Hedging Bonds – Should you do it?
If you are thinking about hedging your bonds, you’ve come to the right place.
Now, this is only something you really need to consider if you invest in international bonds. So before we deal with whether hedging, it is probably worth going over why you might want to invest in international bonds in the first place.
Some of the most common reasons for investing in international bonds are:
- Are the largest component of global capital markets;
- Increase returns;
- Reduce portfolio volatility;
- Help you diversify; and
- Are the only option available (e.g. because you live in a country without high quality government bonds)
Here’s my take on these reasons for investing in international bonds:
1 . The largest component of the global capital markets.
Many people advocate investing in a market portfolio. This is a basket of investments that include all types of investable asset available in the world financial market. The money you invest in each asset should be in proportion to its market share.
If you are investing £10,000 and US stocks are 25% of the capital markets then £2,500 should be invested in US stocks. If UK government bonds are 5% then £500 of your investments should be in UK government bonds.
The idea is straightforward. If you do this you will achieve market returns, and if you achieve market returns you’ll be doing well. That’s because, most people underperform the market.
Many experts agree to a certain extent with this concept, particularly regarding stocks. However, a lot don’t agree that the bond part of an investors portfolio should follow the market portfolio.
Instead, they recommend investing only in local highly rated government bonds.
That’s because other types of bonds come with risk of default and currency risk (I’m covering this next), which in an ideal world you want to avoid.
Bonds should be the safe part of your portfolio. Something to give you some peace of mind when stocks drop double digits, which they inevitably will!
As a result, you want to reduce as much risk as you can in that part of your investment portfolio.
2. Increase your returns.
As I write this UK investors can get a 1.2% yield on 10 year government bond. At the same time Italian government bonds are yielding 2.6% and Greek equivalents are yielding 3.3%.
And right now the US is yielding the same as Italy, 2.6%. So you can definitely increase your returns by adding international bonds to your portfolio. Why wouldn’t you?
You wouldn’t do it because you’d be taking on either currency risk, default risk or both.
Credit risk
Lets’ tackle credit risk first. When you invest in a bond you are essentially loaning an organization money. The lender pays you interest for your trouble.
But this is no different to any other situation where you lend money to somebody. There is a risk that you don’t get your money back.
All bonds come with a certain amount of creditworthiness. The more creditworthy a bond is the better. Because it means the more likely it is that you as an investor will get your money back.
A bond’s creditworthiness is determined by rating agencies. Two of the biggest rating agencies are Standard & Poor and Moody’s.
A Standard & Poor rating of BBB or above and a Moody’s rating of Baaa3 or above signifies investment grade. Ratings below these are considered non-investment grade.
Non-investment grade bonds also go by the names of high yield bonds or junk bonds. The clue is in the name! They generally yield higher than investment grade bonds, but they are a lot less creditworthy. Hence ‘junk!’
High quality government bonds really need to be at least AA. At the time of writing, the UK is rated AA and the US AA+. There are plenty of countries with triple A rated bonds, though.
So a UK investor could invest in US bonds happy in the knowledge that they are going to get their money back.
And as we’ve already seen the US is paying 2.6% compared to 1.2% for the UK. So again, why wouldn’t you?
Currency risk
Well, there is another risk to consider.
If a UK investor invests in US bonds they take on currency risk. Let me explain the rationale behind this.
If somebody living in the UK and somebody living in the US each bought a $100 dollar bond which pays $1 a year, they would both be sure to have $101 after one year.
For an American the value of $101 dollars is unquestionable. It is $101! For somebody living in the UK however, the value of $101 dollars must first be exchanged into pounds. Only then can the true value can be assessed, and here lies the risk.
Right now, the exchange rate is about £0.8 to $1 so $101 dollars is about £81. You would expect to receive £81, but what if the price of the pound moved against the dollar.
If the pound strengthened against the dollar so that $1 was worth £0.6, then $101 would only be worth about £61, which would be terrible for an investor. They’d have lost about £20.
Alternatively, if the value of the pound weakened against the dollar the opposite would be true. Say £1 became equivalent to $1 then $101 would be worth £101. This would be great for an investor because they would have made about £20.
Currency exchange rates can be pretty volatile. During the Brexit vote the pound dropped 10% compared to its high against the dollar in a single day.
In an ideal world, investors should want to avoid both currency risk and any credit risk.
Because of this, most investors would be best served investing in the government bonds of their base currency.
For example, a UK investor would buy UK government bonds denominated in pounds and avoid foreign bonds altogether.
The additional yield on alternative types of bonds just isn’t worth the risk.
If an investor wants to increase the returns on their portfolio there is a more straight forward way. That is to simply increase your allocation to stocks.
If you have a portfolio split equally between stocks and bonds, you could just increase your stock allocation to say 60% stocks.
3 & 4. Reduce portfolio volatility and increase diversification.
The concepts of increased diversification and reduced volatility tend to go hand in hand. Volatility is the extent to which the price of your investments move up and down.
It can be reduced by spreading your money across different assets through diversification.
Lots of investors invest internationally with stocks for these reasons. International economies have a lot of differences. These include: growth rates, interest rate programs, yield curves, inflation policies, and currencies.
These differences can mean that international bonds don’t correlate very well with other assets in your portfolio. In other words, they go up and down in price at different times.
As a result the balance of your portfolio doesn’t move up and down so dramatically. This is because when one asset goes down, another one goes up.
There’s definitely a lot of weight behind this argument. However, the benefits don’t override the downs sides associated with credit risk or currency risk.
5. The only option available
Having said that, there is a situation where portfolio volatility and increased diversification is definitely worth thinking about.
So far I’ve only considered investors who live in a place that has highly rated government bonds. But, there are other investors out there.
There are many countries without highly rated government bonds. Residents of those countries and expat investors may have a decision to make: To decide whether to take on currency risk, default risk or both.
You can go local and invest in bonds that aren’t rated highly, where you would take on credit risk. Alternatively you can take on currency risk and invest overseas. Perhaps, you could even invest in both.
For a lot of investors who live in a place without high quality government bonds, a logical solution is to invest in a basket of highly rated foreign developed country government bonds.
Not only do you avoid credit risk by doing this, you also lesson currency risk by diversifying across a range of currencies. The chances of all the currencies going against you at the same time are a lot less than the possibility of just one going against you.
As an example, say you are a British expat living in a developing country. Also, say the country doesn’t have its own highly rated government bonds.
The local government has government bonds, but they aren’t rated highly and you don’t want to take on credit risk. You might decide to invest in US government bonds.
But luck goes against you. The US dollar weakens considerably against your local currency and damages your investments.
Alternatively, you could have invested in a developed market government bond fund. This should contain a basket of different bonds in different currencies.
The US dollar still weakens considerably against your local currency, but it doesn’t affect you because, you also have euros, Chinese yuan, Japanese yen etc.
By investing in multiple foreign developed market government bonds you avoid credit risk altogether. On top of this, you reduce currency risk at the same time.
OK sounds good but is there a way to avoid currency risk all together?
Hedging bonds
The short answer is yes! These days you can invest in bond funds that are hedged in the currency of your choice.
Typically, the fund manager deals with hedging bonds, or any other investments you decide to hedge.
They do this through purchasing financial products (futures contracts, options or contracts for difference) that move in the opposite direction to your main investments.
Say a fund manager buys £1000 worth of bonds issued by the German government and these bonds are issued in euros. At the same time, the fund manager can buy some kind of investment that moves in the opposite direction of the euro.
As a result, if the euro weakens by 5%, then the hedge will increase in value by 5%. So any impact of currency devaluation will be completely neutralized.
The end result is that hedging bonds enables you to invest in foreign bonds without taking on currency risk.
Sounds good, but as with anything there are drawbacks to hedging bonds.
Drawbacks of hedging
I mentioned earlier that international bonds could be good for correlation and diversification.
Just to be clear, if you have access to local highly rated government bonds, then just invest in them.
However, if these aren’t available for some reason. Say because you live in a country without them you are going to have little choice. You’ll have to invest in international bonds.
In this situation diversification and correlation may improve the overall performance of your portfolio.
Modern Portfolio Theory (MPT) says you can diversify away from the risk of investment loss by reducing the correlation between the securities you select. So the less correlated the assets in your portfolio the better.
Hedging vs Correlation Coefficient
The extent to which one asset (type of investment) moves up and down in the same way as another is defined as the correlation coefficient.
The correlation coefficient works like this.
A value of one shows perfect correlation, a value of minus one shows perfect negative correlation and a value of zero shows no relationship.
In other words the lower the better!
Check out the correlation between US bonds and international hedged and unhedged bonds from 1985 to 2015.
US bonds —> Unhedged International Bonds = 0.51
US bonds —> Hedged International Bonds = 0.90
You can see that hedged bonds are much more correlated, which is exactly what you don’t want. Hedging bonds into a particular currency, makes them act more like that currency.
If a UK investor bought American bonds and hedged them into the pound, they’d really have a kind of expensive British bond.
That’s because hedging costs money. You need to pay for whatever investment you are using.
Remember, hedging requires the fund manager to purchase some alternative investment that moves in the opposite direction to your main investments. This needs to be paid for.
Said another way, you are effectively paying more for something that doesn’t work as well.
The bottom line
Investors who live in countries with highly rated government bonds like the UK and US would be better off going local and simply investing in their local government bonds no matter whether they are classed as resident or not.
But investors who live in places without high quality government bonds are going to have to decide exactly what bonds they invest in.
They may want to go local and take on credit risk, or they may go foreign and take on currency risk. Whichever choice they make, it is unlikely that hedging makes sense.
If you don’t know where you are going to retire you will probably be best served by investing in an unhedged global bond fund.
For a lot of investors hedging bonds simply doesn’t make sense.
you can read more about bonds here
