Bond ETF Allocation between Global Euro Hedged and Eurozone Inflation Protected

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I am helping an elderly retiree to invest a modest sum of money. He has a pension that covers his living expenses, but he does not want to risk losing too much of his capital, so we’ve decided on a 25/75 stock/bond allocation. I’m wondering if we should assign the entire bond portion to a euro hedged global bond ETF (iShares AGGH), or if we should split it between a euro hedged global bond ETF and an inflation protected Eurozone government bond ETF. As the primary goal is simply to protect his savings against inflation, I’m inclined to split the bond portion 75/25 global/Eurozone inflation protected.


There’s an iShares UK ETF (ticker ICBI) that tracks the Bloomberg Barclays Euro Government Inflation-Linked Bond Index, which is about 47% France, 26% Italy, 15% Germany, and 12% Spain, the details of which can be found on the iShares UK website. (Sorry, the forum won’t allow me to post a hyperlink, as I do not have the necessary minimum number of posts.)


I have two minor concerns: (1) the degree of correlation between inflation in Ireland and in the issuing Eurozone countries, and (2) the quality of Eurozone government debt…


As far as I can tell though from the OECD’s website, despite Ireland’s economy being more closely tied to the US business cycle, there is a pretty close correlation between French, Italian, German, Spanish, and Irish inflation. (Again, I can’t post a hyperlink, but googling “OECD Inflation” should lead to the page where the relevant charts can be pulled up.)


And while I’m aware of the problems with Italian public debt, I believe that the probability of a sovereign default is not terribly high, and since the total amount of the portfolio allocated to Italian bonds would be less than 5%, even a default would not be catastrophic (not counting the indirect negative ripple effect such an event would presumably have on the rest of the portfolio).


So my question is whether there’s a strong reason that I may be overlooking not to allocate 25% of the bond portion of the portfolio to inflation protected Eurozone bonds as a small hedge against unexpected inflation.

Any feedback would be greatly appreciated…
 
Hi,
IMO no strong reason, Europe is already in AGGH.
Whats his timescale and risk appetite? If he needs the money at certain dates that should also drive the choice. Carefully consider the tax and costs vis a vis the time needs. Fees + 41%.
Jimmy
 
What kind of money / timeframe are you talking about? I don't see any reason to be looking past Irish state savings. No fees, guaranteed tax free returns. Plus if interest rates increase and you want to exit, there's a predetermined formula to calculate interest.

It can be difficult to explain to someone how an inflation protected bond can have a negative return...
 
Hi Jimmy and RedOnion

Thanks for your replies. I’m aware of the unfairly high exit tax on ETFs, but we’re purchasing iShares ETFs via DeGiro, so at least the brokerage fees and fund expenses are minimal. The sum of money involved is not terribly large, and my friend is keeping some cash on deposit too. I understand that Irish State Savings are a pretty good option for some people, but the return is very low if the savings bond is encashed before ten years, and the money—or some of it anyway—might be wanted before then, though the plan is to hold the investments for eight years until deemed disposal taxes are due.

A 25/75 stock/bond allocation is obviously not risk free, but it’s conservative enough I think. (It would only have lost about 14% in 2008 for example.) My friend does understand that there will be drawdowns, even with inflation protected bonds, but he is willing to take on a moderate level of risk for the benefit of liquidity and in the hope of earning a slightly higher return.

I realize that AGGH contains Eurozone bonds, but they only make up about 25% of the holdings, and although I’m sure that allocating the entire bond portion to AGGH would be fine, I thought it might be no harm for an Irish investor to be overweight Eurozone inflation linked treasuries. I suspect that it probably won’t make a big difference either way, as the return on a broad global euro hedged bond index should be reasonably close to that on Eurozone bonds. I just thought that allocating a quarter of the bond portion to inflation linked treasuries would add a little diversification and some protection against any unforeseen inflation. I know that there’s no decisive reason to do so, but unless you can think of a decisive reason not to that I may be overlooking, that’s what I’m inclined to do.

Once again, thank you both for your comments. I really appreciate it.
 
Not sure that the returns on inflation linked bonds are any higher than Irish state savings once you deduct investment s fees and exit tax and there is certainly more paperwork involved
 
Agree with Red - I wouldn’t look beyond 5-Year State Savings Certificates in this scenario.
 
Thanks jdp and Sarenco.

Again, I do understand the case for State Savings Certificates, but even after tax, the returns on inflation linked bonds should be a little higher. (There’s also a small but nonzero chance that the exit tax rate will be lower in eight years since the life assurance companies have been persistently lobbying the government to reduce the 41% exit tax on funds to bring it in line with the proposed reduction on DIRT tax to the 33% CGT level…)

The cumulative 10 year return on the inflation linked bond ETF as of 31 Oct 2018 is 32.5%, and 59% of that is 19.175% after tax. It’s certainly not a lot more than the 16% on the 10 Year National Solidarity Bond held to maturity, especially considering that the latter is risk free, but the bond ETF is pretty low risk, with a standard deviation of 3.8%. Also, unlike the State Savings products, inflation linked bonds represent a hedge against unexpected inflation and have negative correlation with equities and low correlation with other fixed income securities. They’d probably perform significantly better than savings bonds if interest rates and inflation were to take off in the coming decade.

At a conservative estimate of a projected 5% nominal return on stocks and a 2.5% nominal return on bonds, a 25/75 stock/bond portfolio has an expected annual return of approximately (5*0.25) + (2.5*0.75) = 3.125%. Over eight years, at which point the exit tax is due, €1,000 would amount to c. €1,284 before tax, or c. €1,168 after tax, for an effective annualized return of 1.94%. (Over five years after tax it would be 1.9%, almost twice the rate of the five year savings bond.) So, as usual I suppose, it comes down to a risk/reward trade-off decision, but I don’t think a 25/75 stock/bond portfolio is excessively aggressive.
 
...but the bond ETF is pretty low risk...

Most bond funds carry significant risks beyond that of holding bonds directly, you don't seem to have an appreciation of how many of those funds are constructed nor the risk attributes of bonds for that matter. A slightly higher allocation to equities and a concentration on cash and near cash instruments - state savings certificates, would probably be the wise and simpler move. You are way over thinking it.
 
Thanks Jim

I do appreciate that the net asset values of bond funds fluctuate, and that they they behave differently from individual bonds in other ways too, which (credit risk aside), guarantee return of principal when held to maturity. That said, I’m not sure that the view that individual bonds are less risky is completely correct if the planned holding period for the fund is greater than its duration.

If interest rates rise, then holding an individual bond to maturity has a hidden opportunity cost, while the decrease in bond fund net asset values will be partially made up for by the fact that cash flows from coupon payments and maturing bonds will be reinvested by the fund manager at the prevailing higher rate.

This is only a toy example, since interest rates are not going to jump by this amount overnight, but the previous total return on the 10 year National Solidarity Bond was 25%, not 16%, and if the State were to suddenly increase the return from 16% back to 25%, then a €1,000 bond bought when the rate was 16% would be worth only €928, since €928 * 1.25 = €1,160.

I don’t really think I’m overthinking it, but then, that’s exactly what somebody who was overthinking it would think :)

You may well be right that a little more in stock and the rest in cash equivalents / savings bonds would be simpler and wiser. I’ll certainly consider it... Thanks again.
 
That said, I’m not sure that the view that individual bonds are less risky is completely correct if the planned holding period for the fund is greater than its duration.

That is not what I said. You need to appreciate that bond markets do not operate like equity markets and that bonds are the favorite tool for financial engineering. Consequently bond funds can expose you to risks well beyond the underlying bonds.
 
No, it's still worth 1,000:

Sorry! You’re right of course. My example only works for straight bonds, not for State Savings products, which are puttable bonds, and so never worth less than their par value. That was a case of late night under-thinking :(

That is not what I said.

I didn’t mean to attribute an oversimplified view to you. I do appreciate that bond funds are riskier than State Savings products, that bond markets work differently than stock markets (much bigger, traded over the counter by institutional investors and therefore less transparent, potentially illiquid, more complex etc.), and that bond funds that normally have low volatility can be subject to unpredictable tail risks in a crisis. (Vanguard’s TIPS fund in the US underwent a drawdown of over 15% in 2008 after the collapse of Lehman Brothers, for example, when Lehman was forced to sell the TIPS it was holding as collateral and expectations of post-crash deflation set in.) In calling the iShares inflation linked bond government fund “pretty low risk,” I only meant relatively safe by comparison to stock funds and other types of bond fund (corporate, long-term, emerging market, high yield, unhedged foreign currency etc.)

Thank you both for your feedback.
 
I didn’t mean to attribute an oversimplified view to you. I do appreciate that bond funds are riskier than State Savings products, that bond markets work differently....

Nope still not there.... for example many of the bond funds may not even hold the bonds of the index they track because of liquidity issues.. using synthetics to replicate performance may expose you to unknown risks. It is just not possible for all the funds in Europe to hold the same German bond for instance.
 
I’m aware of the fact that most fixed income ETFs use sampling rather than full physical replication, and that the swaps that they enter into involve counterparty risk (though UCITS rules require collateralization and limit the amount of exposure to a single counterparty). And I’m also aware that in addition to the long list of risks that I’m aware of, there are no doubt others of which I’m unaware.
 
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