Currency-Hedged Foreign Bonds = Teh Suck

[TripleB]

On Bogleheads now, people are clamoring over Vanguard's new currency-hedged international bond funds. The theory being that since they are denominated in USD, there's no currency risk, unlike unhedged foreign bond funds.

Here's the big fail in the logic, and why no one should EVER invest in currency-hedged international bond funds:

Suppose Country A issues a bond denominated in USD. The local currency rises 10% comparative to the USD. Country A is able to pay back the bond, easily, because it's cheaper for them to do so, since they could theoretically pay back the loan in full, at a 10% profit, immediately.

The investor gets back their USD based principal.

Now suppose Country A's currency drops 10% comparative to the USD. This would likely happen if their economy starts taking a shit. Now, not only can they not afford the regular payments, because their economy sucks, but now the loan is 10% more expensive due to currency changes.

Country A defaults. Investor gets screwed.

Now compare this to an unhedged bond fund:

Country A's currency rises 10% comparative to USD. Bond is denominated in Country A's currency, so Investor gets an additional 10% return.

Country A's currency drops 10% comparative to USD. Country A might still be able to pay back the bond, because unlike in the hedged example, the principal and all coupon payments didn't increase 10% relative to their currency. Investor gets paid back, but loses 10% relative to USD.

Which would you rather have?

Example 1) Currency Hedged - Upside is limited to bond terms. Downside is likely complete drop.
Example 2) Upside is unlimited if USD drops relative to this foreign currency. Downside is a slightly less likely default, since the borrowing country doesn't worry about currency risk.

I'm much prefer example 2, if I were inclined to invest in foreign bonds. I'd use example 1 under no circumstances.

People are ignoring the fact that if you as the investor are getting a hedged bond fund, it means that it's riskier for the borrower, and they are more likely to default. And you are limiting your upside.

Most importantly, what's the point of investing in foreign bonds, if you aren't getting currency diversification?

These instruments seem like Mortgage Backed Securities, where due to call-risk, when interest rates drop, the borrowers call the loan and refinance at a lower rate, so you have no upside, but there is unlimited downside if interest rates rise. The worst of both worlds.

I now have a list of 3 investments that one should never invest in:

1) MBS
2) Callable Investment-Grade Bonds
3) Currency Hedged Foreign Bonds

[craigr]

Here are some more bond funds to avoid:

4) Junk Bonds
5) Inflation indexed bonds
6) Foreign inflation indexed bonds
7) Emerging market bonds

[stone]

TripleB, I just checked out that Vanguard fund. You can get it hedged either to USD or to CHF. It has 40% of the portfolio as USD denominated bonds, 28% Euro, 19% Yen, 5% GBP and also Thai Baht, Czech Koruna etc etc denominated bonds.

I totally agree that government bonds denominated in a currency not controlled by that government have a severe default risk. Emerging market local currency debt (eg Malaysian Ringitt denominated Malaysian government bonds) has exchange rate risk but not default risk. But you can have a fund of local currency debt with the fund then being hedged to the USD using curency futures or whatever. That hedging does not influence the default risk of the underlying bonds. The hedging does provide a cost drag and a layer of counterparty risk  and I agree that it makes the whole excersize seem pointless. To my mind the only point in holding foreign bonds would be if you didn't trust gold to protect you from the risk of your own currency collapsing (or slumping slowly over the decades). I do have some doubts about how the PP is putting all of its eggs in one basket with having gold as the one holding for this purpose even though gold is what is best at this job.