redbarn wrote: ↑Mon Feb 22, 2021 8:51 pm
Also, the Vanguard quote is just saying that the return of a hedged bond is less explained by the underlying yield. That would be true even if there was no relationship between interest rates and exchange rates, and therefore says nothing at all about whether diversification benefits are being washed out by the hedging or not.
Totally agree.
redbarn wrote: ↑Mon Feb 22, 2021 8:51 pm
If interest rates and exchange rates moved 1-to-1, then it is true that hedging currency exposure would also kill off interest rate diversification.
I don't think so. If interest rates moved 1-to-1 with exchange rates (such that a drop in an interest rate would immediately depreciate the exchange rate of the currency by the same amount, since money would flee the lower-yielding currency) then an
unhedged international bond would offer no interest rate diversification. Ex: if the german interest rate decreased by 1% on a 7Yr bond, but this caused a depreciation of 7% in the exchange from Euro-to-USD, then your bond hasn't changed value in USD terms.
But because the bonds are hedged, any effect an interest rate change has on the currency exchange doesn't matter at all. If german rate increases caused the Euro to appreciate vs the dollar, or depreciate, or cause no change or whatever, it doesn't matter. It's hedged to the USD, the currency contract will offset the exchange rate movement. So all you get is a bond that is purely and fully sensitive to the german interest rate.
As Vanguard puts it:
The decision to hedge also impacts the return experience of a U.S.-based investor. This is because an investment in an international bond by a U.S.-based investor consists of three return components: The price return, the income return, and the currency return. By hedging, you replace the volatile currency return component with a return component approximately equal to the short-term interest rate differential between the USD and the currency of the bond.
The currency hedge just means that the currency return of the bond is now USD ST rate - Ex-USA ST rate. But it has no effect on the price return of the bond, which comes from interest rate movements, spreads widening/tightening, etc.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson