Are Bonds worth considering

[GeoffF100]

I had a look at Vanguard Global Bond Fund (hedged into GBP) vs VGOV on Morningstar. (VAGP is cheaper than the Vanguard Global Bond Fund, but does not have as long a history.) VGOV has been trounced. I am feeling more inclined to buy VAGP (or its accumulating version VAGS) than VGOV in my ISA and SIPP. I am already buying low coupon gilts outside my tax shelters. They have a better tax treatment and no ongoing charges.

Worth considering these had different durations and the recent bond market crash due to rising interest rates effected VGOV far more due to its longer duration. VGOV has a duration around 9.3 years at present but a couple years back it was around 12.

The rising interest rates reduce the duration of a bond portfolio even if the average maturity remains the same.

Yes, as I have said, I believe that was the main factor there. VAGP still has the shorter duration. That will not help if interest rates fall, however.

[Hariseldon58]

Worth considering these had different durations and the recent bond market crash due to rising interest rates effected VGOV far more due to its longer duration. VGOV has a duration around 9.3 years at present but a couple years back it was around 12.

The rising interest rates reduce the duration of a bond portfolio even if the average maturity remains the same.

Yes, as I have said, I believe that was the main factor there. VAGP still has the shorter duration. That will not help if interest rates fall, however.

Going forward if interest rates fall then VGOV with its longer duration will gain slightly more, its more a question of picking a duration that suits your needs.

For myself I have chosen to have my gilts split between IGLS ( 1-5 yr gilts). and GBPG ( 1-10 gilts) and TR26 linker with my dollar exposure between TP05 and ITPS ( under 5 years and total index ) TIPS plus nominal treasuries VUTA

I have added a more speculative holding of UBTL ( 20+ year TIPs) now at around £200k , I’ll roll this over into shorter durations if things progress as I think they will, interest rates falling over the next year or two. If I’m wrong then I still have a 2.5% real returns as the YTM of the underlying portfolio.

[bluedonkey]

Speaking as a bonds newbie, I am quite happy just directly buying a selection of shorter dated UK gilts.

[GeoffF100]

If the UK government totally defaulted on its debt, gilts would become worthless. The pound would fall, but it would not fall to zero. Foreign bonds hedged into GBP would still be worth something.

I do not have a link, but Vanguard published a study in which it concluded that foreign equities should not be hedged, but foreign bonds should be hedged. The purpose of holding bonds is to reduce portfolio volatility. Unhedged foreign bonds are volatile because of exchange rate movements, so they are not very effective at reducing portfolio volatility. You would get a better return from a combination of GBP hedged bonds and equities with the same volatility.

My portfolio consists of three roughly equal parts: unsheltered cash/bonds, unsheltered equities with large capital gains, and sheltered equities. Sheltering bonds would be a poor use of my tax shelters. I oscillate between two views. The first view is that I should rebalance my portfolio, but that would involve buying bonds within my tax shelters. The second is that my cash/bond holdings have several times the value of my house, so why would I want more of them? The money will all go to charity in the end, so why does it matter? Such are the problems of having money.

[Hariseldon58]

If the UK government totally defaulted on its debt, gilts would become worthless. The pound would fall, but it would not fall to zero. Foreign bonds hedged into GBP would still be worth something.

I do not have a link, but Vanguard published a study in which it concluded that foreign equities should not be hedged, but foreign bonds should be hedged. The purpose of holding bonds is to reduce portfolio volatility. Unhedged foreign bonds are volatile because of exchange rate movements, so they are not very effective at reducing portfolio volatility. You would get a better return from a combination of GBP hedged bonds and equities with the same volatility.

My portfolio consists of three roughly equal parts: unsheltered cash/bonds, unsheltered equities with large capital gains, and sheltered equities. Sheltering bonds would be a poor use of my tax shelters. I oscillate between two views. The first view is that I should rebalance my portfolio, but that would involve buying bonds within my tax shelters. The second is that my cash/bond holdings have several times the value of my house, so why would I want more of them? The money will all go to charity in the end, so why does it matter? Such are the problems of having money.

I have seen the Vanguard paper on hedging bonds but that overlooks the other aspects I have already touched upon plus if you are tempering the volatility of a global equity portfolio, which is probably largely US dollar denominated then you hedge that bond exposure to a minority currency the £ then that’s a very different beast...

I understand your personal position is not related to this question so I will not comment any further.

[GeoffF100]

Here is a good article on bond hedging:

https://www.bankeronwheels.com/etf-currency-risk/

Interestingly, bond hedging works better if you have a weak currency like GBP than if you have a strong currency like USD or (usually) EUR, because of the profit you make on the hedge, as a result of the interest rate differentials. If I decide that I want to rebalance, selling some equities within my tax shelters and buying VAGP would be a sensible course of action.

[GeoffF100]

An important point is that the YTM for VAGP underestimates the return, because it does not include the hedge return. VAGP should return more than VGOV. The previous article on picking a bond fund is also good:

https://www.bankeronwheels.com/european ... bond-etfs/

[Hariseldon58]

Geoff100 referred to this earlier and here is a link https://static.vgcontent.info/crp/intl/auw/docs/literature/research/brief-understanding-the-hedge-return.pdf

[GeoffF100]

It may have been a different article. That article addresses bond fund volatility, but not the volatility of the portfolio as a whole. It is from a US perspective only, and does not address hedging equities. I think there was a more comprehensive article, but I could not find it. The Vanguard articles seem to have been progressively dumbed down over time.

[Oggy]

Maybe of some practical interest
Aged 77 retd 20+ years with a30/70 equity/bond portfolio
Bonds have been a single investment ie a Vanguard Global Bond index fund hedged to the Pound for many of those years
Portfolio has been through many ups and downs during this time including the last year or two
The bond part of my portfolio has however done what it was supposed to do
Reduced portfolio volatility
Preserved wealth
Grown a little
The stockmarket is a lifetime play and big drops are part of the game-investors should be aware of this
Bond fund did what it was supposed to do even though bond drops of last year or twos magnitude was unusual
I alway have 2-3 years living expenses in cash equivalents to ride out market drops without selling equity or bonds when they are down
Worked well -so far!
xxd0

I am 59 currently with no income. I like this idea, principally on the basis of preserving wealth and reducing volatility. My thoughts would possibly be to go 50/50 equity/bonds, with bonds in an ETF - VAGS or VAGP. I too have around 2-3 years spend in cash equivalent.

Sense check welcome!

[richfool]

In terms of hedging or not hedging bonds, as the £ sterling has been a weakening currency over the last 50 years or so, (at least against major western currencies including the US dollar) and seems likely to continue in that trend, surely there is merit in not hedging one's overseas bond investments (at least as far as the US is concerned), thus taking advantage of the weakening £ pound? A weakening home currency would thus enhance both the foreign dividend payments and the capital value of the investment.

For those reasons I have chosen not to hedge my US treasuries ETF by holding VUTY.

A comparable situation applies to equity holdings such as Middlefield Canadian Income Trust, which I hold. Its investments aren't hedged, thus providing exposure to the Canadian dollar.

[GeoffF100]

In terms of hedging or not hedging bonds, as the £ sterling has been a weakening currency over the last 50 years or so, (at least against major western currencies including the US dollar) and seems likely to continue in that trend, surely there is merit in not hedging one's overseas bond investments (at least as far as the US is concerned), thus taking advantage of the weakening £ pound?

You are forgetting the profit made by the hedge. This is explained in the Banker on Wheels article linked above. I will simplify matters by glossing over some details. Bonds in stronger currencies than the pound generally pay less interest. The currency hedge effectively converts those lower rates of interest into the higher rates that have to be paid for UK bonds to compensate for the likely fall in the pound. So yes, the pound may continue to fall, but you are likely to be compensated by the profit made by the hedge. All this depends, of course, on the market correctly pricing the respective interest rates and the futures contracts used to hedge against currency risk.

[Hariseldon58]

In terms of hedging or not hedging bonds, as the £ sterling has been a weakening currency over the last 50 years or so, (at least against major western currencies including the US dollar) and seems likely to continue in that trend, surely there is merit in not hedging one's overseas bond investments (at least as far as the US is concerned), thus taking advantage of the weakening £ pound?

You are forgetting the profit made by the hedge. This is explained in the Banker on Wheels article linked above. I will simplify matters by glossing over some details. Bonds in stronger currencies than the pound generally pay less interest. The currency hedge effectively converts those lower rates of interest into the higher rates that have to be paid for UK bonds to compensate for the likely fall in the pound. So yes, the pound may continue to fall, but you are likely to be compensated by the profit made by the hedge. All this depends, of course, on the market correctly pricing the respective interest rates and the futures contracts used to hedge against currency risk.

The hedge return can be negative, a few days ago I looked at the Vanguard US Treasury Bond index ETF (unhedged) vs Vanguard Treasury Bond Fund hedged to sterling on a five year total return basis, interestingly enough the £/$ exchange rate was pretty much identical for the starting and finishing dates , the unhedged version was 3% or so ahead, of course it doesn't prove anything, when the two are graphed against one or another you see significant differences, in both directions against one another over that period.

I tend to Richfools argument that the pound has a history of disappointment, but Geoff100's argument to favour hedged bonds has much merit when we see that the bulk of a Global equity portfolio is exposed to the US $ and the hedging will mitigate the currency volatility of the bond component.

[richfool]

You are forgetting the profit made by the hedge. This is explained in the Banker on Wheels article linked above. I will simplify matters by glossing over some details. Bonds in stronger currencies than the pound generally pay less interest. The currency hedge effectively converts those lower rates of interest into the higher rates that have to be paid for UK bonds to compensate for the likely fall in the pound. So yes, the pound may continue to fall, but you are likely to be compensated by the profit made by the hedge. All this depends, of course, on the market correctly pricing the respective interest rates and the futures contracts used to hedge against currency risk.

The hedge return can be negative, a few days ago I looked at the Vanguard US Treasury Bond index ETF (unhedged) vs Vanguard Treasury Bond Fund hedged to sterling on a five year total return basis, interestingly enough the £/$ exchange rate was pretty much identical for the starting and finishing dates , the unhedged version was 3% or so ahead, of course it doesn't prove anything, when the two are graphed against one or another you see significant differences, in both directions against one another over that period.

I tend to Richfools argument that the pound has a history of disappointment, but Geoff100's argument to favour hedged bonds has much merit when we see that the bulk of a Global equity portfolio is exposed to the US $ and the hedging will mitigate the currency volatility of the bond component.

Thank you Hariseldon for your input.

Geoff, your points noted and links read, thanks. I had looked at it from the perspective that that particular ETF was only holding US treasuries, therefore US dollars, as opposed to, for example, VAGP, which holds bonds from a range of different countries. Therefore there was only the potential movement between the £ and the US dollar to consider. Hedging, to me, only seemed to further complicate things and costs money/adds to costs. VUTY has very low costs, with a OCF/TER of 0.07% and no hedging costs.

[GeoffF100]

According to the article, there are not many currencies to hedge in typical global bond funds. VAGP has an OCF of 0.1%. Perhaps I can be a bit clearer by considering just GBP and USD.

Usually, GBP is weaker than USD. The market usually compensates for that by demanding a higher interest rate for UK bonds. Currencies are usually hedged with one month futures contracts. The price of those futures contracts is determined by the market, but depends on the one month interest rates in the two currencies, and the increase or decrease that the market expects for GBP/USD in that month. If there are no costs, and the market gets it right, hedged US bonds should break even with unhedged US bonds (and also unhedged UK bonds). The advantage of bond hedging is not that it is profitable overall, but that it reduces volatility.

Of course, you may think that UK interest rates are not high enough to compensate for the currency risk of holding UK bonds, or you may think that the futures contracts are mispriced. You can, of course, bet against the pound, either directly or in the futures market. That is active investment. You will most likely do better by buying cheap trackers and sitting on them.

[richfool]

According to the article, there are not many currencies to hedge in typical global bond funds. VAGP has an OCF of 0.1%. Perhaps I can be a bit clearer by considering just GBP and USD.

Usually, GBP is weaker than USD. The market usually compensates for that by demanding a higher interest rate for UK bonds. Currencies are usually hedged with one month futures contracts. The price of those futures contracts is determined by the market, but depends on the one month interest rates in the two currencies, and the increase or decrease that the market expects for GBP/USD in that month. If there are no costs, and the market gets it right, hedged US bonds should break even with unhedged US bonds (and also unhedged UK bonds). The advantage of bond hedging is not that it is profitable overall, but that it reduces volatility.

Of course, you may think that UK interest rates are not high enough to compensate for the currency risk of holding UK bonds, or you may think that the futures contracts are mispriced. You can, of course, bet against the pound, either directly or in the futures market. That is active investment. You will most likely do better by buying cheap trackers and sitting on them.

Thanks Geoff. But does that OCF include the cost of hedging, or is that an additional cost?

Yes, I suppose I am also taking a position against the pound. Many of us are to an extent taking advantage of, or benefiting from sterling weakness when receiving dividends from investments in companies (equities) that trade overseas.

[GeoffF100]

But does that OCF include the cost of hedging, or is that an additional cost?

The cost of hedging would be included in the transaction costs. Unfortunately, the MIFid II transaction costs are rubbish. There is no standard method of calculation, and even Vanguard's numbers do not always make sense. Vanguard's FTSE 100 Unit Trust has crazy high transaction costs, much higher than VUKE, which tracks the same index, but the total return has been almost identical. Indeed the unit trust noses ahead in the longest term. There is probably something strange in the way that the transaction costs are calculated for unit trusts. The transaction costs for Vanguard OEICs look much more plausible.

Futures contracts have very low costs, particularly to a giant like Vanguard, but there will be a cost. As I have said, Vanguard uses hedged global bond funds with some UK bond fund exposure in its packaged funds. Some of its competitors use just UK bond funds. They are cheaper, but less well diversified. None of them use unhedged foreign bonds to any significant extent, as far as I know.

[richfool]

This is an extract from one of the links provided by Geoff. I am drawn to the last paragraph/bullet point. (highlighted by me)

The hedge return and yield to maturity

On a long-term basis, the yield to maturity of a
domestic bond allocation serves as a reasonable
guide for predicting total return of the investment.
We demonstrate this in the full research paper by
comparing the initial yield of US bond investments
with the return realised over the following five years.
For hedged international bonds, however, the
predictability of the initial yield is reduced, from
about 85% to just 59%.
This leads us to conclude that initial yield is a less
useful metric for a hedged international bond
portfolio than it is for domestic bonds, because of
the impact of the hedge return over time.

Reduce focus on yield; keep focus on
diversification
The research underlying this brief highlights four
observations about the effect of hedging on returns:
• Hedging international bonds doesn’t produce a
bond fund without currency return. But it greatly
reduces the impact that currency has on the investment.

Source: https://static.vgcontent.info/crp/intl/ ... return.pdf

This highlights to me that whilst hedging should smooth out currency fluctuations, it can also reduce the return if one is specifically seeking to take advantage of one currency's depreciation against another, for example, sterling's depreciation against the USD, (which was my intention with my holding of VUTY).

[GeoffF100]

As I have said, if the market believes that the pound will fall against the dollar, it will demand higher interest rates from UK bonds. That view will also be reflected in the pricing of US bonds hedged into sterling. If you believe that the market has got it wrong, and that the pound will fall further against the dollar than the market expects, then you are free to bet against the market.

[richfool]

As I have said, if the market believes that the pound will fall against the dollar, it will demand higher interest rates from UK bonds. That view will also be reflected in the pricing of US bonds hedged into sterling. If you believe that the market has got it wrong, and that the pound will fall further against the dollar than the market expects, then you are free to bet against the market.

Geoff, VUTY (US Treasuries) shows a yield of 4.02%. Whereas VGOV and IGLS show yields of 1.6% - 1.67%. Wouldn't that, on the face of it, suggest that US Treasuries represent a higher risk than UK Gilts? Accepted their respective pricing will also be a factor. But whatever, the US treasuries are providing a higher (immediate) income.