Should I buy government bonds UK expats and non residents guide

This week we take a look at UK government bonds and ask whether they make a good investments for expats and other non residents?

To understand whether or not you personally should be investing in UK bonds you need to understand the risks associated with bonds.

Yes, you read that right! Contrary to popular belief bonds can be risky, especially if you go for the wrong ones.

Though not as risky as many other investment assets, UK government bonds still come with certain risks. Understanding these will help you understand whether or not they are the right option for you.

What are bonds?

Bonds are loans. When you buy or invest in a bond you essentially lend money to an organisation for a set period of time. The organisation in question will pay you back your money at an agreed time in the future and pay some interest for the privilege. Typically this is paid every sixth months.

Though you can invest in individual bonds, it is a lot more convenient for most people to invest in them through funds which contain a basket of different bonds. For expats and non residents in particular index tracking ETFs are a great choice. Essentially, they are easy for us to access.

Bonds alongside stocks make up the key investment asset classes in most people’s portfolio. Even people who don’t invest will often have some exposure to bonds through their pension. After all pensions are basically a combination of stocks and bonds with some tax sheltering applied.

Of course, some people have other types of investment asset, but even then, the majority of those will be heavily concentrated in the big two.

And it makes sense because these days anybody with a brokerage account can put together a strong investment portfolio with a couple of ETFs. Stocks provide the big returns, but bonds provide stability and safety you need to carry you through over the course of time.

But and it’s a big BUT…… only to a certain extent because bonds themselves come with their three key risks: Interest rate, default and currency and so its worth going over these individually in a bit more detail.

Interest rate risk

The key way you make money through bonds is via regular interest payments. On the surface, it’s a lot like a high interest savings account. Bonds pay interest and said interest is usually based on central bank interest rates.

Central banks can raise and lower interest rates in an attempt to help the economy. This directly impacts bond interest rates and in turn this can impact bond prices.

When central banks raise interest rates, new bonds have higher interest payments. This means existing bond prices go down. Why buy a £100 bond paying 2% interest when you can buy a new one paying 4%!

The older bonds price will drop just as soon as the new interest rates come into play. In other words, you’ll loose money. And nobody likes doing that.

Now that said, it’s not quite as bad as all that for a couple of reasons.

Why interest rates rate rises might not bad

Firstly, if you own an individual bond and you hold it to the agreed date you’ll get all your money back. It’s doesn’t matter that the price is lower now on the secondary market as long as you aren’t forced to sell it early.

Some very sophisticated investors look to make money from buying bonds and then selling them for a profit on the secondary market. On the other hand, most of us don’t need to bother with that. We can just make money from the interest payments until its time to get our money back.

And mentioned above. Expats and non residents will typically invest in bonds via an ETF. This type of investment works a little bit differently. The important concept to grasp is this.

There is a constant turn over of bonds with a fund.

That’s because older ones are constantly being replaced with newer issues. If interest rates go up these newer issues will have higher interest rate payments. For most people, most of the time, this will mean you make more money than you would have done had the interest rates not gone up anyway.

In other words, the increase in interest rate will more than make up for the temporary loss of value over the long term.

The key takeaway here being as long as you are in it for the long term you should usually make money regardless of whether or not interest rates go up or down.

Now, all that said. In the short term, bonds can crash and in fact, though less usual they can crash just as hard as stocks under the right conditions. And to make matters worse, again, though unusual, they can crash at exactly the same time as stocks.

Some people, would prefer not to go through that and luckily there is a straight forward way to minimise interest rate risk (even though it is only likely to be a temporary state of affairs) and that’s to buy short term bonds.

Why short term bonds are different

Bonds are loans for a set period of time. The longer that period of time the more interest you usually get. People want more interest for parting with their money for longer. It’s a fair deal, but also one that comes with risk because the longer the time period the greater the interest rate risk.

How much would you want to hand over for a bond paying 1% interest that has 20 years to go, when you can buy a new one paying 5%? Not much is the answer.

But what about an older one year bond paying 1% compared to a newer one paying 1.5%? Yes, it would be worth less, but not by nearly as much. Funds with shorter time periods more quickly turnover their bonds so that they can more quickly take advantage of the new interest rates.

Luckily for us, at the time of writing there has been some swift and severe interest rate rises that has caused one of the biggest bond market crashes in history so we can compare how different funds with different time periods behave in a crisis.

The table below compares three UK government bond funds (all from iShares). A quick look at the fact sheets of these funds reveals a Weighted Average Maturity. This is the length of time until the average bond in the fund will mature or be redeemed by its issuer i.e. the agreed time when you get your money back. This is tabled alongside the performance.

In other words, how much did longer bond funds lose compared their shorter counterparts.

Weighted Average Maturity vs Performance

Fund	Weighted Average Maturity	Performance %
iShares UK Gilts 0-5yr UCITS ETF	2.5	-9
iShares Core UK Gilts UCITS ETF	12	-34
iShares Index-Linked Gilts UCITS ETF	17	-50

I think the table illustrates this point nicely. Whilst a weighted average maturity of 2.5 has still had a drop of 9%, that sure beats drops of 34% or 50%!

And for one of the biggest crashes in bond history it ain’t really much at all, because remember the bonds in that fund will quickly be replaced with newer issues paying much higher interest rates meaning you’ll recover your losses much quicker than with the other two.

So in short, interest rate risk is usually a short term problem, but if you want to minimise it, go for the bonds or bond funds with the lowest times to maturity you can get your hands on.

Default risk

As with anytime you lend money there’s a chance you might not get your money back. With bonds this is default risk.

When you buy bonds you lend a government or a company money. The interest rates you get in return tend to be higher the greater the default risk.

Typically, companies in good health pay less interest than those that are not doing so well and similarly developed market governments tend to pay less interest than those of developing countries.

So if you want to keep default risk to a minimum you are usually best sacrificing higher interest payments and sticking with developed market government bonds. Examples being the those from the UK, US, Germany and Japan.

Currency risk

For UK residents currency risk is pretty straight forward. You’re outgoings are in pounds so your bonds should be in pounds to avoid currency risk.

If you invest in the bonds of another country there’s a risk the pound could strengthen against that currency and you would loose money.

On the other hand, a short term UK government bond fund isn’t going to be suitable for a British expat living and intending to retire in the US. If the pound weekend 20% against the dollar (as it has this year) you’d be 20% down before we even consider any market performance, interest rate changes etc.

US government bonds would be a much better choice.

Similarly other UK expats living and intending to retire in other developed market economies should probably do the same because the prevailing wisdom seems pretty clear on this. You should invest in bonds denominated in your home currency.

And that’s where it can get a little more complicated for a lot of British expats. Because whilst there will be UK expats living in places like the US, Germany and Japan with full intention to retire there, plenty of others will be intending to retire back in the UK.

Others won’t live in developed countries, and I’m pretty sure the odd one won’t yet know where they intend to retire. So what can you do if you fit into one of these categories?

Let’s take a look.

What if I’m living overseas but intend to retire back home?

Most expats that intend to retire back in the UK should probably be investing in UK bonds.

Investing in any other country’s bonds (at least without hedging which we are coming to) leaves you open to currency risk, which for most people simply isn’t worth it.

Whether or not you should invest in UK bonds if you are living in a developing market will depend on:

• Whether or not you intend on retiring there
• The quality of the developing market’s government bonds

If you are intending to retire back in the UK, you should probably just stick to buying UK bonds. If you don’t know where you are going to retire we are coming to that question later. For everybody else it will depend on the quality of your particular market’s government bonds.

Lots of companies do credit ratings. S&P, Moody’s and Fitch are three big ones. Taking a look at S&P’s we can see the following ratings for some notable developing countries:

Bond credit ratings for selected countries

• Argentina CCC+
• Brazil BB-
• China A+
• India BBB
• Indonesia BBB
• Mexico BBB
• Poland A-
• Saudi Arabia A-
• Thailand BBB+
• Turkey B

This should bring back some good (or bad) memories from school. They go from bad D (in default) to excellent AAA (prime). In an ideal world you’d go for prime if available.

However, at the time of writing these tend to be restricted to a few countries, namely, Australia, Canada Switzerland, Sweden, Germany and the Netherlands. The UK, France, Ireland and US are all AA and Spain and Japan are both A.

With that in mind, I’d probably be happy investing in anything rated A- or above, so the bonds of China, Poland and Saudi Arabia would be fine. Others may be comfortable with Bs. How comfortable you feel about the government of the country you reside in, will probably have a lot to do with it.

In any case, let’s just assume you are like me and won’t accept anything below A and your county doesn’t have anything above B. Here’s some options for you:

Options for residents of countries with lower quality government bonds

Save in a local bank account. Bonds basically provide something very similar to a savings account anyway, just with slightly higher interest rates. Sacrificing a little return for more security probably never did anybody any harm.

If you don’t trust the local banks with your money you can just store money in your brokerage account or expat bank account. Unless you live somewhere very remote you should be able to find one with your desired currency.

(We’ve written about expat bank accounts here, and brokerage accounts here if you don’t already have one).

Invest in other countries’ bonds. There’s no avoiding currency risk with this option, but you can avoid default risk. You could choose the US or UK for example even though you weren’t living in those countries. Yes, you are taking on currency risk, but you are avoiding default risk.

Perhaps, a country nearby has better quality bonds that you could choose. These might behave more like your country’s bonds and thus work to minimise currency risk a little. You wouldn’t be limited to a single countries bonds either.

There’s nothing to stop you dividing your capital between a local country and the US for example. And in fact this could make sense because the US dollar tends to go up when other currencies go down, particularly developing market currencies. Having some US dollar denominated bonds alongside some developing market bonds could lower risk.

Spreading your bets through multiple currencies, is an option too. A global aggregate bond fund might be an easier option to deal with. An example being iShares Core Global Aggregate Bond UCITS ETF (AAAG or SAGG {if you are paying in pounds}).

When you invest in this kind of fund, you get bonds from all over the world. More high quality developed market government bonds than anything else but little bits of everything non the less. The downside of a fund like this would be a longer weighted average maturity (WAM).

There are quite a few global bond funds out there. We picked this one because it had the lowest but it is still 8.5 years which means you get some interest rate risk with it. Most people with look at that as an intermediate term rather than short term. To put that in perspective, UK bond funds with WAMs of 2 & US treasuries with WAMs of around 6 months are available right now.

Another option would be to go for an EM bond fund. As this is focused on developing markets it may perform more in line with the currency of the country you are living in, but again you’d be taking on default and interest rate risk.

The safest solution – might just be a mix of some or all of the above. I like the idea of splitting my cash between a standard savings account in my local currency, short term US treasuries, and short term UK bonds. Alternatively you could swap out the UK and add a global or EM bond fund.

You just want to keep it as simple as possible but adequate for your own risk profile. (We’ve covered risk profile here if you aren’t too confident about your own).

How to invest if I don’t know where I’m going to retire?

If you don’t know where you are going to retire investing in UK bonds only really makes sense if you’ve narrowed it down to a few options and the UK is one of them.

Say you are living in the US and you think it is going to be a toss up between each you could simply split your money equally between the two.

If you have absolutely no idea, then you might be better off opting for a global bond fund. That way you are spreading your bets. And whilst you will be exposed to some currency risk it shouldn’t be as great as if you’d placed all your eggs in one basket.

Should I buy Inflation protected bonds?

Now, you may have heard of inflation protected or linked bonds. These are often called ‘linkers’ in the UK.

In theory they sound great. A perfect inflation protector. However, practice is another story.

Though not all, most inflation protected bond funds have long average weighted maturities so they come with considerable interest rate risk and as interest rates tend to rise in times of inflation they might not behave quite how you would expect.

Have a look at the two charts below. The top one shows iShares Index-Linked Gilts UCITS ETF GBP (INXG). A go-to inflation protected fund for UK investors. The bottom one shows inflation in terms of RPI over the same time period. Can you see the problem?

iShares Index-Linked Gilts UCITS ETF GBP (INXG)

UK inflation (RPI)

As inflation has been increasing, those inflation protected bonds have been halving in value ie the opposite of what you’d want to happen.

The problem essentially comes from the fact these are longer bonds.

If you are concerned about inflation a better way to deal with it is probably to invest in short term bonds. That’s certainly the way I like to do it.

Because these are regularly getting replaced with newer issues they also tend to keep up with inflation and you don’t have to pay more for the privilege.

Should I hedge my bonds?

The jury is out on hedging bonds. Some people think you should invest in international bonds hedged to the currency you use (or will use in retirement). The argument being you get diversification without currency risk.

However, others say hedging isn’t worth it because it comes with a cost and the minute currency A is hedged to currency B, it just acts like currency B anyway, so you may as well just buy currency B bonds.

In other words rather than a UK investor hedging some international bonds in pounds they would probably be better off just sticking to UK bonds as you can expect a similar performance, but hedging usually comes with some additional costs which subtract from your returns.

Summary

• You can minimise interest rate risk and inflation risk by opting for short term bonds.
• You can minimise default risk by going for developed market government bonds.
• You can minimise currency risk by opting for bonds of the country where you live or intend to retire
• If the country you are living in doesn’t have high quality government bonds there are still options you can take.
• If you don’t know where you are going to retire you might want to invest in a global fund.