to stick with USD corporate bonds compared to EUR corporate bonds.
Thank you, that is very helpful.

Perhaps with BH it is because they have European assets via the insurance business? I.e. it is a way of hedging the balance sheet exposure to the USD/ EUR rate? SImilarly insurance policies they have issued in Europe may pay premiums in Euros and pay out in Euros?
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