The bond/gilt market

MK62

Linton said:

MK62 said:

Surely if the risk free rate was 5% today, and the market expected that risk free rate to return to 3% at some point in the next 15 years, then the YTMs on the two bonds would not both be 5% today........

People seem to be making heavy weather of this , gilts reallty are  pretty straightforward though the maths can be a little messy.  You can work out the behaviour of the markets purely on the basis of the coupon and capital repayment value at naturity being fixed at the point you buy the bond and that market pricing operates on the basis of bonds being held to maturity.  This means that expectations of future prices are pretty irrelevent. 

WHat does matter is the current interest rate.  The price of the shortest duration gilts match the interest rates set by the government.  Longer duration ones are set by the markets but are strongly nfluenced by the prices of shorter dated ones - Clearly the market will quickly remove any step change at one particular naturity date.
 . 

Of the 5 pages of comments, I'm not sure why you then single this one out as "making heavy weather"....but hey-ho......merely pointing out that if current market expectations suddenly changed as stated, then the YTMs on 15y and 50y zc gilts may have been the same before that change, but wouldn't be after it.

If you could actually work out the "behaviour of the markets" so easily, we'd all be rich... .......as for the market expectations of future prices being irrelevant, this might be true for current bond holders who plan and fully expect to hold until maturity.......but I'm not so sure it's irrelevant for others......perhaps those considering a buy or sell.

And while it's fair to say "What does matter is the current interest rate", it's not the only thing...eg, inflation (and the market's expectation of it) is also a factor.......as is the current state of the "markets" (eg, an equity crash can produce a "flight to safety", driving bond prices up......it's still a supply and demand market after all)

Mikeeee_2

Should I open up another can of worms and let everyone know that Money Market Funds are just vehicles for purchasing very short dated government bonds?? 

Linton

Mikeeee_2 said:

Should I open up another can of worms and let everyone know that Money Market Funds are just vehicles for purchasing very short dated government bonds?? 

Not a can of worms and not actually true.  MM funds may also hold many other things, for example corporate bonds, foreign exchange, bank deposits, derivatives, securitised loans and cash. 

Looking at one chosen at random UBP <MM fund as only 12% classified as Government bonds ( the data doesnt say which giovernment) and 49% corporate bonds.

zagfles

OldScientist said:

zagfles said:

OldScientist said:

zagfles said:

I understand that, but it misses the point I was making. Clearly, if the YTM changes from 3% to 5% on both the 15 and 50 year gilt, that would mean the price drop will be much greater on the longer dated gilt, as you illustrate above.

The point is I don't understand why the YTM should change the same for both gilts, unless the assumption is that events now which eg cause interest to rise, will result in higher rates in 15+ years time than previously expected.

The simple answer is that, outside simple illustrative examples like the one I chose, the YTM will not necessarily change by the same amount for gilts of different maturities for several reasons:

Yet the formula you quoted assumes it will, if I've understood it correctly

a) The yield curve is unlikely to be flat since it tends to rise as maturity increases. If I understand correctly, this is because longer maturity gilts are less 'risk free' since there is always the possibility of 'unknown unknowns' leading to non payment of capital. For example, the probability of the UK defaulting on its debt in the next year is much lower than over the next 50 years and therefore the market usually expects to be paid more to hold 50 year gilts than one year gilts.

Which makes sense, but we're talking about a change in the YTM/"risk free rate"/price. Fair enough, if an event occurs which is likely to change the prospect of the govt's ability to repay debt in 50 years time. But my point was an event occuring which is likely to cause a temporary rise in interest rates.

While the formula I quoted makes an assumption about the coupons (zero coupon) in order to make the maths more straightforward), it makes no assumption about the yields, so you have not understood it correctly. However, in the example I gave where I used the formula I assumed that the yield curve was flat (as I stated).

I was referring to the formula in your example.

If you are interested in the effect of news on gilt prices, there is an interesting paper by Elmendorf et al., "The effect of news on bond prices: Evidence from the United Kingdom, 1900-1920" (a google search will find it - it is freely available).

If you're looking to use such 'events' to predict what will happen to gilt prices you're probably going to be disappointed!

Not sure evidence from 1900-1920 will still be relevant! But who knows.

I did mention in another thread that there does seem to be overreation to current events in the longer dated gilts market and it could present an opportunity but I doubt I'll try to time the market, something I've always thought is a mug's game.

zagfles

masonic said:

zagfles said:

masonic said:

zagfles said:

Johnjdc said:

Mikeee is correct. The risk free rate is the risk free rate, that's what it's called and it just means the nominal return you can get without risking your nominal capital.

The fact that the real terms return might be lower, or even negative, is something to consider when investing, but doesn't affect the definition of the terms.

Now it's just semantics. On that definition you can get "risk free" 27% pa return on Turkish govt bonds

Turkish govt bonds should probably not be considered risk free. That is why there is a significant spread over the lowest risk bonds available.

Why not? Setting aside default risk and currency risk, so eg for a Turk living in Turkey, why aren't Turkish govt bonds "risk free"? It's blatently obvious to any investor in Turkish govt bonds that inflation risk is the biggest risk in buying govt bonds. Whatever definition of "risk free" is commonly used.

It's also obvious to buyers of flat gilts in any country that inflation is a risk, albeit a far lower risk than in Turkey.

Setting aside default risk and currency risk, all countries would have the same credit rating and citizens would universally adopt their local currency in all countries, as they do in places like the UK and the USA. In that world you would be correct, inflation risk would remain and that would be equal whatever currency you held. We would also have no need for forex markets and currency speculators, so it would certainly have its upsides. However, countries have different credit ratings, symbolising different default risks, and more importantly they have currency risk: When a currency devalues, things get relatively more expensive in that currency than they are in other currencies. As a result, sometimes citizens of a country utilise bonds of different countries because they are closer to the "risk free rate". They may even use the currency of a different country in the more extreme cases because they cannot predict what they will have to pay for things in their local currency from week to week or month to month, even if prices in other currencies are stable. This is all currency risk, and a risk premium above the "risk free rate" is priced into the yield of bonds issued in that currency. As defined by the financial sector, the "risk free rate" is currency independent in an efficient market (and I am putting the term in quotes to be clear that I am using this this accepted definition of it being free of capital risk, rather than asserting there are no risks at all - nothing provides this guarantee). If you see a higher rate of return, then it will be due to the inclusion of an additional risk premium.

I agree with you that it is obvious to buyers of fiat bonds in any country that inflation is a risk (hopefully it is or they are in for disappointment). But the "risk free rate" is proxied by short duration treasuries (conventionally the 3 month Treasury is adopted as the proxy for the "risk free rate"), so inflation is not usually a concern over such a short term. Indeed, with the lag of index linking, it is unlikely you'd be able to replace your 3 month Treasury with an alternative index linked bond that delivers the desired result. Consumers with no appetite for risk generally shouldn't invest at the "risk free rate" because they have access to FSCS-backed savings products that usually pay higher rates than can be obtained by all and sundry including institutional investors on bond markets. These are also labelled risk free, despite having no inflation protection.

Considering longer duration bonds, which normally pay more than the "risk free rate" due to a duration risk premium, this is where inflation can be more material. But while buyers of the inflation linked variety avoid the risk of their investment devaluing as compared with some official measure of inflation, their outcome in nominal terms could be above or below the "risk free rate" and/or the implied rate of inflation determined by the market price of the bond when they invest. The return in real terms can be either positive or negative due to the same factors, but it will be known from the outset. I'm a big advocate of securing inflation linked returns where possible, but there are times when it makes no financial sense to do so. But that's another discussion.

You seem to refer to "currency risk" as the risk of the currency devaluing - that risk exists in all currencies, obviously some more than others. Currency devaluation's main cause is probably inflation, or at least relative inflation (between countries).

I was taking "currency risk" to mean investing in a foreign currency, a currency you're not going to be spending so you have to convert it back to your own currency to spend. So for a UK citizen living and spending in the UK, there is no "currency risk" investing in UK gilts, but there is inflation risk. Exactly the same for a Turk living in Turkey investing in Turkish govt bonds. Both have no "currency risk", both do have "inflation risk". 

The big difference is obviously the scale of the risk. You can't say the Turk has "currency risk" but the Brit doesn't. Either both do or neither do. The GBP could devalue, the TRY could devalue. Both are a risk. The difference is the scale of the risk. The yields on the Turkish govt bonds are far higher than UK gilts not because of the risk of default, but because the risk of very high inflation.

Linton

zagfles said:

masonic said:

zagfles said:

masonic said:

zagfles said:

Johnjdc said:

Mikeee is correct. The risk free rate is the risk free rate, that's what it's called and it just means the nominal return you can get without risking your nominal capital.

The fact that the real terms return might be lower, or even negative, is something to consider when investing, but doesn't affect the definition of the terms.

Now it's just semantics. On that definition you can get "risk free" 27% pa return on Turkish govt bonds

Turkish govt bonds should probably not be considered risk free. That is why there is a significant spread over the lowest risk bonds available.

Why not? Setting aside default risk and currency risk, so eg for a Turk living in Turkey, why aren't Turkish govt bonds "risk free"? It's blatently obvious to any investor in Turkish govt bonds that inflation risk is the biggest risk in buying govt bonds. Whatever definition of "risk free" is commonly used.

It's also obvious to buyers of flat gilts in any country that inflation is a risk, albeit a far lower risk than in Turkey.

Setting aside default risk and currency risk, all countries would have the same credit rating and citizens would universally adopt their local currency in all countries, as they do in places like the UK and the USA. In that world you would be correct, inflation risk would remain and that would be equal whatever currency you held. We would also have no need for forex markets and currency speculators, so it would certainly have its upsides. However, countries have different credit ratings, symbolising different default risks, and more importantly they have currency risk: When a currency devalues, things get relatively more expensive in that currency than they are in other currencies. As a result, sometimes citizens of a country utilise bonds of different countries because they are closer to the "risk free rate". They may even use the currency of a different country in the more extreme cases because they cannot predict what they will have to pay for things in their local currency from week to week or month to month, even if prices in other currencies are stable. This is all currency risk, and a risk premium above the "risk free rate" is priced into the yield of bonds issued in that currency. As defined by the financial sector, the "risk free rate" is currency independent in an efficient market (and I am putting the term in quotes to be clear that I am using this this accepted definition of it being free of capital risk, rather than asserting there are no risks at all - nothing provides this guarantee). If you see a higher rate of return, then it will be due to the inclusion of an additional risk premium.

I agree with you that it is obvious to buyers of fiat bonds in any country that inflation is a risk (hopefully it is or they are in for disappointment). But the "risk free rate" is proxied by short duration treasuries (conventionally the 3 month Treasury is adopted as the proxy for the "risk free rate"), so inflation is not usually a concern over such a short term. Indeed, with the lag of index linking, it is unlikely you'd be able to replace your 3 month Treasury with an alternative index linked bond that delivers the desired result. Consumers with no appetite for risk generally shouldn't invest at the "risk free rate" because they have access to FSCS-backed savings products that usually pay higher rates than can be obtained by all and sundry including institutional investors on bond markets. These are also labelled risk free, despite having no inflation protection.

Considering longer duration bonds, which normally pay more than the "risk free rate" due to a duration risk premium, this is where inflation can be more material. But while buyers of the inflation linked variety avoid the risk of their investment devaluing as compared with some official measure of inflation, their outcome in nominal terms could be above or below the "risk free rate" and/or the implied rate of inflation determined by the market price of the bond when they invest. The return in real terms can be either positive or negative due to the same factors, but it will be known from the outset. I'm a big advocate of securing inflation linked returns where possible, but there are times when it makes no financial sense to do so. But that's another discussion.

You seem to refer to "currency risk" as the risk of the currency devaluing - that risk exists in all currencies, obviously some more than others. Currency devaluation's main cause is probably inflation, or at least relative inflation (between countries).

I was taking "currency risk" to mean investing in a foreign currency, a currency you're not going to be spending so you have to convert it back to your own currency to spend. So for a UK citizen living and spending in the UK, there is no "currency risk" investing in UK gilts, but there is inflation risk. Exactly the same for a Turk living in Turkey investing in Turkish govt bonds. Both have no "currency risk", both do have "inflation risk". 

The big difference is obviously the scale of the risk. You can't say the Turk has "currency risk" but the Brit doesn't. Either both do or neither do. The GBP could devalue, the TRY could devalue. Both are a risk. The difference is the scale of the risk. The yields on the Turkish govt bonds are far higher than UK gilts not because of the risk of default, but because the risk of very high inflation.

Given that most things you buy are based directly or indirectly on commodities traded on world warkets investing in global bonds may well reduce the risk of localised UK inflation.   |For example the Wealth Preservation funds wre for a while heavily invested in US inflation linked bonds.  I cant see Rurkey being relevent but US or a global bond fund may be.

masonic

zagfles said:

masonic said:

zagfles said:

masonic said:

zagfles said:

Johnjdc said:

Mikeee is correct. The risk free rate is the risk free rate, that's what it's called and it just means the nominal return you can get without risking your nominal capital.

The fact that the real terms return might be lower, or even negative, is something to consider when investing, but doesn't affect the definition of the terms.

Now it's just semantics. On that definition you can get "risk free" 27% pa return on Turkish govt bonds

Turkish govt bonds should probably not be considered risk free. That is why there is a significant spread over the lowest risk bonds available.

Why not? Setting aside default risk and currency risk, so eg for a Turk living in Turkey, why aren't Turkish govt bonds "risk free"? It's blatently obvious to any investor in Turkish govt bonds that inflation risk is the biggest risk in buying govt bonds. Whatever definition of "risk free" is commonly used.

It's also obvious to buyers of flat gilts in any country that inflation is a risk, albeit a far lower risk than in Turkey.

Setting aside default risk and currency risk, all countries would have the same credit rating and citizens would universally adopt their local currency in all countries, as they do in places like the UK and the USA. In that world you would be correct, inflation risk would remain and that would be equal whatever currency you held. We would also have no need for forex markets and currency speculators, so it would certainly have its upsides. However, countries have different credit ratings, symbolising different default risks, and more importantly they have currency risk: When a currency devalues, things get relatively more expensive in that currency than they are in other currencies. As a result, sometimes citizens of a country utilise bonds of different countries because they are closer to the "risk free rate". They may even use the currency of a different country in the more extreme cases because they cannot predict what they will have to pay for things in their local currency from week to week or month to month, even if prices in other currencies are stable. This is all currency risk, and a risk premium above the "risk free rate" is priced into the yield of bonds issued in that currency. As defined by the financial sector, the "risk free rate" is currency independent in an efficient market (and I am putting the term in quotes to be clear that I am using this this accepted definition of it being free of capital risk, rather than asserting there are no risks at all - nothing provides this guarantee). If you see a higher rate of return, then it will be due to the inclusion of an additional risk premium.

I agree with you that it is obvious to buyers of fiat bonds in any country that inflation is a risk (hopefully it is or they are in for disappointment). But the "risk free rate" is proxied by short duration treasuries (conventionally the 3 month Treasury is adopted as the proxy for the "risk free rate"), so inflation is not usually a concern over such a short term. Indeed, with the lag of index linking, it is unlikely you'd be able to replace your 3 month Treasury with an alternative index linked bond that delivers the desired result. Consumers with no appetite for risk generally shouldn't invest at the "risk free rate" because they have access to FSCS-backed savings products that usually pay higher rates than can be obtained by all and sundry including institutional investors on bond markets. These are also labelled risk free, despite having no inflation protection.

Considering longer duration bonds, which normally pay more than the "risk free rate" due to a duration risk premium, this is where inflation can be more material. But while buyers of the inflation linked variety avoid the risk of their investment devaluing as compared with some official measure of inflation, their outcome in nominal terms could be above or below the "risk free rate" and/or the implied rate of inflation determined by the market price of the bond when they invest. The return in real terms can be either positive or negative due to the same factors, but it will be known from the outset. I'm a big advocate of securing inflation linked returns where possible, but there are times when it makes no financial sense to do so. But that's another discussion.

You seem to refer to "currency risk" as the risk of the currency devaluing - that risk exists in all currencies, obviously some more than others. Currency devaluation's main cause is probably inflation, or at least relative inflation (between countries).

I was taking "currency risk" to mean investing in a foreign currency, a currency you're not going to be spending so you have to convert it back to your own currency to spend. So for a UK citizen living and spending in the UK, there is no "currency risk" investing in UK gilts, but there is inflation risk. Exactly the same for a Turk living in Turkey investing in Turkish govt bonds. Both have no "currency risk", both do have "inflation risk". 

The big difference is obviously the scale of the risk. You can't say the Turk has "currency risk" but the Brit doesn't. Either both do or neither do. The GBP could devalue, the TRY could devalue. Both are a risk. The difference is the scale of the risk. The yields on the Turkish govt bonds are far higher than UK gilts not because of the risk of default, but because the risk of very high inflation.

You are right that currency devaluation sometimes translates into inflation, but not always and not for everyone.

For example, the local economy can go on as it was before, the effect of currency devaluation being a cheaper cost of living as viewed by foreigners, but no perceptible change for the locals, unless they start buying imported goods and services. This is where they feel selective inflation on certain items that is not a result of the suppliers of those goods and services increasing their price in the foreign currency. If they consume a lot of imported goods and services, or if they are a business importing raw materials, or even if they have wealth that they wish not to be devalued, they can avoid this risk by holding cash or assets denominated in a more stable foreign currency. I think the perception of currency risk as purely a concern for assets exposed to foreign currencies is a luxury of those living in countries with a 'reserve quality' home currency.

A second example is that the UK's currency has halved in value compared to the US dollar since the 1970s, but US inflation has averaged about 3.3% over the subsequent 4 decades and the UK rate is about 3.6%. That's only a sufficient difference to account for about a 13% relative devaluation. So in that case a significant devaluation didn't translate into a corresponding inflation burden on the UK population. Incidentally, neither did the rampant money printing that went on globally over the last 15 years or so (until recently?) So it can take a long time for inflation to catch up, whereas the effect of a falling currency on money spent on goods and services that are priced on international markets is not as forgiving.

The main risk someone investing in TRY-denominated debt should fear is what the TRY will be worth when it is repaid. I would call that currency risk. I am applying the 'currency risk' label to both UK and Turkish investors in Turkish bonds, as I agree with you that it makes no sense to call it different things to different investors depending on where they live. It doesn't seem right to call it inflation risk when it is particular to foreign exchange movements and may or may not result in the money going less far depending on the spending needs of the recipient.

Whether it should be called inflation or currency risk depends on how you are framing it, so let's not get drawn into another semantics discussion, because all that matters is that there is a risk premium due to a higher perceived risk, which sets it above the risk level of other lower risk assets considered close or at the "risk free rate" as it is commonly labelled. </Humphrey Appleby>

zagfles

masonic said:

zagfles said:

masonic said:

zagfles said:

masonic said:

zagfles said:

Johnjdc said:

Mikeee is correct. The risk free rate is the risk free rate, that's what it's called and it just means the nominal return you can get without risking your nominal capital.

The fact that the real terms return might be lower, or even negative, is something to consider when investing, but doesn't affect the definition of the terms.

Now it's just semantics. On that definition you can get "risk free" 27% pa return on Turkish govt bonds

Turkish govt bonds should probably not be considered risk free. That is why there is a significant spread over the lowest risk bonds available.

Why not? Setting aside default risk and currency risk, so eg for a Turk living in Turkey, why aren't Turkish govt bonds "risk free"? It's blatently obvious to any investor in Turkish govt bonds that inflation risk is the biggest risk in buying govt bonds. Whatever definition of "risk free" is commonly used.

It's also obvious to buyers of flat gilts in any country that inflation is a risk, albeit a far lower risk than in Turkey.

Setting aside default risk and currency risk, all countries would have the same credit rating and citizens would universally adopt their local currency in all countries, as they do in places like the UK and the USA. In that world you would be correct, inflation risk would remain and that would be equal whatever currency you held. We would also have no need for forex markets and currency speculators, so it would certainly have its upsides. However, countries have different credit ratings, symbolising different default risks, and more importantly they have currency risk: When a currency devalues, things get relatively more expensive in that currency than they are in other currencies. As a result, sometimes citizens of a country utilise bonds of different countries because they are closer to the "risk free rate". They may even use the currency of a different country in the more extreme cases because they cannot predict what they will have to pay for things in their local currency from week to week or month to month, even if prices in other currencies are stable. This is all currency risk, and a risk premium above the "risk free rate" is priced into the yield of bonds issued in that currency. As defined by the financial sector, the "risk free rate" is currency independent in an efficient market (and I am putting the term in quotes to be clear that I am using this this accepted definition of it being free of capital risk, rather than asserting there are no risks at all - nothing provides this guarantee). If you see a higher rate of return, then it will be due to the inclusion of an additional risk premium.

I agree with you that it is obvious to buyers of fiat bonds in any country that inflation is a risk (hopefully it is or they are in for disappointment). But the "risk free rate" is proxied by short duration treasuries (conventionally the 3 month Treasury is adopted as the proxy for the "risk free rate"), so inflation is not usually a concern over such a short term. Indeed, with the lag of index linking, it is unlikely you'd be able to replace your 3 month Treasury with an alternative index linked bond that delivers the desired result. Consumers with no appetite for risk generally shouldn't invest at the "risk free rate" because they have access to FSCS-backed savings products that usually pay higher rates than can be obtained by all and sundry including institutional investors on bond markets. These are also labelled risk free, despite having no inflation protection.

Considering longer duration bonds, which normally pay more than the "risk free rate" due to a duration risk premium, this is where inflation can be more material. But while buyers of the inflation linked variety avoid the risk of their investment devaluing as compared with some official measure of inflation, their outcome in nominal terms could be above or below the "risk free rate" and/or the implied rate of inflation determined by the market price of the bond when they invest. The return in real terms can be either positive or negative due to the same factors, but it will be known from the outset. I'm a big advocate of securing inflation linked returns where possible, but there are times when it makes no financial sense to do so. But that's another discussion.

You seem to refer to "currency risk" as the risk of the currency devaluing - that risk exists in all currencies, obviously some more than others. Currency devaluation's main cause is probably inflation, or at least relative inflation (between countries).

I was taking "currency risk" to mean investing in a foreign currency, a currency you're not going to be spending so you have to convert it back to your own currency to spend. So for a UK citizen living and spending in the UK, there is no "currency risk" investing in UK gilts, but there is inflation risk. Exactly the same for a Turk living in Turkey investing in Turkish govt bonds. Both have no "currency risk", both do have "inflation risk". 

The big difference is obviously the scale of the risk. You can't say the Turk has "currency risk" but the Brit doesn't. Either both do or neither do. The GBP could devalue, the TRY could devalue. Both are a risk. The difference is the scale of the risk. The yields on the Turkish govt bonds are far higher than UK gilts not because of the risk of default, but because the risk of very high inflation.

The main risk someone investing in TRY-denominated debt should fear is what the TRY will be worth when it is repaid. I would call that currency risk. I am applying the 'currency risk' label to both UK and Turkish investors in Turkish bonds, as I agree with you that it makes no sense to call it different things to different investors depending on where they live.

In which case both UK and Turkish investors investing in UK gilts have 'currency risk'.

It doesn't seem right to call it inflation risk when it is particular to foreign exchange movements and may or may not result in the money going less far depending on the spending needs of the recipient.

The massively predominant risk to a Turkish investor investing in Turkish govt gilts is inflation, even if he/she only ever buys wholly domestically produced products and services. It's not exchange rate movements (which are mainly an effect of inflation anyway, not a cause).
The exact same risk a UK investor in UK gilts faces, except for scale. UK inflation is likely to be far lower than Turkish.

Whether it should be called inflation or currency risk depends on how you are framing it, so let's not get drawn into another semantics discussion, because all that matters is that there is a risk premium due to a higher perceived risk, which sets it above the risk level of other lower risk assets considered close or at the "risk free rate" as it is commonly labelled. </Humphrey Appleby>

It's the whole point about the term "risk free rate", and why I think it's misleading. It's easy to see in high inflation environments like Turkey where inflation risk is far higher, but the same risk (different scale) applies to the UK and other countries. Nowhere is "free "of that risk.

Linton

zagfles said:

masonic said:

zagfles said:

masonic said:

zagfles said:

masonic said:

zagfles said:

Johnjdc said:

Mikeee is correct. The risk free rate is the risk free rate, that's what it's called and it just means the nominal return you can get without risking your nominal capital.

The fact that the real terms return might be lower, or even negative, is something to consider when investing, but doesn't affect the definition of the terms.

Now it's just semantics. On that definition you can get "risk free" 27% pa return on Turkish govt bonds

Turkish govt bonds should probably not be considered risk free. That is why there is a significant spread over the lowest risk bonds available.

Why not? Setting aside default risk and currency risk, so eg for a Turk living in Turkey, why aren't Turkish govt bonds "risk free"? It's blatently obvious to any investor in Turkish govt bonds that inflation risk is the biggest risk in buying govt bonds. Whatever definition of "risk free" is commonly used.

It's also obvious to buyers of flat gilts in any country that inflation is a risk, albeit a far lower risk than in Turkey.

Setting aside default risk and currency risk, all countries would have the same credit rating and citizens would universally adopt their local currency in all countries, as they do in places like the UK and the USA. In that world you would be correct, inflation risk would remain and that would be equal whatever currency you held. We would also have no need for forex markets and currency speculators, so it would certainly have its upsides. However, countries have different credit ratings, symbolising different default risks, and more importantly they have currency risk: When a currency devalues, things get relatively more expensive in that currency than they are in other currencies. As a result, sometimes citizens of a country utilise bonds of different countries because they are closer to the "risk free rate". They may even use the currency of a different country in the more extreme cases because they cannot predict what they will have to pay for things in their local currency from week to week or month to month, even if prices in other currencies are stable. This is all currency risk, and a risk premium above the "risk free rate" is priced into the yield of bonds issued in that currency. As defined by the financial sector, the "risk free rate" is currency independent in an efficient market (and I am putting the term in quotes to be clear that I am using this this accepted definition of it being free of capital risk, rather than asserting there are no risks at all - nothing provides this guarantee). If you see a higher rate of return, then it will be due to the inclusion of an additional risk premium.

I agree with you that it is obvious to buyers of fiat bonds in any country that inflation is a risk (hopefully it is or they are in for disappointment). But the "risk free rate" is proxied by short duration treasuries (conventionally the 3 month Treasury is adopted as the proxy for the "risk free rate"), so inflation is not usually a concern over such a short term. Indeed, with the lag of index linking, it is unlikely you'd be able to replace your 3 month Treasury with an alternative index linked bond that delivers the desired result. Consumers with no appetite for risk generally shouldn't invest at the "risk free rate" because they have access to FSCS-backed savings products that usually pay higher rates than can be obtained by all and sundry including institutional investors on bond markets. These are also labelled risk free, despite having no inflation protection.

Considering longer duration bonds, which normally pay more than the "risk free rate" due to a duration risk premium, this is where inflation can be more material. But while buyers of the inflation linked variety avoid the risk of their investment devaluing as compared with some official measure of inflation, their outcome in nominal terms could be above or below the "risk free rate" and/or the implied rate of inflation determined by the market price of the bond when they invest. The return in real terms can be either positive or negative due to the same factors, but it will be known from the outset. I'm a big advocate of securing inflation linked returns where possible, but there are times when it makes no financial sense to do so. But that's another discussion.

You seem to refer to "currency risk" as the risk of the currency devaluing - that risk exists in all currencies, obviously some more than others. Currency devaluation's main cause is probably inflation, or at least relative inflation (between countries).

I was taking "currency risk" to mean investing in a foreign currency, a currency you're not going to be spending so you have to convert it back to your own currency to spend. So for a UK citizen living and spending in the UK, there is no "currency risk" investing in UK gilts, but there is inflation risk. Exactly the same for a Turk living in Turkey investing in Turkish govt bonds. Both have no "currency risk", both do have "inflation risk". 

The big difference is obviously the scale of the risk. You can't say the Turk has "currency risk" but the Brit doesn't. Either both do or neither do. The GBP could devalue, the TRY could devalue. Both are a risk. The difference is the scale of the risk. The yields on the Turkish govt bonds are far higher than UK gilts not because of the risk of default, but because the risk of very high inflation.

The main risk someone investing in TRY-denominated debt should fear is what the TRY will be worth when it is repaid. I would call that currency risk. I am applying the 'currency risk' label to both UK and Turkish investors in Turkish bonds, as I agree with you that it makes no sense to call it different things to different investors depending on where they live.

In which case both UK and Turkish investors investing in UK gilts have 'currency risk'.

It doesn't seem right to call it inflation risk when it is particular to foreign exchange movements and may or may not result in the money going less far depending on the spending needs of the recipient.

The massively predominant risk to a Turkish investor investing in Turkish govt gilts is inflation, even if he/she only ever buys wholly domestically produced products and services. It's not exchange rate movements (which are mainly an effect of inflation anyway, not a cause).
The exact same risk a UK investor in UK gilts faces, except for scale. UK inflation is likely to be far lower than Turkish.

Whether it should be called inflation or currency risk depends on how you are framing it, so let's not get drawn into another semantics discussion, because all that matters is that there is a risk premium due to a higher perceived risk, which sets it above the risk level of other lower risk assets considered close or at the "risk free rate" as it is commonly labelled. </Humphrey Appleby>

It's the whole point about the term "risk free rate", and why I think it's misleading. It's easy to see in high inflation environments like Turkey where inflation risk is far higher, but the same risk (different scale) applies to the UK and other countries. Nowhere is "free "of that risk.

Investing, however you do it, cannot be free of risk unless you find some one else with the ability to take on the risk for you eg with an index linked bond or annuity. Both of these are underwritten by the UK government.  But the ability of these to return more than inflation is limited.  You may need a higher return in order to retire at the time you would like with an acceptable standard of living.

There is no single tool that will solve this long term investing risk problem.  All you can do is to use the various tools together to achieve a result that you find acceptable both in terms of cost and degree of guaranteed financial security.

Equities are one such tool.  You can safely assume that they will protect you against inflation in the long term but they could do anything in the short term.  Sadly the boundary between the two is unpredictable.  They have inherent risk even when they do what they are supposed to do. There is nothing useful for which you can rely on them with 100% certainty.

Developed world bonds such as fixed gilts do a different job.  They are risk free in the sense that they will do exactly what they say they will do in returning a specified, regular amount of cash and then the original lump sum at a specified date with 100% certainty which is useful in the shorter term.  Unfortunately in the long term what they do is not what you might want them to do.  The risk is of your own creation in using them for some other objective.  It is no good complaining that your use of a hammer and a screwdriver to open a tin can caused you to cut your hand.  The fault and risk is yours for using the wrong tool.

But you could use risk free bonds, gilts, for a purpose that matches their capabilities.  For example should you have a lifetime fixed rate mortgage and bought  a gilt that returned sufficient income there would be no risk at all of you losing your home.  Unlike other loans there is no risk that the borrower,  the UK government, will be unable to meet its obligations 

Note that in all these discussions zero risk means zero risk assuming the continued existance of the world as we know. it.  WIthout that constraint all bets on anything are off.

masonic

zagfles said:

In which case both UK and Turkish investors investing in UK gilts have 'currency risk'.

No disagreement there, but the amount of risk will be proportional to the instability of the currency. Hence we have the US dollar referred to as the global reserve currency and used unofficially in other countries.

zagfles said:

The massively predominant risk to a Turkish investor investing in Turkish govt gilts is inflation, even if he/she only ever buys wholly domestically produced products and services. It's not exchange rate movements (which are mainly an effect of inflation anyway, not a cause).
The exact same risk a UK investor in UK gilts faces, except for scale. UK inflation is likely to be far lower than Turkish.

TRY has lost 92% of its value against USD over the last 10 years, 40% in the last year. Turkey's recent inflation problems have been rather more short-lived, but there is clearly a longer-term problem here that came home to roost in 2022. Hence I would suggest that it was the economic policies that drove this currency devaluation and subsequently drove a spike in inflation. So the inflation was effect not cause.

That's what turns investors off. No sensible investor, wherever they live, would be willing to invest in a bond denominated in a serially devaluing currency unless they are compensated for this currency devaluation risk by a very high coupon. Otherwise they'd just convert their TRY to USD and invest in a US Treasury, then convert back from USD to many more TRY for a much higher return.

What matters for globally traded securities is how they are likely to perform relative to one another, and for bonds, currency devaluation over the holding period is a major factor, which is why the coupons required to attract investors to be repaid in TRY, rather than USD or GBP or EUR, are so high. The coupon must cancel out any anticipated devaluation for the debt of one country to be on a par with another in this respect.

zagfles said:

It's the whole point about the term "risk free rate", and why I think it's misleading. It's easy to see in high inflation environments like Turkey where inflation risk is far higher, but the same risk (different scale) applies to the UK and other countries. Nowhere is "free "of that risk.

There are many terms in common usage that are a bit of a misnomer, and "risk free rate" certainly lives among them. It's important to remember that the "risk free rate" cannot be achieved through investing in anything in the real world. It is purely theoretical. The 3 month US Treasury is regarded as a proxy for it because it is the closest one can practically get to determining the rate. The actual risk free rate would be somewhat lower, but it is impossible to say by how much, so instead the 3m Treasury rate is used as an estimate.