I’ve been thinking whether, like Pitbull, it’s time to become Mr. Worldwide. Should I move out of UK Gilts and into International bonds?
As we slowly inch towards a new tax year, I’m thinking about filling up my ISA allowance and my bi-annual rebalance. And over time, I’m trying to simplify my portfolio down towards a simple global portfolio (as espoused by Lars Koijer over on Monevator).
So why am I complicating things by thinking of changing my asset allocation?
Being, among many things, a mathematician at heart, I always try to take things back to first principles. The first principle of investing is that we invest because of inflation. As Monevator puts it:
The first reason we invest is to maintain the spending power of our money. Every year we need to grow our savings by at least the rate of inflation.
A second principle is that a globally diversified passively invested portfolio is the cheapest, simplest and effective (risk/return) way to invest.
So a valid question I get is: why do I invest only in Gilts and not International bonds?
My reason in the past has been due to the first of the two principles above – inflation. I’m most concerned about inflation risk. Put another way, I want my assets to increase when my liabilities increase. My spending is linked to what our Government spends. If they spend (and borrow) more, then I receive more goods and services from the public sector. Be those higher pensions, public services, benefits or infrastructure. Likewise, if the Government cuts spending then there is a cost to me. Either through having to replace those services through my own pocket or by having to put up with sh*tter services.
The high-level theory is that if a Government spends more, it has to borrow more. By supplying more Gilts (relative to demand) Gilt prices fall. On the other hand, a Government that borrows less would see prices rise. These movements offset against changes in spending.
Perhaps naively, I’m now starting to see that this theory doesn’t necessarily translate into practice.
I’m no tin-foil type. But I’m sympathetic to arguments alleging asset price distortion. Through a combination of quantitative easing, the post-Global Financial Crisis pursuit of yield, the boatload of money pension schemes keep dumping into Gilts and mismanagement of the Government purse – I can see merit in those points. There is also growing evidence that past Governments woefully underestimated the costs of austerity.
So I’m feeling a diminished case for UK Gilts. But what are the arguments for their international counterparts?
As I’ve said before, there are two things under the control of an investor: levels of risk and cost. You can’t guarantee returns and the evidence is that tactical asset allocation doesn’t work. Or at the very least, I ain’t smart enough for it to work for me.
First, let’s look at levels of risk.
By investing internationally you are much more diversified. You invest in more securities, more countries, different credit rating levels and different maturities. You are less vulnerable to interest rate risk. Or, the technical term: the risk your central bank “goes off on one”.
It’s the classic case of eggs and baskets.
The classic measure of investment risk is volatility (leaving aside the many issues with that measure). When it comes to International bonds they are much less volatile than local market bonds.
However, that’s after currency hedging (FX). Investing in International bonds without FX hedging increases volatility. That’s because you are adding currency risk on top of your investment. The swings and roundabouts of sterling (or your local currency) versus the basket of worldwide currencies.
This, of course, can work both ways. Sometimes hedging can leave you as a real loser (like NOW Pensions). But for the most part, currency hedging with Government bonds has the effect of levelling out returns and volatility between countries.
One of the reasons we invest in Gilts is that they have a low correlation to equities. Or in normal person speak, their returns tend to not follow the pattern of equities.
We can see this in correlation coefficients between assets. Correlation coefficients range from 1 to -1, where 1 means when one item increases the other will increase and where -1 means that when one item increases the other decreases.
Looking at the 2019 JPMorgan Capital Market Assumptions report: UK Gilts and UK equities have an expected correlation of -0.08. In other words, the returns on UK Gilts and UK equities are not expected to move together. In fact, they very slightly tend to move in opposite directions (when UK equity returns rise, UK Gilt returns fall). Similarly, Worldwide equities and UK Gilts have a correlation of 0.01 meaning again there is effectively no expected relationship between the returns of the two assets.
International bonds have slight negative correlations to UK equities and Worldwide Equities. The respective correlations are -0.14 (vs -0.05) and -0.08 (vs 0.01). This means that International bond returns are expected to very slightly tend to faIl when equity returns rise.
That said, we should still be mindful that in periods of financial crisis the correlation of different assets tends to converge. That is, in a financial crisis most asset returns fall together at the same time.
However, by investing in International bonds we increase the chance of our bonds not following the same pattern as our equities.
By investing in International bonds instead of Gilts we are also taking on different types of risk. It’s easiest to show this in a picture:
The UK tends to issue much longer maturing bonds than other countries. Nearly half are long-term bonds (15+ years). International bonds are on average much shorter in length. The average maturity for the UK Gilt fund is 15.6 years. Just 8.6 for the International bond fund. This is also reflected in the (jargon warning) Effective Duration of the bonds. The UK fund has an Effective Duration of 11.1, and the International fund 6.8. The longer the duration of the bond the more sensitive the returns are to changes in interest rates. All else equal (big assumption!), longer maturity bonds also tend to have higher yields (though not always, if the yield curve ‘inverts’ for example).
Despite the ongoing political shenanigans, the UK is a pretty strong and stable (…) country. It’s never defaulted on its debt (sort of). That’s reflected in its AA credit rating. To be honest, I don’t understand why it’s not AAA rated, but those credit rating guys are very smart and never get it wrong.
When we look to the International bonds the picture is more mixed. There are some stronger countries in there (Germany, AAA) but also some more ‘ropey’ ones (Japan – A, Spain – A, Italy – BBB). So by investing in International bonds, we are taking on a mixed-bag. And in my opinion, going from a zero percent chance of any of our holdings defaulting to a non-zero chance some will.
If I haven’t bored you already, that’s enough about risk. Let’s finally turn our attention to cost.
The good news is that the cost of investing in International bonds is about the same as UK Gilts. If not a little cheaper.
The cheapest UK Gilt funds/ETFs as of writing (Feb 2019) are Lyxor’s GILS (0.07%) and Vanguard’s VGOV (0.15%). I currently hold VGOV.
The cheapest International bond funds/ETFs as of writing are iShare’s Global Aggregate ETFs (0.1%).
My presumption had been that the cost of hedging would make hedged International bond funds more expensive. I was pleasantly surprised to find they are the same cost (at least for iShares at 0.1%). This tallies with what some knowledgeable readers have told me in the past: that the cost of currency hedging has significantly fallen over time. You can also see this in a chart from Vanguard:
When I started planning this post I was very much on the fence about whether to switch any Gilts to International bonds. I’m definitely leaning much more towards moving some or all of them having now typed this out.
That’s because the overall risk appears to be lower in International bonds (on a personal level). At the same time, the costs are also slightly lower. I still have this nagging thought in that back of my mind about whether I should care about how much the Japanese Government dishes out to its pensioners. And whether being less invested in Gilts leaves me vulnerable to sharp liabilities shocks.
I know there are lots of much smarter people out there, so I’d really like to hear from you about what you think. If you’d like to share your thoughts please leave a comment.
All the best,
Young FI Guy
[Edit: changed the wording in the ‘Correlation’ subsection]
This isn’t intentional, but all the following links are from Vanguard. I read a lot of material from various sources. But most were either superficial or far too verbose. The FI community is also a disappointing source for discussion. Most bloggers are 100% equities. I’ll confess I don’t find their arguments particularly compelling. Some notable exceptions are DIY Investor, Fire V London and Retirement Investing Today.
Vanguard – Going global with bonds: https://institutional.vanguard.com/VGApp/iip/site/institutional/researchcommentary/article/InvResGoingGlobalWithBonds
Vanguard – three tips for investing in bonds: https://www.vanguard.co.uk/adviser/adv/articles/research-commentary/asset-classes/three-tips-for-investing-in-bonds.jsp
Vanguard – The role of home bias in global asset allocation decisions: https://personal.vanguard.com/pdf/icrrhb.pdf