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Cost of hedging in Bond Fund or ETF

Gilts, bonds, and interest-bearing shares
Hariseldon58
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Cost of hedging in Bond Fund or ETF

#220772

Postby Hariseldon58 » May 10th, 2019, 10:31 pm

There are quite a few passive and active bonds funds that are hedged back to sterling.

Eg a short US treasuries hedged to sterling ETF, like iShares IBTG 1-3 year US treasury bonds ETF, hedged to sterling, the charge is 0.22% , slightly more than unhedged dollar version. The distribution yield is 1.9%, much higher than the equivalent duration gilts.

My understanding was that hedging involved a cost that was related to the different interest rates in the relevant currencies, on the face of it this has a higher yield for a similar credit quality.

My interest is normally aimed firmly at equities but I can see a larger fixed interest portfolio to run alongside my equities would be a good idea and wondered if anyone with more knowledge could help with this apparent anomaly.

Alaric
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Re: Cost of hedging in Bond Fund or ETF

#220780

Postby Alaric » May 10th, 2019, 11:41 pm

Hariseldon58 wrote:Eg a short US treasuries hedged to sterling ETF, like iShares IBTG 1-3 year US treasury bonds ETF, hedged to sterling, the charge is 0.22% , slightly more than unhedged dollar version. The distribution yield is 1.9%, much higher than the equivalent duration gilts.


I'd be inclined to think that yields on short duration bonds would be primarily influenced by domestic issues, whilst exchange rates have any number of drivers. Perhaps there's an arbitrage opportunity.

It might well be a risk v return trade off. Invest in US Bonds for a higher return at the risk the exchange rates could go the wrong way. Particularly in short term markets, free lunches are unlikely.

Hariseldon58
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Re: Cost of hedging in Bond Fund or ETF

#220800

Postby Hariseldon58 » May 11th, 2019, 8:36 am

@Alaric

I’m interested in how a hedged short US Gov’t ETF appears to give me the higher yield without the currency risk for apparently little additional charge.

I came across some info on iShares site, can’t find the link now which detailed the hedging time frame ( 1 month ?) that suggested good but not perfect hedging.

I must admit I would like to have a far more detailed understanding before making any significant investments...

Alaric
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Re: Cost of hedging in Bond Fund or ETF

#220811

Postby Alaric » May 11th, 2019, 9:12 am

Hariseldon58 wrote:@Alaric

I’m interested in how a hedged short US Gov’t ETF appears to give me the higher yield without the currency risk for apparently little additional charge. .


On the "no free lunch" principle, there's likely a low risk of a sizeable loss hidden in there somewhere. Failure of the hedge on extreme currency fluctuations perhaps?

Spet0789
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Re: Cost of hedging in Bond Fund or ETF

#220864

Postby Spet0789 » May 11th, 2019, 2:03 pm

Alaric wrote:
Hariseldon58 wrote:@Alaric

I’m interested in how a hedged short US Gov’t ETF appears to give me the higher yield without the currency risk for apparently little additional charge. .


On the "no free lunch" principle, there's likely a low risk of a sizeable loss hidden in there somewhere. Failure of the hedge on extreme currency fluctuations perhaps?


No, the hedge will be a forward contract so entirely linear. The only risk of loss on the hedge is if the major bank the fund will have hedged with goes from looking fine last month to bankrupt this month, and at the same time the fund is owed money under the contract (ie the USD has fallen vs GBP). As the USD tends to act as a a safe haven, this seems unlikely to me.

The only ‘trick’ is that while you have 1-3 year duration in USD, you have only 1 month duration in GBP. So if GBP rates fall, a Gilt fund will show some capital gains while the UST fund with GBP hedge won’t. But of course this could equally well benefit you. If UST yields fall but gilt yields don’t, you will see outperformance of the hedged fund.

Hariseldon58
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Re: Cost of hedging in Bond Fund or ETF

#220959

Postby Hariseldon58 » May 11th, 2019, 7:42 pm

@Spet0789

That’s interesting, I am bringing my ‘equity like’ exposure down, the bond passives I am using will include sterling, dollar and hedged to sterling.

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Re: Cost of hedging in Bond Fund or ETF

#221015

Postby tikunetih » May 12th, 2019, 8:09 am

Hariseldon58 wrote:That’s interesting, I am bringing my ‘equity like’ exposure down, the bond passives I am using will include sterling, dollar and hedged to sterling.


Is this a permanent portfolio shift, or might a change in conditions (valuations) one day prompt you into again re-raising the equity allocation?

Hariseldon58
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Re: Cost of hedging in Bond Fund or ETF

#221025

Postby Hariseldon58 » May 12th, 2019, 9:21 am

@tikunetih

The increase in Bonds allocation is permanent.

The logic of more cash/bonds is preservation / cash flow rather than all out growth.

Portfolio return in excess of inflation that I targeted since 1990 was 4 % , I was fortunate to achieve 7% plus, looking forward the 4% target remains. Bonds returns I would have expected then was inflation plus 1-2%, I imagine the actual results were much higher ( I don’t have the figures to hand) and looking forward I am looking for inflation plus 0.5% ( that could be wildly optimistic in some potential scenarios !)

Thus the portfolio now aims for 3.3% rather than nearer 4% real returns, one quote summarises the lead to this change.

Bernstein’s “When you have won the Equity game, stop playing”

Whilst a virtually 100% Equity portfolio is feasible for us, it’s bound to lead to changes in behaviour in the event of a severe market fall, curtailing our extensive travelling in the winter periods.

In theory we could probably be 100% bonds and carry on as we are for 30 years plus.

It’s easy to forget that money has more utility now rather than later, I am 60 and having seen 2 out of the 8 students in my university ‘maths group’ pass away this year... clearly not statistically valid but illuminating.

Thus a substantial bond reserve would assist cash flow in down markets. The 20% bond allocation should probably be higher but baby steps !

Separately I am reversing portfolio changes I made last summer thinking that Brexit would resolve itself by now, a return to largely passive, with factor tilts. (Reduction in investment trusts and bias to uk equities)

My judgement that common sense would prevail by now, was wrong, common sense may prevail eventually but I was wrong on the timing and a return to my standard portfolio mix is now sensible when I don’t have a clue what will happen next!

I have been gently unwinding since the beginning of April and had taken some profits earlier, overall the cost will be neutral, as the slightly loss making assets are sold now.

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Re: Cost of hedging in Bond Fund or ETF

#221104

Postby WorkShy » May 12th, 2019, 5:44 pm

Currency hedging has nothing to do with the underlying assets. It is simply a function of covered interest rate parity, a no-arbitrage condition

Imagine you want to invest in a fund that invests in USD assets. You invest GBP100k. The fund then executes a short GBP/USD (sell GBP, buy USD) spot transaction at say 1.30 to convert the GBP100k to USD130k. This leaves you with an open fx position, short GBP/USD. To hedge that fx risk, you need to buy GBP/USD (buy GBP, sell USD) forward for whatever time period that you want the hedge to exist for. Let's use 12 -months as an example. So at a spot level of 1.30, the 12-month GBP/USD fx forward outright is 223 pips higher or 1.3223. The difference between the spot rate of 1.30 and the forward rate of 1.3223 is known aS the fx swap implied yield and in this case is around 1.71%. This yield stems from the difference between the 12-month rates in both GBP and USD.

Take the counterfactual: if the forward rate was the same as the spot rate, it would be possible to take GBP, convert to USD, invest in a time deposit in USD at a higher rate than in GBP and then convert back to GBP using the forward hedge. You'd have no fx risk but have earned a risk free profit from the rate differential. So the fx forward rate represents the breakeven rate that will compensate for that rate differential.

So when buying any asset in a foreign currency, if you currency hedge the position a period of time, you will pay or receive the rate differential for that time period. If the foreign short rates are higher than your domestic currency, that will result in a lower effective yield; this is the case of the US, where short rates are higher than the UK. By comparison if you currency hedge a currency risk where the foreign short rates are lower than your domestic currency, that will result in a higher effective yield; this is the case when you invest in EUR assets, since EUR short rates are lower than the UK.

So yes, you can invest in a short duration US Treasury fund at a higher yield than a equivalent short duration UK Gilt fund but once you currency hedge that yield pickup will be reduced. In fact the effective post FX hedging may well be worse than the Gilt yield.

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Re: Cost of hedging in Bond Fund or ETF

#221246

Postby hiriskpaul » May 13th, 2019, 11:02 am

Just to add to what workshy has said, which I completely agree with, I would add that forward FX prices are constructed by FX traders from the spot rates and the respective currency interest rates. In fact all forward traders do is enter the term into their trading system and the trading system works out the forward rate. A spread is applied, above the normal spot spread, which can be thought of as the cost of the product.

There is no additional expected return from say a GBP hedged UST fund compared with an equivalent duration gilts fund, but you are more diversified across issuers.

There is a paper somewhere on Vanguard's web site that suggests a hedged bond fund has lower volatility than a straight GBP bond fund. I assume that would imply better risk/return characteristics, but it is a while ago I read the paper.

Personally I like to have additional currency risk in my bonds, as this risk is an additional hedge against a falling pound. That currency risk is of course not always beneficial!

Hariseldon58
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Re: Cost of hedging in Bond Fund or ETF

#221421

Postby Hariseldon58 » May 13th, 2019, 10:05 pm

Thank you for the detailed replies, my suspicions were that there was no free lunch is correct and I appreciate the explanation.


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