Mr Worldwide?

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?

First Principles

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?

Government spending

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?

International Bonds

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.

Diversification

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.

Volatility

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.

Source: Vanguard

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.

Source: Vanguard

Correlation

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.

Different risks

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:

Own analysis. Data from iShares (IGLT v AGBP)

Maturity

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).

Credit quality

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.

Cost

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:

Source: Vanguard

Concluding

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]

Further reading:

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

50 thoughts on “Mr Worldwide?

  1. Thanks for this. I have pondered this very question for a while, and having had no basis for a decision, have ended up with a not very intentional mix of global bonds and gilts. Intinctively I don’t like hedging as it isn’t something I understand, but it certainly seems preferable to not hedging, if the aim is reduced volatility.

    1. Hi Red Kite, good to hear from you.

      I’m no fixed income expert (so take what I say with a pinch of salt!). As I understand it, the hedging isn’t too complicated. For each currency, the manager will work out the series of cash flows. This will be the collection of the regular coupons and redemptions. The manager will then buy a set of futures or options that corresponds to the timing and amount of each of those cash flows that moves in the opposite direction to any currency fluctuations.

      I’ll confess that my ignorance of fixed-income has invariably held me back towards making a firm decision! But I’m always trying to learn. 🙂

      1. Thanks YFG.

        You casually talk about ‘futures’ and ‘options’ as though we mere mortals understand them….I could just nod (virtually) as though I know what you are saying, but really I’m thinking ‘don’t really understand these complex financial instruments so should I really be buying them?’. (I’m no finance expert at all, clearly!)

        1. A future is just an agreement to buy or sell something at a set price at a set time in the future. With bond hedging, you purchase a future such that you on the specified coupon dates you sell your foreign currency receipts in exchange for your currency at the date your purchase.

    1. Hi Dearieme, the answer is not ‘because I’m young’ rather the empirical evidence is that over the long-run equities have consistently produced a higher long-run real return than bonds. If I may, I’d tentatively that both yourself and the article writers are confusing hedging and protection – which are two distinct subjects. I think the authors of the article have slightly misunderstood the underlying academic paper. Having read the paper, I don’t think what the article writers have quite captured accurately what it actually says. For me, the key line is this:

      This result does not imply that equities underperform inflation over the very long run; indeed there is ample evidence that equities outperform other traditional asset classes in real terms over long horizons—see among others the Ibbotson SBBI Yearbook (2008) and the Barclays Capital Equity-Gilt Study (2008). However, these results do suggest that investors with strong non-consensus views regarding inflation may be able to enhance returns by tilting portfolios toward or away from equities, conditional upon their expectations for inflation trends.

      1. I remember once reading that equities don’t protect you from inflation at the time – they compensate you for inflation after the event. (At a guess: interest rates are raised to fight inflation; bad for equities. Then as inflation declines, interest rates are lowered; good for equities.) If you are young that’s fine. But once you are old you may have died or become decrepit before the equities ever deliver their reward.

        Put otherwise: considerations “over the long-run” maybe irrelevant to the old. If I ran the portfolio of a perpetual institution – say a Cambridge college – then I could take a very long view on behalf of the college. But if I ran a fund that provided pensions for elderly retired college staff I would need to adopt a quite different horizon.

        Remember too that a pension fund won’t be able to accumulate and reinvest dividends in the way you can – it needs to distribute income or capital gains. That means that even equities can fall behind inflation for seriously long periods when they are shorn of dividend reinvestment.

        In yet other words: investing for retirement is an easier problem than investing in retirement.

        1. Yes these are all excellent points. All very fair.

          I come at this from the very unusual position of an exceptionally long time horizon.

          Your comment about pension funds is important and extends even to those with active members. Master Trust pension funds have the issue of trying to prevent ‘winners and losers’. It can be great to get the best returns but not so if it means half your members have little to show for 30 years of saving.

  2. “It’s never defaulted on its debt (sort of)”: if by ‘debt’ you mean Gilts then it has has never defaulted on them. The “sort of” is based (I’m guessing) your letting yourself be conned by shabby journalism implying that calling a callable War Loan was a default. It wasn’t – there was a distasteful bit of inertia selling of its replacement, but that’s a million miles from a default. But if that’s not what you’re hinting at I need a different guess. Maybe HMG has defaulted on debt owed directly to another government?

    If I’m still wrong then sorry, but what were you hinting at?

    1. Oh I’m not talking about the War Loan (I agree with you that I think a bit much was made out of that). Rather I was talking about UK debt borrowed from the US during WWI and stopped servicing in the 1930s. I was trying to find a good link for it. But really struggled (being swamped by the War Loan). I’ve found a better one now from the BBC which I will replace in the article.

      http://news.bbc.co.uk/1/hi/magazine/4757181.stm

      From the BBC:

      And while the UK dutifully pays off its World War II debts, those from World War I remain resolutely unpaid. And are by no means trifling. In 1934, Britain owed the US $4.4bn of World War I debt (about £866m at 1934 exchange rates). Adjusted by the Retail Price Index, a typical measure of inflation, £866m would equate to £40bn now, and if adjusted by the growth of GDP, to about £225bn. “We just sort of gave up around 1932 when the interwar economy was in turmoil, currencies were collapsing,” says Prof Harrison.

      P.S. Thank you as ever for the typo spotting!

    1. I saw ZX’s comments last week. I’m secretly hoping he’ll lend his insights here!

      From a personal point of view, back when I was an ‘active stockpicker’ I used to invest in Emerging Market debt for much of the reasons ZX eludes to.

      In terms of my decision here, I would be looking to buy an ‘all-world’ rather than a ‘developed’ bond fund.

    1. There are several reasons Phil.
      1. You may think that yields will fall further. Just because yields are low, doesn’t mean they can’t go lower.
      2. A rise in interest rates doesn’t mean bond returns fall (only their price).
      3. You may be one of the many people who think that the equity markets are overvalued.
      4. Bonds still provide diversification and de-risking benefits.

      It’s worth having a look at this excellent short piece from Cullen Roche (PragCap): https://www.pragcap.com/repeat-after-me-bonds-dont-necessarily-lose-value-when-rates-rise/

      1. Thanks. It could be possible that rates stay lower (or negative) for longer than people might expect. And I believe that both bond and equity markets are over-valued. But at such rates, I can’t imagine that they would provide a positive real return over 30 or 50 years!

  3. Interesting stuff as always YFG.

    I’ve been through a similar (but less sophisticated) thought process. I feel more comfortable taking a view that covers the whole world (for both bonds and equities) rather than just the UK. So I’m essentially in a mix of Vanguard’s global 80:20 and 60:40 funds as well as a bit of L&G’s global tracker – my pension is more problematic so not for now.

    The two issues I have not got completely comfortable with are:

    a) The currency risk which you discuss above. It GBP strengthens a lot then I’m worried about my UK spending power plummeting – I’m not sure that the cost of hedging would justify the risk. I partially rationalise it to myself as my UK state pension will be in pounds but that’s pretty weak

    b) The fact that going globally actually means being c. 50% in the US. I worry that I’ve replace exposure to the UK market to exposure to the US market. I know that’s what the maths says but that’s no comfort.

    So no real answers but you’re not alone in thinking about all of this!

    1. Hi Caveman, good to hear from you. Your two issues are the most difficult ones and very tricky. They’ll matter differently to different people.

      A good example on the currency risk is RIT who is in the process of moving to Cyprus. The nice rise in the FTSE100 from sterling devaluing isn’t much comfort when those pounds are worth less in Paphos! The maths is maybe easier if you are staying in the UK. But we live in a global economy now where everything interacts with everything.

  4. Great article as always Young Fi Guy. Very thought provoking!

    I settled on a 3 fund approach for my personal SIPP as I repeatedly found myself going back to the simple approach to investing championed by Lars Kroijer. Passive, low cost, buy and forget. I opted for an 80/20 equity/bond split as I won’t be retiring for at least 16 years.

    It should have been Vanguard’s LS80 but I had doubts on its heavy weighting to the UK (although loving the principle).

    So Vanguard’s FTSE Global All Cap Index Fund got the nod as it simply reflects the world’s weighting and includes emerging markets and small cap. On the bond side is 10% in L&G’s All Stocks Index Linked Gilt Index Trust I Acc (UK focus) and 10% in Vanguard’s Global Bond Index Fund (as it says).

    I’ve read so much on why you shouldn’t invest in bonds or gilts at the moment but I’m neither convinced nor an expert. However, this approach lets me sleep at night, which is pretty important!

    1. Thank you for the kind words. I’m moving towards a similarly simple portfolio. We can write and think about investing all day long. But I think it’s good enough and helps me sleep easier too!

  5. Interesting article, as usual!

    Just to point out that the iShare’s pound-hedged Global Aggregate ETF has only been around for less than a year and half, so it’s kind of hard to judge its real performances (tracking error and similar).

    Also, it has less than 90 millions of assets under management -> greater risk of being de-listed, and, most probably, a pretty high bid-ask spread. That kind of spread/liquidity issues can eat into your profit way more than you would expect if you ever had to sell.

    Regarding the cost of currency hedging – all true, it has dropped considerably. I’ve got a Invesco S&P 500 EUR Hedged with lower TER than my Vanguard’s one, 0,05%!! I have to say though, it has performed quite horribly since I first bought it!

    1. Hi Young Investor, thank you for the nice words.

      Your point on the iShares ETF is spot on. I try to avoid talking too much about individual products (I’m wary of the FCA rules). But yes, it’s pretty new. It’s tracking performance has been “so so”. Having spoken to some people at Blackrock they see this (and a few other funds) as part of their core building blocks for portfolio management so I’m sure there’ll be significant flows into it over time.

      There’s a similarly cheap and short tenured State Street ETF. Though it’s hard to look past the Vanguard fund which has significantly more AUM and a long and stellar track record.

      I’ll confess, I’m a bit like Al Pacino in Godfather 3 with Vanguard. Try as I might to rely less on them they keep pulling me back in!

  6. Great article on International bonds. A few years ago I was mainly cash and equities (mostly global) but the cash became too much of a hassel. I read up on govt. bonds and came to the conclusion that Global hedged was best because of diversification (the inclusion of US treasuries in a Global bond fund appealed to me because when the proverbial hits the fan there is a rush to Treasuries). My only bond fund is Dbx Trackers Global Govt Bond ETF (xgsg). Its not cheap at 0.25% but I am happy with its performance also it was the only etf available at the time. You have mentioned an aggregate bond fund however this would include corporate bonds, this part may be a drag on the fund when equities tank, but it is cheap. Thats my not very scientific take on Global bonds.

    1. Hi Mick, thank you. And thank you for the thoughtful comment. Your point regarding corporate bonds is an important one. The international bond funds I’m talking about here include corporate bonds whereas a gilt fund obviously doesn’t.

      I drafted a (long) section for this post about that and some of the differences between indices. Govt only vs aggregate, aggregate vs high yield, global vs developed. But I felt it became too long and technical. Maybe it’d be worthy of a follow up. Or perhaps something more suitable for Monevator.

      1. Yes agreed Aggregate vs Govt is very technical. Most of the research I done was via American web sites and books who mostly favour aggregate bond funds because they give the bond part of the portfolio a higher yield. However over the long term an Intermediate term Govt bond fund would produce exactly the same returns. The reasons put forward for similar returns was because corporate bonds were priced off govt. bonds and as a group when defaults were included their long term results would be the same. If a fund chose a set of corporate bonds to be included with Govt. bonds that were different from the whole market then returns could be better or worse than a pure Govt bond fund. That was my take on aggregate bond funds after reading a lot of stuff that made my eyes bleed.

  7. Hard for me to make insightful comments in a comment! If we narrow the question down to simply whether it makes sense to switch into foreign government bonds from Gilts

    1. Global fixed income allows the investor to achieve exposure to global macro risk factors (inflation profile, economic cycles and policy rates). Realistically, everyone in the UK is exposed to these factors and while Gilts reflect these to some degree, a global portfolio will reflect this better.

    2. The diversification benefit is relatively clear. If we look at UK Gilt index returns over the last twenty years we obtain a return of 5.26%/annum with a volatility of 5.76%, a return/risk ratio of 0.91. If we look at G10 global bond index, excluding the UK, currency hedged into GBP, we obtain a return of 4.99% with a volatility of just 2.97%, a return/risk ratio of 1.68. The monthly return correlation is 75%. In any portfolio optimization, an allocation to Glits and international sovereign bonds sits much closer to the efficient frontier than Gilts alone.

    3. Currency hedging generally makes sense. The returns of the G10 ex-UK bond index over the same period, currency unhedged, are 5.14%/annum with a volatility of 9.3%, a ratio of just 0.55. The correlation with UK gilts is 60%. You achieved a very modest higher return and slightly lower correlation but with 3x the volatility. The currency risk simply overwhelms duration risk. Most forms of asset optimization will again tend to prefer the currency hedged variation. There are exceptions (EM debt can be one) but the base case should be FX hedged.

    4. Market capitalized bond index trackers may not make sense. Do you really want to own a government bond fund that increases the weight of a country as it gets more indebted? You might argue that the yield compensates you for this but empirically this is nonsense (hello Japan). Bond markets are not like equity markets. Central banks have bought trillions of bonds through QE programs. Regulations force banks, pension funds and life companies to own specified proportions of bonds. Moreover, if these entities lock up these these bonds, are they really available? What is the actual free float? Even some equity indices such as the S&P500 are float adjusted; with government bonds this is even more relevant. I would argue strongly for capped indices; it maintains diversification. Country weighting should fit your objectives, not sovereign debt levels.

    5. (Heresy) Actively managed funds may still make sense. Unlike major equity markets, where the data suggests passive beats active, the data on for bond markets is far less clear. In fact most of the data I see suggests active still outperforms passive. True, much of that outperformance is still eaten up by the higher fees. When you disaggregate that outperformance very little comes from genuine alpha. Most comes from systematic beta, generated by exploiting persistent forms of risk premia (underweighting Japanese debt and overweighting EM debt has worked for 20 years). There are more non-economic agents operating in bond markets; there is regulatory arbitrages etc. I’d also say the many passive funds don’t help themselves by selecting poor indices (often not capped, using cheap index providers), overtrading due to month-end rebalances, not exploiting primary debt issuance concessions etc. Look at the tracking error and tracking difference. The cheaper active funds may well still outperform passive trackers.

    1. Thanks as always ZX for sharing your thoughts – I really appreciate it!

      #4 and #5, in particular, have been on my mind. I think I responded to a comment by dearieme either here or on Monevator on both of those important issues. I haven’t had much joy finding any global capped bond index funds – do you happen to know any off the top of your head?

      Likewise, I’m still considering actively managed funds. My reticence is less the heresy but more along the lines of whether I have the ability to make a good call on manager selection. It’s something I’m much less experienced with and it would be dishonest of me to profess possessing much skill in selecting managers!

      I always worry with my posts that: (i) I’m talking out of my a*se and (ii) I’ll bore people to tears. Given the seemingly positive reaction to this post (nobody has called me an idiot yet, so either I’ve done alright or people are being polite) perhaps there’s scope for a more in-depth look here. That said, I’ll only do it if I can find a way to make it interesting and engaging.

  8. Are you sure the ETF charges include the hedging costs? How could the charge be 0.1% including hedging when the cost of hedging looks to be greater than 0.1% for any currency according to the chart (albeit for hedging dollars, but I don’t see why the costs for hedging the pound shouldn’t be similar)? Could the hedging costs be included in the index the ETF is tracking?

    1. Hi pagwblog. I’m not exactly sure how hedging costs are incorporated into fund charges. The whole transactions costs stuff from MIFID II is as clear as mud. So I’m not sure whether hedging costs would fall into the management fee, transaction costs or drag on performance.

      Looking at Vanguard (who are one of the most transparent on this), their global bond fund has ongoing costs of 0.16% and transaction costs of 0.08%. (https://www.vanguardinvestor.co.uk/content/documents/legal/vanguard-full-fund-costs-and-charges-2018.pdf)

      It’s possible Vanguard (and others) are able to negotiate cheaper hedging costs. Potentially, they may be utilising securities lending.

      My presumption is that the costs of hedging and the delay in buying new issues (though I understand fund managers are getting a bit smarter with this) will come out in any underperformance to the index (tracking difference and/or tracking error). You can always find the costs for a fund (and all the instruments it holds, including any forwards used for hedging) in the fund annual reports.

      1. Not engaging my brain here. The costs of the hedging instruments would be expensed in the P&L of the fund (IFRS 9, Fair Value through Profit and Loss) so they would be part of transaction costs.

    2. For funds, FX hedging costs are typically included in transaction costs (since they are transactions with a bid-offer). The FX hedged index will use closing mid-rates to calculate it’s FX hedged total returns.

      FX hedging for G10 currencies is cheap. Imagine you have a fund with a size of GBP1bn invested in US assets (say US Treasuries but it doesn’t matter). Typically funds may use a set of rolling 1-month GBP/USD FX hedges. Rather than do the full £1bn on one day then wait a month before rolling this into another £1bn 1-month FX hedge, they can smooth this exposure by doing say £50mm each day of the month (21 business days in a month x 50mm is roughly £1bn), each with a 1-month tenor.

      So every day they ask for £50mm notional of what is termed a 1-month GBP/USD FX swap (they will sell spot GBP/USD in £50mm and buy GBP/USD for forward delivery in 1 month). How much does this cost in bid/offer? Well right at this minute I can see on JPM Morgan’s interdealer platform, that with GBP/USD spot at 1.3080, the bid/offer for £50mm of an 1 month GBP/USD FX swap is 1.309862/1.309867. I can buy GBP/USD spot at 1.3080 and sell 1m forward at 1.309862 or sell GBP/USD spot at 1.3080 and buy 1m forward at 1.309867. So the bid/offer is 0.000382% or from mid 0.00019086%. You do 12 rolls of each 1m hedge per year, so the total cost from mid is around 0.00229%, or 0.23bp.

      In reality, I’m not going to pay away that much bid/offer by just asking one bank. I’m either going to call out an ask 10 banks and take the best offer or I going put the order into one of the banks’s algo platforms with a target to execute at very close to mid over the day.

      1. Thanks ZXSpectrum48k for the in depth reply.

        Regarding “FX hedging for G10 currencies is cheap”, I read that late last year the cost of hedging USD to the euro and yen had risen to around 3% annualised (e.g. https://www.bloomberg.com/news/articles/2018-10-17/bond-traders-get-paid-big-to-dump-u-s-treasuries-and-go-abroad, https://www.alliancebernstein.com/library/rising-usd-hedging-costs-3.htm). The Bloomberg article says that short-term interest rates determine currency costs, and the difference between USA rates and those elsewhere had driven up the hedging costs – I supposed that the same could be true for GBP-USD hedging, but I don’t know. YFG’s chart doesn’t seem to cover this period.

        I guessed that the mechanism is that if the USA bond yield minus hedging cost were higher than, say, European bond yields, European investors would buy USA bonds and contracts to swap dollars for euros when they want to realise their investment (presuming the USA and European bonds are seen as equally risky). As more investors do this, the cost of those currency contracts will rise, and equilibrium will be reached when the USA bond yield minus hedging cost equalled the European bond yield. This would imply that hedging costs ought to cancel out risk-adjusted interest rate differences in an efficient market. And from the articles I linked to, it does seem like the costs can become large enough not just to cancel out interest rate differences, but to reverse them (I don’t understand how that could come to be the case). Does this mechanism make sense? If not, what stops the hedging costs rising to cancel interest rate differences? I’d quite like to know – it seems important to understand whether hedging will mean you pretty much get the rate of return on your local bonds. It doesn’t seem consistent with your calculations for GBP-USD hedging costs, though.

        Do you know of any sites that are tracking hedging costs between currencies, which might be informative?

        1. I was talking about transaction costs from FX hedging.

          What you are talking about is something that isn’t really a ‘cost’. It’s a fundamental no-arbitrage relationship termed covered interest rate parity. If you could take money out of a UK deposit account and place it another deposit account, in another country, but at a higher rate of interest and then hedge out the FX risk, you could essentially make a risk free profit (assume no credit risk). This can’t happen. So the difference between the spot FX rate and the forward FX rate (the FX swap) over a time period (3m, 6m, 12m etc) is determined by the interest rate differential between the two countries.

          So in the UK, 3m LIBOR is 0.86%. In the US, 3m LIBOR is 2.65%. The difference is 1.79%/annum or 0.45% over 3m. If the current GBP/USD spot rate is 1.31, the 3m forward GBP/USD rate is 1.3160 (0.0060 higher), or 0.45% higher. No arbitrage. So what you gain in terms of depositing money at a higher rate in the US, you pay back through FX hedging the US$ risk back into Sterling. So for countries with higher short-term rates than the UK (US, Australia Turkey for example), currency hedging will reduce the yield on the assets you buy. For countries with lower short-term rates than the UK (Euro area, Japan, Switzerland), currency hedging will raise the yield on the assets you buy. It’s not a ‘cost’, however, since if this wasn’t the case you would be able to make risk-free profits.

          If you buy a 10-year US Treasury bond at 2.66% and FX hedge for 12-months, you will earn the 2.66% yield and lose 1.75% FX hedging (GBP/USD spot at 1.31, forward at 1.333). If you buy a French 10-year government bond at a 0.52% yield and FX hedge for 12-months, you will earn 0.52% and gain 1.3% from FX hedging (EURGBP spot at 0.865, forward at 0.8766). So yes it’s perfectly possible for the higher yielding US market to yield less after FX hedging than the lower yielding Euro market. What actually matters is not the yield of the asset but the difference between the asset yield and the short-term rate in that market. In the US, 1-year rates are above the 10-year bond yield, so you drop yield relative to the UK. In Europe, 1-year rates are negative while the French bond yield is positive, so you pick up yield.

          1. Thanks for that ZXSpectrum48k. Yes I agree that “cost” may not be the right term, but at least it’s something that seems like it should be taken into account when hedging foreign bonds. It sounds like my expectation that the return on hedged foreign bonds will be about the return on local bonds is about right to first order, though substantial differences can still exist. I think this matters for the main article because currently the interest rate on a decent UK savings account is larger than that on gilts, so it seems better to hold cash than gilts (unless it’s valuable to you that there is a chance that gilts will rise in value in the next stock market downturn). The returns from hedging look to imply that broadly it will similarly be better for ordinary UK investors to hold cash than hedged foreign bonds. Could it be worth holding US treasuries unhedged instead?

  9. Thanks for the article, the data on currency hedging costs is really interesting.

    But you need to re-think this bit:

    “We can see this in correlation coefficients between assets. Looking at the 2019 JPMorgan Capital Market Assumptions report: UK Gilts and UK equities have an expected correlation of -0.08. Roughly speaking this means that were UK Equities to go up, UK Gilts would go down 8% of the time. Similarly, if Worldwide equities were to go up, UK Gilts would go up only 1% of the time (correlation of 0.01). International bonds are less correlated than UK Gilts. In the two examples above, International bonds would typically go down 14% and 5% of the time were equities to go up (correlations of -0.14 and -0.05 vs -0.08 and 0.01 respectively).”

    Obviously this is not how correlation works! Otherwise -0.08 (down 8% of the time) would be the same as +0.92 (up 92% of the time). See here for a 7 minute explanation of correlation: https://www.youtube.com/watch?v=ugd4k3dC_8Y

    1. I spent more time on this bit that probably the rest of the article combined. It’s a difficult thing to put into simple English. I’m going to try and have another go and hopefully get it right this time…

      1. Perhaps it’s easiest to say that when equities go down, bonds go up around half the time (since all the correlations are close enough to zero for practical purposes). (Zero correlation does not necessarily imply this, but I would guess that it is true in this case.)

        1. Pagwblog – that’s definitely not the case though, as bond returns are rarely negative (at least in nominal terms over periods of at least a year), and equity returns are positive quite a bit more than half the time over a year.

          I guess if trying to boil it down to something very simple/easy to understand, then you can say that equity returns don’t tell you much about bond returns, but when equity returns have been higher than usual in the past, bond returns have, on average, been slightly lower than usual, and vice versa.

          However, as YFG says, correlations are themselves unstable over time, so you can’t rely on them when you perhaps need them most.

          I think it’s also worth noting (if I’ve understood correctly) that the correlations in the JPMorgan report are JPMorgan’s own long-term “assumptions” looking forwards, rather than actual historic correlations.

          We can all agree correlation is not a concept that’s widely understood (in fact it’s probably widely misunderstood) or easy to explain.

          1. That’s right, the JPMorgan correlations are forward looking assumptions. Thus they should be seen as expected correlations. (though based, in part, on historical data)

      2. Just a further thought – actually the correlation between equities and bonds is not necessarily as important as bonds just having lower volatility for someone drawing down their investments. Suppose that the fluctuations in equity and bond values were perfectly correlated, but the volatility of bonds were only 10% that of equities. Then in a financial crisis when equities fell 50%, bonds would fall 5% – so you would still be able to sell them at 95% of what they were worth pre-crisis, which would still be very helpful for paying the bills. Having a correlation below 1 would help more, but it’s not necessary to make it worth holding some bonds. Maybe you all already think this, but it’s not a point I see made often, with the low correlation between equities and bonds often being held up as the most important factor (even though, as noted before, it can’t be relied on in a crisis).

  10. @YFG – thanks for the shout out.

    As you say I do believe in bonds. The chief argument for me is the low correlation. Be careful with the ‘zig vs zag’ analogy – this sounds like negative correlation not zero correlation and there is an important difference.

    While I emphathise with the “yields of <2%, and base rates rising, you'd be mad to invest in bonds now surely?" argument (a la @Phil Money Mongoose), in practice neither argument stacks up.

    I struggle with the international vs domestic argument however and don't have the expertise / tools / platforms that @ZX48k has to hand. His data above sound compelling but I don't see an easy way to go long G10-ex-UK gilts.

    These days I am slowly tilting my bond exposure towards Domestic Inflation-Linked Gilts, i.e. INXG, and away from US corporate / high yield bonds. I do continue to have some direct GBP holdings in e.g. NWBD that yield 6%+ and have been very stable of late in terms of GBP capital values.

      1. I defer to @ZX48K for hard data. But my guess is that when ‘all sh*t breaks loose’ (aka ‘risk off’) correlations converge on 1 ie everything tanks, but in most months the correlation is low ie bonds have good months and bad months independently of equities having good/bad months. If you look at last 12 months the USA and Asia have had wild swings, and bonds have been pretty steady Eddie.

        1. From two datasets to hand:

          – Over 5 years (monthly) to 2016 UK Gilts and UK equities had a correlation of -0.2.
          – From 1995 to 2012: US bonds had a correlation of -0.22 to MSCI World and -0.2 to MSCI US. UK bonds had a correlation of -0.09 to MSCI UK and -0.06 to MSCI World.

      2. Correlations move around. I’ve seen data that historic average UK equity / gov bond correlation is 0.3 but has ranged from 0.74 (outbreak of WW2) to -0.31. Nominal gov bonds did their job in the financial crisis but didn’t in the 1970s.

  11. Very interesting discussion. Does hedging work as well as advertised over time? i.e. does it remove all currency risk? 90%? Only 60%? Does hedging work effectively during a crisis? e.g. during the Global Financial Crisis. Does much of the cost of hedging show up in tracking difference rather than OCF?

    I want my bonds to reduce volatility during a stock market downturn so ZX’s volatility numbers are pretty persuasive – if that low volatility means global bonds perform during times of trouble. I also need my bonds to pay the bills and those are in sterling. Those two considerations drive my questions about how accurate hedging is and under what circumstances. The need for bonds to hold up during a crisis also makes me shy of lowering credit quality.

    ZX – I don’t follow your point 1. Are UK residents not exposed to global factors as mediated by local conditions in the UK – and gilts will be the fixed income instrument that’s most sensitive to UK inflation, economy, interest rates? I guess you’re making a larger point in few words, so apologies if I’ve misunderstood.

    @ Dearieme / YFG – the evidence I’ve read on equities vs inflation is that high unexpected inflation environments are bad for equities. But over the long-term equities comfortably outperform inflation – hence the claims that they protect against inflation. That doesn’t seem to be the case when inflation is on the rampage. Linkers seem to be the only asset class reliably expected to do a job under those circumstances.

    1. FX hedging should work very well (>95% and probably 99%) but it has one limitation. The fund will only hedge the principal (and possibly any clearcut cashflows such as coupons or dividends). They will not hedge the P&L on that principal since they don’t know whether it will be positive or negative. So if a fund FX hedged every month, say on the first of that month, and over that month, the assets returned 10%, then that 10% return would not have been hedged. If the return was -10%, then the hedge would have been too large (they would have overhedged). Now, most funds will hedge more frequently than once a month. They will typically have a portfolio of rolling FX hedges (to reduce the size of each hedge and spread the risk). Some of these may need to rebalanced more frequently, possibly daily or even intraday. For example, funds may have daily redemptions or subscriptions that would require FX hedges to be rebalanced. In reality, therefore, the fund will usually define tolerances, at which point the hedge may need to be tweaked. As the cost of FX hedging has fallen, that tolerance has fallen (since it’s always a balance between the quality of the FX hedge and costs). Nonetheless, no FX hedge can protect against “gap” risk from the very rapid rapid movement of the underlying assets. As a result, the quality of the FX hedge is to some degree a function of the volatility of the underlying assets.

      Regarding Gilts vs. other bond markets. This is a complicated and I can’t do it justice in a comment. Clearly there is a transmission channel from global factors into the Gilt market. We import inflation from other countries and one would expect that to be reflected in our market. The problem is whether how clean that transmission channel is. The reality is many bond markets are now fairly distorted and Gilts are no exception. First, by the BoE and it’s QE program. Second, by prudential regulations on banks, life insurers etc. Third, by the fact that it is a much longer duration market than typical and the price behaviour of ultra-longs may often be more dominated by supply-demand, regulation etc than monetary policy or inflation and real yield expectations. So there is an argument for having a basket of global bonds so you are more directly connected to the sources of those factors. The problem, as you rightly point out, is that you’re most sensitive to the UK factors. So the question becomes: what is the correct weighting? And that is very hard to answer without a clear understanding of the objectives (and even then it’s pretty hard).

  12. On cost, the like for like comparison is UK gilts versus global government bonds. The cheapest intermediate global government ETFs I can find cost 0.25% – a tie between IGLH and XGSG.

    AGBP is liable to be more volatile in a crisis due to corporate bond / lower credit quality components.

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