Cash & Bonds Do Australian Investors Need International Bonds?

Vanguard here and even in the US are increasing encouraging investors to invest in HEDGED International Bonds for diversification, safety etc. I’m not all that well read on Bonds but I’m coming to the conclusion it’s all a bit of a con.

I’ll restrict my discussion to Governments Bonds being the safest of Bonds.

It’s widely accepted that International bonds should be Hedged. The trouble is “hedged” Global Bonds end up simply mimicking local Bonds. There doesn’t appear to be much in the way of diversification / protective advantage.

The best argument I’ve seen in relation to this is from David Swensen’s “Uncoventional Success”. It’s written in relation to the US but given Australia’s credit rating and excellent history of honouring it’s debt obligations I’d suggest that the same applies here:

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By asset size, foreign-currency-denominated bonds represent a formidable market, falling just short of the aggregate market value of U.S.-dollar-denominated debt. Yet, in spite of the market's size, foreign bonds offer little of value to U.S. investors.

Consider bonds of similar maturity and similar credit quality, with one denominated in U.S. dollars and the other denominated in foreign currency. Because monetary conditions differ from country to country, the two bonds would likely promise different interest rates. An investor might expect that different interest rates and different economic conditions would lead to different investment results. If, however, the investor hedges each of the foreign bond's cash flows by selling sufficient foreign currency in the forward markets to match the anticipated receipt of interest and principal payments, then the U.S. dollar cash flows of the dollar-denominated bond match exactly the U.S. dollar cash flows of the foreign-currency-denominated bond hedged into U.S. dollars.


Fully hedged foreign bonds mimic U.S. bonds (with the disadvantage of added complexity and costs stemming from the hedging process)... Foreign-currency-denominated bonds play no role in well-constructed investment portfolios.

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Thoughts?

 

I have never invested in bonds either @Nodrog but I have been wondering if I should. Your point is a good one. If I bought VIF (hedged) how is that different to VAF? I know VIF is international and VAF is Australian but once you hedge the international bonds have you taken away the point of difference? Maybe just buy Australian and be done with it? Maybe I should just stick with term deposits for our cash holdings

 

Why do you need bonds at all with their current rate? My feeling is that you should only have in bonds what you intend to spend in the next 5 years......(eg too short a time to come back from a downturn), otherwise you should just be invested in diversified equities.

 

Apparently its only been over the last few years that Vanguard have been recommending International Bonds. Global Bond Markets are worth about $92T and US bonds make up about 43% of the total global capital market, I'm guessing with Vanguards index methodology of 'own everything' they wanted access to the whole pie rather than a big slice, and due to currency risk with those international bonds, the safest bet is hedging

Currency hedging reduces volatility but it also can reduce returns over the longer term due to the costs involved with the hedging

 

For the same reason I need term deposits/cash - age. We have always been fully invested but are now in early years of retirement and now want a buffer in case of a downturn. The question is where best to invest the buffer?

 

Yes, that’s what I’m thinking too @Redwing

 

I still don’t like Bonds. The only Bonds I ever owned were underpants. But I’ve now found a non Bonds brand that’s cheaper and offers better protection.

There’s no guarantee that Bonds will always protect your ar*e especially when you need it most. They don’t always go the opposite direction to equities during major negative events.

I favour cash and short duration Term Deposits (no longer than 6 months). I personally generally prefer being heavily invested in equities with say at most a 5 year cash buffer. However whilst in the earlier stage of retirement (major SORR zone) combined with increasing risk factors worldwide I’m holding a lot more cash than I would if outside the critical SORR zone.

Unlike bonds cash has a guaranteed value when you need it the most. Hence given the above I strongly favour cash over bonds. As these risks subside especially SORR then I’ll return to my normal state of near all equities with a modest cash buffer.

Given our circumstances the whole SORR thing is near verging on paranoia and probably not needed as even in a worst case scenario we would be fine if holding 100% equities. But there’s an element of psychological comfort being early retirees and greed as well given what could happen to markets at this latter stage of the cycle.

Fortunately it doesn’t matter what happens, we should still be ok. Depending on what the future holds our decisions may see us a bit richer or a little poorer. But thankfully it really doesn’t matter. The important thing is though our decisions will have us sleeping like a baby. And that’s what one needs when enjoying the later stage of their life in retirement.

 

I have an even less expensive version of non-Bonds. Not saying what that is but use your imagination if you will.

 

Hey @Nodrog , how would you know when you are outside the SORR zone? This is a genuine question as I'm still trying to get my head together on the entire subject.

Let's say, just after you retire a bear market starts and continues for 5 years, then the next 5 years you get a bull run recovery and you break even on your portfolio at 10 years on a real return basis. In this case, wouldn't your SORR be exactly the same as when you started out as your starting portfolio value did not change? Shouldn't SORR be determined on portfolio size and not time?

 

But now your money has to last 10 years less.

 

I think I should stop wondering and reading and just stick with term deposits

 

Between you and @Nodrog i have been turned right of bonds

 

My guess also is that it depends on how much dividends you receive from your portfolio : if it is at say 150% of your annual expenses then even if the markets tank, dividends get cut by 30%, it would still be enough to cover your living expenses, so you don’t need bond in your portfolio? Just cash/TDs as cushion?

 

Maybe bonds make more sense when interest rates and/or inflation are much higher (and conversly bond prices are lower)? Either way for a small investor I tend to agree with the equities and cash buffer strategy over bonds.

 

SK I know you’re trying to be frugal by being economical with material but surely you can afford better than this:

 

If the size of your portfolio is big enough SORR is likely not a concern anyhow other than psychological. It shouldn’t be in our case but we are who we are.

 

You are right Anne I don't need bonds. I think because I have always been fully invested I am having a problem looking at cash and thinking something is wrong and I should do something with it. Its a mind set thing really. I just needed a realty check, thankyou

 

In regard to cash / Term Deposits (and Bonds) there’s the valid argument that inflation is one of the biggest enemies over time hence why equities are king. However in the case of SORR we’re not talking about long term holding of large allocations of cash. Much of one’s accumulation years and potentially much of one’s retirement years can be dominated by equities if one chooses.

With SORR we’re only talking about a relatively smaller window of time where there’s real “optionality” value of cash. That is, for this window of time the protection and opportunity offered by cash is of far greater worth than its low returns. However the longer one holds large exposure to cash the value disappears and is replaced by the real danger of erosion by inflation etc. Again, long live equities. Terrible job of explaining that but google “cash optionality”.

As for how long a period one should protect against SORR it will vary for everyone in my view. You’re trying to protect against a very nasty event leading up to and in the early stages of retirement. In our case it could be 5 to 10 years but if the market tanks in the early stages of this period well we’ll deploy much of our Cash into the market and I’ll consider the SORR exercise finished with. If not well we’ll hang on to the Cash until we feel comfortable with our risk position which is really just more psychological than anything in our case.

 

@Islay, from memory given your level of wealth I don’t think anything more than a few years cash buffer if that is needed? I’m just a nutter who likes plenty of cash at this stage of the cycle to keep my paranoia from getting out of hand. Truth be told it’s probably due to greed more than anything. We’re just very fortunate to be in a position to take these decisions without it having any impact on our lifestyle.

 

Then there’s this gem in relation to Cash and risk in general from my keepers archive which I choose however not to follow. But there’s an important message in this as well: