Non US Hedged Bonds

Discussion of the Bond portion of the Permanent Portfolio

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Hal
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Non US Hedged Bonds

Postby Hal » Mon Jul 17, 2017 3:25 am

Hoping some of the wiser folk could explain if hedged bonds make any sense in a non US permanent portfolio.

So... Using Australia as an example. The prospective PP investor goes to the Vanguard website and finds the following two choices for bonds

https://www.vanguardinvestments.com.au/ ... ctType=etf

VGB is only Australian Government Bonds. 2/3 Federal Gov't, 1/3 State Gov't,while
VIF consists of Overseas Sovereign Bond (Hedged). USA 27.9%, Japan 30.3% plus many smaller countries.

Consider this scenario.
1. Our massive housing bubble bursts
2. Banks start to fail
3. Government tries to save banks and gets itself into deep debt/trouble
4. Australian currency falls, bonds get sold off

(actually, this sounds like what happened in Iceland !! )

How would our Australian PP investor fare with VGB and VIF? What would happen in both scenarios?

From what I see, the hedged bonds would be better. Value gets dragged down due to the currency hedge, but not affected by capital flight out of actual Australian bonds
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Mark Leavy
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Re: Non US Hedged Bonds

Postby Mark Leavy » Mon Jul 17, 2017 9:20 am

Hi Hal - your post has me curious. I have never heard of hedged bonds before. If you are so inclined, I would love to hear how they work.

Unfortunately, I am not one of the wiser PP folks that can help you out.

For me, I always raise a red flag when I hear of anything that has built in hedging. I assume that the mechanism extracts a cut - and may not hedge the thing that I care most about.

I *really* like the Harry Browne philosophy of using multiple uncorrelated, highly volatile assets - that rely on economic cycles for hedging. Nothing you could line up on a narrow timeline in a spreadsheet.

Again, out of ignorance, if you look at the assets as they would perform in your own country, would you be better off exposing yourself to the unhedged versions - while also possessing other assets that tend to respond to different economic conditions?
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Re: Non US Hedged Bonds

Postby Hal » Mon Jul 17, 2017 11:05 am

Good to hear from you Mark,

Vanguard has many good research papers on hedging

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

Yes, you are correct - there is a cost to hedging in increased fees, however...

In a flight to safety scenario, a small country's bond market AND stock market would be sold down.
The funds would probably go to a "safe harbour" like US bonds.

So while in the US, the PP diversification works well, in a small country, you could potentially have both bonds and stocks correlated.

This is why I am pondering over hedged international bonds and local bonds.
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Mark Leavy
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Re: Non US Hedged Bonds

Postby Mark Leavy » Mon Jul 17, 2017 11:42 am

Hal wrote:Good to hear from you Mark,
...
Eg. https://personal.vanguard.com/pdf/ISGHC.pdf
...[/i]
This is why I am pondering over hedged international bonds and local bonds.


A very good read. Thank you. My (shallow) understanding is that the hedging is related to currency exchange rates. I may have misread it...
If that is the case, then I (again) argue that you are better off hedging world economies rather than locally optimizing.

As a permanent traveller, I usually carry a few grand in mixed currencies with me at any one time. To be honest, though, I convert them into USD when I calculate my daily Net Worth.

My apologies if I missed it. What country are you using for your investments? I seriously would not use the Harry Browne methodology in a country that did not a have dominant world currency. If you are somewhere else, then I firmly believe that you should use your intuition. You sound like someone that has a good handle on the situation.

Mark
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Tyler
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Re: Non US Hedged Bonds

Postby Tyler » Mon Jul 17, 2017 12:18 pm

I'm personally not a huge fan of hedged bonds for the same reason I'm not a fan of TIPS. From what I understand, they're essentially speculative investments disguised as passive indices. The return of hedged bonds depends on forward-looking currency expectations, just like the return of TIPS depends on forward-looking inflation expectations. Since nobody can predict the future, IMHO you're opening yourself up to more risk by exposing yourself to human infallibility in the pricing.

I can see the appeal of hedged bonds for those who turn to bonds strictly for fixed income where consistency is important, and I imagine that's why you see plenty of hedged international bond funds but very few hedged international stock funds. But I personally don't like them as much in a portfolio (like the PP) where the diversifying value of the price movement is more important than the coupon alone.
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Re: Non US Hedged Bonds

Postby Hal » Mon Jul 17, 2017 4:47 pm

Thanks Mark and Tyler,

Yes, I live in Australia, so the AUD is certainly not a major world currency !
I am leaning towards not using Hedged International Bonds, rather diversifying internationally via the Equity portion.

A very good point about the "Hedge" itself being a speculative product.
Will leave the Gold in the PP to do the job as a "second" currency

Have to give it some more thought....

All comments welcome !
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Re: Non US Hedged Bonds

Postby jhogue » Wed Jul 19, 2017 8:59 am

Hal,

Flesh out your scenario further:
1. If the Australian housing bubble bursts, a burst of deflation is bound to follow. When that happens you don’t want to hold VIF, you want actual Australian government bonds, preferably not even in the form of the Vanguard ETF, VGB.

2. If the Australian currency falls massively in value, you do want to be holding gold, perhaps outside of Australia just in case the Australian government hits the panic button and tries to impose capital controls. While I doubt that the Perth Mint or the Western Australian government would have a problem, there are plenty of options for you in Europe and North America—just in case an new Australian government tried to do something really stupid, like imposing capital controls.

3. Finally, I think you may be looking at Australia through the wrong end of the telescope. That’s understandable. We Americans do it to ourselves all the time.

Consider the following:
Australia is an English-speaking country with a democratic government, respect for the rule of law and private property. It is rich in natural resources, produces agricultural commodities that are in daily demand globally, and has highly developed trading relationships with large economies in Europe, North America, and Asia. It is a member of the G-20 and the Australian dollar trades freely on international markets.

If and when the Australian housing bubble collapses, I am guessing that plenty of newly wealthy Chinese would regard it as the buying opportunity of a lifetime. Maybe even an American or two (or two million) looking for fun, travel, and adventure Down Under!

My advice is implement your basic Australian PP and get a good night’s sleep.
“Groucho Marx wrote:
A stock trader asked him, "Groucho, where do you put all your money?" Groucho was said to have replied, "In Treasury bonds", and the trader said, "You can't make much money on those." Groucho said, "You can if you have enough of them!"
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Re: Non US Hedged Bonds

Postby Hal » Wed Jul 19, 2017 9:49 pm

Thanks for the analysis jhogue,

Could you expand a bit on why you believe Hedged International Bonds are less desirable than Australian Gov't Bonds.
Same reason as Tyler?

I would imagine PP'rs in Canada would face the same issue.

Also, If it is best to hold just Australian Bonds, what are your thoughts on holding a mix of international shares and Aussie shares. What proportions would you consider? Tylers site would suggest that less than half domestic shares would be optimal. Also vaguely remember Harry Browne saying having an international equity mix is fine as prosperity tends to affect shares globally.

And yes ! I do sleep well at night!! Already have the PP, however I like to do "what if" scenarios. Find it much more comfortable when facing major changes when you have already worked through a few potential outcomes.

The PP - helps your sleep and your finances :)
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Re: Non US Hedged Bonds

Postby jhogue » Sat Jul 22, 2017 10:14 am

Hal wrote:Thanks for the analysis jhogue,

Could you expand a bit on why you believe Hedged International Bonds are less desirable than Australian Gov't Bonds.
Same reason as Tyler?

I would imagine PP'rs in Canada would face the same issue.

Also, If it is best to hold just Australian Bonds, what are your thoughts on holding a mix of international shares and Aussie shares. What proportions would you consider? Tylers site would suggest that less than half domestic shares would be optimal. Also vaguely remember Harry Browne saying having an international equity mix is fine as prosperity tends to affect shares globally.

And yes ! I do sleep well at night!! Already have the PP, however I like to do "what if" scenarios. Find it much more comfortable when facing major changes when you have already worked through a few potential outcomes.

The PP - helps your sleep and your finances :)


Hal,
1. My concerns about VIF are similar to Tyler’s, but I would state them somewhat differently. When I looked under the hood at the holdings of VIF, I did not like what I saw. Why should you buy debt with Italy or Mexico’s credit quality instead of Australian government bonds? (Hint: You shouldn’t.) Secondly, the weightings used to construct the VIF portfolio depend upon an underlying synthetic bond index that may (or may not) reflect the actual instantaneous conditions of the global bond market at any given point in time. That’s not what you want for the bond portion of an Australian PP in order to react instantly to your scenario of a real estate bubble-triggered deflation in the domestic Australian economy. You might go back and re-read CraigR and Medium Tex’s chapter on bonds in their Permanent Portfolio book and pay special attention to the chart that shows how TLT, an ETF composed of 99%+ US Long Term Treasury bonds, reacted to the real estate melt down in the USA in 2008. (Hint: They shot through the roof!)

2. My general reservation for both VGB and VIF is that they are exchanged traded funds, rather than actual Australian government bonds. ETFs contain two sorts of hazards. One is the problem of counter party risk inherent in synthetic financial products with managers. Most of the time this isn’t a problem, but how can you be certain that your ETF manager won’t do the financial equivalent of running off to Las Vegas with his hot new secretary and your cold hard cash? (Hint: You can’t.) ETFs are for convenience, not for safety.
The second problem with ETFs is that they have expense ratios. Your fact sheet says that you will pay 0.20% to own an Australian bond ETF. In the USA, I pay 0% to own US Treasury bonds in my brokerage account. I suppose Australians can get the same deal. (Hint: Free is better.)

3. Fluctuations in the equity markets of smaller economies are more heavily influenced by regional economic conditions than in larger domestic economies like The USA, China, and Japan. Take Switzerland (8 million people) as an example. Even though it has an ultra-strong currency and a robust internal economy, its domestic economy is so interconnected with the EU (300 million people) that if the EU rises or falls, the Swiss economy is sure to follow. Thus the general rule of thumb might be the smaller the economy and the more trade-oriented it is, the larger the percentage of a small country PP should be devoted to an equity index fund that reflects the regional economy. I can’t give a precise proportion, but you might start by studying the size of the Australian GDP and comparing it to an average of Australian imports and Australian exports.
“Groucho Marx wrote:
A stock trader asked him, "Groucho, where do you put all your money?" Groucho was said to have replied, "In Treasury bonds", and the trader said, "You can't make much money on those." Groucho said, "You can if you have enough of them!"

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