Global Bond Funds vs Cash ISAs

[GeoffF100]

I have been wondering about the Vanguard Global Bond Index Fund:

https://www.vanguardinvestor.co.uk/inve ... ion-shares

This fund would be a lot more convenient than transferring money to and for Cash ISAs. The Vanguard Global Bond Index Fund is hedged into Sterling. This article explains how this works:

https://personal.vanguard.com/pdf/ISGHC.pdf

That looks sensible, but what about risk/return? The Yield To Maturity (YTM) of the Vanguard fund is 1.7% p.a. The OCF for the fund is 0.15%, so I expect that the net return, provided that there are no defaults, is 1.55% p.a.

Vanguard gives the distribution by S&P credit rating as AAA 39.4%, AA 15.8%, A 21.8%, BBB 18.8%, less than BBB 0.1%, and not rated as 4.1%.

We can get the average annual default rates from 1981 to 2008, for each credit rating, from Wikipedia:

https://en.wikipedia.org/wiki/Bond_credit_rating

(N.B. The title for the "1978-2008" table is wrong.) Aggregating these average annual default rates gives AAA 0.00%, AA 0.003%, A 0.014% and BBB 0.055%.

If we count "less than BBB" and "not rated" as BBB, the overall default rate becomes:

0.00% + 0.003% + 0.014% + 0.055% = 0.072%

Adjusting for defaults, it would appear that the expected net annual return is likely to be about 1.48%.

Money Saving Expert gives the best interest rates for Cash ISA transfers:

https://www.moneysavingexpert.com/savin ... -transfers

The expected net annual return for the Vanguard fund is about the same as for a 1 year cash ISA bond (1.45%), but significantly less than for a 2 year bond (1.86%). the best rate for a 5 year bond is 2.15%. (The 5 year best rate outside a tax shelter is currently 2.5%.) These deposits are all guaranteed by the FSCS, but the UK government guarantee my not be completely safe.

The Vanguard Global Bond Index Fund diversifies risk away from the UK government, but the bond default rates may be greater than the Wikipedia numbers suggest.

Have I got these numbers right? What is your assessment of the pros and cons?

[AleisterCrowley]

What about the effects of interest rate rises over the holding period?

[hiriskpaul]

An important missing factor is associated with the shape of the yield curve. Just a quick back of the envelope calculation as I don't have much time!

5 year gilts are yielding about 0.5% less than 10y, or roughly a 0.1% drop in yield per year. The duration of the fund is given as 6.8, implying approximately a 0.68% increase in price if the yield drops 0.1%. This is likely an overestimate as convexity (not provided by Vanguard) will drag it down, so let's say somewhere around 0.5%. You need to add that 0.5% into the expected return.

A couple of other things to consider:
- the price of the fund will likely to react positively to a stock market crash - bank deposits will not.
- the fund is available on instant access (2 day settlement), term deposits typically are not

[hiriskpaul]

What about the effects of interest rate rises over the holding period?

Good point as well. These may or may not be fully priced in!

[GeoffF100]

Adding about 0.5% to the yield makes the bond fund much more attractive. The yield is then reasonable in comparison with Cash ISAs. Using the bond fund clearly involves less work, and offers more flexibility. It may be more risky, but I am only thinking about roughly 4% of my portfolio here. My portfolio is not very liquid because of capital gains tax and other reasons, but a little elbow room to make small changes is useful.

[Alaric]

Using the bond fund clearly involves less work, and offers more flexibility. It may be more risky, but I am only thinking about roughly 4% of my portfolio here.

For higher risk and higher return, you could also consider a Corporate Bond fund or ETF. The same exposure to interest rate rise of course and the addition of a risk of the yield gap to Gilts and other Government paper increasing.

[GeoffF100]

At age 68, with nearly 60% equities, I feel that I have enough risk in my portfolio, but a small holding in the global bond fund would not greatly increase it.

[GeoffF100]

Here is an interesting study on currency hedging overseas bonds:

http://www.vanguard.com/pdf/icrifi.pdf

Hedging appears to be good for bonds, but not for equities.

The tracking error is small for the Vanguard Global bond fund, so the hedging does not appear to be too expensive. One of the risks quoted in the KID for this fund is that the hedging may not be perfect. The Life Strategy 60 had about half of its bond exposure in this fund when I last looked. The remainder was in UK bonds / gilts. This looks like a sensible addition to my portfolio.

[GeoffF100]

I had not appreciated that withholding taxes applied to interest as well as dividends. Here are the withholding tax rates and rules:

https://uk.practicallaw.thomsonreuters. ... sc.Default)&firstPage=true&bhcp=1

Nonetheless, the expected returns from the Vanguard fund look reasonable, for someone who already has heavy exposure to UK bank deposits (albeit protected by the FSCS) and bonds.