June 17, 2013

Foreign currency exposure dominates the volatility profile of international bonds. In this interview, Christian Loxham, a trader in Vanguard Fixed Income Group, explains Vanguard’s reasoning behind why international bond investing should be hedged, and the strategy that is being applied to the new Vanguard Total International Bond Index Fund .

Before we delve into a discussion of hedging in our new international bond index fund, can you briefly talk about the fund in general?

Sure. International bonds often are an overlooked asset class even though they represent the largest segment, over one-third, actually, of the global investable market. So by introducing the new Total International Bond Index Fund. Vanguard is able to provide investors with exposure to that global investable market. And Vanguard research also shows that including currency-hedged international bonds in a diversified portfolio can help to lower total portfolio volatility, similar to the role played by international equities in portfolios.

Is this why we think international bond investing should be hedged?

Foreign currency exposure by far dominates the volatility profile of international bonds. It accounts for about two-thirds of volatility. So currency hedging will minimize that currency volatility or currency risk. And in doing so, the investors can isolate the interest rate and the credit risk and can maximize the diversification benefit that international bonds bring to their portfolio.

What do you mean by currency risk?

Currency risk arises when an investor’s home-based currency is different from the currency denomination of the bonds he holds.

The best way to illustrate this is with an example. And just keep in mind, this is a purely hypothetical example. Suppose a U.S. investor, living in the U.S. buys 1 million of a British government bond. The exchange rate at the time of the purchase is, let’s say, 1.5, so $1.5 to 1. In other words, the value in U.S. dollars of his or her investment is $1 million. This means the investor would need to convert $1 million at the spot rate to buy 1 million, which he can then invest in the British government bond.

Now suppose the investor holds onto his investment for one month, and over that time the market value of that bond in pound terms remains unchanged, but the exchange rate of the pound versus the dollar falls to one. Now, again, in the real world such a drop would be highly unlikely. When the investor at that point wants to sell his investment, the sale could net him 1 million. When he converts his proceeds of the sale back to dollars, he will only be left with $1 million and will thus incur a $500,000 loss.

How can an investor hedge against this currency risk?

The way we can hedge against currency risk, currency volatility, is by entering into a foreign-exchange transaction that’ll essentially have the opposite return profile of our unhedged currency position.

So in our example of the U.S. investor holding a U.K. government bond for one month, the hedge could be to enter into a forward currency contract where the investor sells 1 million to buy U.S. dollars one month later at an agreed-upon exchange rate. And this forward currency contract is initiated when the investor purchases the U.K. government bonds at the exchange rate. And, just to remind you, the exchange at the time is $1.5 to 1 pound.

Now, if the pound’s exchange rate falls to one versus a dollar, our investor will lose $500,000 when converting his proceeds in pounds from the sale back to dollars. However, this time the investor can close out his forward position. So how will this work? On the sell date, the investor agreed to sell 1 million and receive $1 million. So all he needs to do now is to close out his forward contract by buying 1 million versus a dollar at the then-current spot rates.

But this time it will only cost him $1 million while he’ll be receiving $1.5 million from the forward transaction that he initiated a month ago. So the investor incurs a $500,000 gain, offsetting the currency loss that he would have incurred on his U.K. bond position.

Now keep in mind that if the pound was to rise over that time period, the opposite will happen. The investor will lose on his forward contract and that loss will offset the currency gain on his U.K. bond position.

How will Vanguard hedge against currency volatility that you just described in our Total International Bond Index Fund?

The Total International Bond Index Fund is an index fund and tracking a Barclays index, using the Barclays index currency-hedging methodology. And this includes executing all of the currency trades at the same time the Barclays index prices these currencies. And by the way, the exact same methodology is currently being used for our offshore Vanguard Global Bond Index Fund, which we’ve been successfully managing since 2008.

Will you walk us through how this would workthe roles, the timing?

To hedge out currency volatility, Barclays uses one-month forward currency exchange transactions, as the index is rebalanced the last business day of the month. So every month-end, these contracts are rolled forward for the next month. So the Barclays methodology will have us hedge out the expected market value at the following end-of-month for the currencies at the portfolio level, and this will include the market value of the bonds, denominated in their respective currencies, plus the one-month accrued interest.

So, to give you an example, suppose our month-end market value exposure to British pounds in the fund is 100 million. So one can imagine, if you were to ignore the interest paid by the British pound-denominated bonds during the month for which we are hedging, we’d systematically be left with some residual amount of British pounds that was not hedged out. In other words, we’d systematically be underhedging. So if the accrued interest amounts over one month sum up to, for example, 1 million, we will enter into a contract selling 101 million sterling versus the dollar, selling one month later.

And then at the following month-end, we’ll enter into a spot rate, which will be the reverse of the previous month’s forward trade. In other words, we’ll be buying 101 million versus dollars at the current time’s exchange rates. And the gain or loss from the hedge transaction will offset the loss or gain of the fund’s pound exposure converted back to dollars.

What’s the cost of this hedging?

There is a cost associated with currency hedging, but we’re confident we can keep those costs to a minimum. First off, all currency trades for the fund will be executed at exactly the same time the index prices the currency exchange rates. So, more to the point, all the spot trades will be executed at the exact same level the index prices their spots. As for the forward contracts, those cannot always be implemented at the levels assumed by the index. We’ll be paying a so-called bid-offer spread on the forward points. And the forward points are basically the difference between the spot rate and the forward rates.

But this brings me to a second point, which is liquidity. Liquidity is crucial to keeping costs low. Eighty percent of Vanguard’s Total International Bond Index Fund will consist of euros, Japanese yen, and British pound exposure. And those are three of the most liquid currencies in the world. And, in addition, those currencies will be hedged back to the dollar, which is the most liquid currency in the world. So the cost of hedging these currencies back to dollars will be minimal.

To give a concrete example, typically the bid-offer spread on forward points for pounds sterling for a one-month forward contract is less than three-tenths of a basis point. This means that for every $10,000 invested, it will cost the investor less than $0.30.

And, also, I would like to stress that all currency trades will be executed in competition with multiple dealers, ensuring Vanguard’s best execution practices.

Are there any major risks involved here?

There are two ways of looking at this question. The risks of the fund performing differently from the benchmark are minimal as we’ll be following the Barclays index methodology down to the T. The outright risk, on the other hand, lies in the fact that there is no way we can predict the exact market value of the foreign currency exposure one month forward. So the amount by which the hedge put on at the beginning of the month is different from the ultimate end-of-month market valuethat will result in some exposure to foreign currencies.

But since we roll and adjust our hedging position every month, we will minimize that currency risk from over- or underhedging.

What has Vanguard’s experience been, executing our hedging strategy that you just described?

We’ve had a great track record since 2008 of managing our offshore Vanguard Global Bond Index Fund. Now, it’s important to note that we are not marketing, and we do not market, this fundor any other Irish-domiciled Vanguard fund, for that matterto U.S. investors. But solely in response to your question about our expertise with the hedging strategythis fund uses the exact same methodology for currency hedging as the Total International Bond Index Fund. And, in addition to that, the Global Bond Index Fund has the same level of complexity as the Vanguard Total International Bond Index Fund. So, in short, we are very confident that we have the experience trading international bonds as well as the operational and risk management expertise.

Notes:

• For more information about Vanguard funds visit our Funds, Stocks, and ETFs page or call 800-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
• All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future results. Diversification does not ensure a profit or protect against a loss.
• Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
• The Total International Bond Index Fund is subject to currency risk, which is the chance that currency hedging transactions may not perfectly offset the fund’s foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies. The fund will incur expenses to hedge its currency exposures.