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The FX Dilemma: An Introduction to Hedging Currency Risk in Bond Portfolios

Hedging costs, currency movements, and the characteristics of underlying assets, are among the many factors to consider in deciding whether to hedge FX risk.

When deciding on strategic asset allocations many investors grapple with the dilemma of whether or not to hedge currency risk. Historically, a typical approach was to hedge currency exposures in foreign bond portfolios, while leaving foreign equity portfolios largely unhedged. However, the lower yield environment in the eurozone relative to other developed bond markets, such as the U.S., encourages many investors both to seek higher yields abroad and to question whether hedging foreign bond allocations is still worth it.

The answer to this question clearly depends on investors’ individual risk-return preferences, with more risk-averse market participants tending to hedge most of the currency risk of bonds. However, an informed investment decision should also take into account several other factors, such as the level of currency hedging costs, expectations for foreign exchange (FX) movements and the characteristics of the underlying bond portfolios. Importantly, whether or not to hedge currency risk does not need to be a binary decision, and in some cases partial hedging can be appropriate.

Cost of currency hedging

For euro-based investors wishing to hedge U.S. dollar assets, the return drag from hedging has risen from 0% at the beginning of 2014, to over 2% today. Why has this happened?

Hedging costs can be decomposed into two parts:

  1. Short-term rate differential: This is the difference between short-term rates in the domestic and foreign currency. When investors wish to hedge a foreign currency exposure, they implicitly pay the foreign cash rate and receive the domestic cash rate (known as covered interest rate parity). So any changes between these rates impact the hedging cost.
  2. FX/currency basis: This is the additional cost investors pay to buy and sell currencies forward, on top of the rate differential. This factor largely depends on imbalances between supply and demand across different currencies.

As Figure 1 shows, both of these components have expanded relative to four years ago. The differential between U.S. dollar and euro short term rates (in grey) has grown as a result of diverging Federal Reserve and ECB policy rates. At the same time, the FX basis (in blue) has remained negative due to strong net demand for U.S. dollars globally.

Decomposing currency hedging costs (USD to EUR)

However, as the chart also shows, the current level of hedging cost is sizable but not unprecedented. Investors faced comparable if not higher hedging costs in 1999-2000 and 2005-2006, periods in which the Federal Reserve also raised interest rates (and also very briefly when Lehman Brothers defaulted in 2008). One important difference, however, is the starting level of yields: 2% hedging drag when 10-year U.S. Treasuries yield close to 2.5% is far harder to cope with than when they yielded more than 4%, which was the case in previous periods of high hedging costs.

Time is unlikely to solve the dilemma and, on the contrary, may make it worse. If the Federal Reserve continues its hiking cycle ahead of the ECB, the differential between U.S. dollar and euro short-term rates could widen further.

Benefits of hedging high quality bond portfolios

Does this mean investors should stop hedging currency risk in their bond portfolios? We do not think so, and to see why, it is important to consider the impact of hedging on risk as well as return. Comparing unhedged and hedged U.S. Treasury investments since the launch of the euro (shown in Figure 2 and 3) highlights two key points:

  1. Leaving high-quality bond allocations unhedged (blue line) materially increases risk relative to a currency hedged investment (yellow line). Although a euro-based investor would have improved cumulative returns by not hedging currency exposure, the much higher volatility – driven by currency risk – would have halved risk-adjusted returns, represented by the Sharpe ratio.
  2. Although saving 2% per year in hedging costs may sound appealing, these savings can be easily wiped out by currency volatility. In fact, historically the U.S. dollar has depreciated more than 2% versus the euro almost half of the time on a one-year rolling horizon (green bars).

Return and volatility of hedged and unhedged bond investments: 1998 to 2017

Cumulative returns of hedged and unhedged bond investments

Currency hedging and bond characteristics

The removal of currency hedging can profoundly change the risk-return profile of bond allocations. But does this equally apply to all types of bonds?

It does not, because the additional risk generated by foreign currency exposure depends on two different factors:

  1. The correlation between the portfolio and foreign currencies. High quality currencies such as the U.S. dollar often tend to strengthen when riskier bonds like high yield are under pressure. So for euro-based investors in U.S. high yield, not hedging U.S. dollar exposure may reduce portfolio losses in periods of market stress, as the currency gains may partially offset the underlying high yield losses. In general, the lower the correlation between underlying asset and foreign currency, the lower the incremental risk generated by leaving currency exposure unhedged, since a larger share of the risk is diversified away (see the illustrative example in Figure 4).
  2. The risk of the underlying portfolio. The higher the volatility of the underlying bonds, the lower the incremental risk introduced by leaving currencies unhedged. As an illustrative example (see Figure 4), consider a currency with 10% volatility, uncorrelated with the underlying bond portfolio. If the volatility of the hedged bond portfolio was 2%, unhedged currency risk would increase it by 8.2%. If the bond volatility was 10%, currency risk would increase it by only 4.1%.

Incremental volatility from fully unhedged currency exposure

Partially hedged portfolios

Similar considerations also apply to partially hedged portfolios. Figure 5 shows how the long-term expected return and estimated volatility of a U.S. Treasury and U.S. high yield portfolio vary depending on the hedge ratio, from the perspective of a euro-based investor1.

Expected return and volatility by hedge ratio

For both asset classes removing currency hedging is expected to increase returns, as savings of direct hedging costs are not expected to be eroded by fluctuations in the value of the U.S. dollar over the long term. However, consistent with the above, the impact on volatility is much larger for Treasuries than for high yield bonds. Partially hedging low-quality bond portfolios, such as high yield, may help enhance returns without necessarily adding – or even slightly reducing – volatility relative to a fully hedged allocation. This is because high-quality currency exposure may help diversify the underlying credit risk.

A final point is that the above results can differ if currency hedging is conducted at the total portfolio, or multi-asset level, rather than the individual asset class level. Multi-asset hedging goes beyond the scope of this paper but further details can be found in “Currency Hedging Optimization for Multi-asset Portfolios” by Helen Guo and Laura Ryan, and “Optimal Currency Hedging: A Factor Perspective” by Steve Sapra and Lutz Schloegl. Ultimately the chosen currency hedging framework should take into account investors’ specific portfolios and objectives.

In short, when it comes to currency hedging decisions for bond portfolios, investors should carefully consider multiple dimensions, including not only hedging costs and expected FX movements, but also the specific credit risk of the underlying assets, the related currency exposures and their mutual interactions. They should also ensure their hedging policies are consistent with their specific return targets and risk budgets. Even in the presence of high hedging costs, currency hedging bond portfolios is often still appropriate, although in some cases partial hedging may be beneficial.

1 Expected returns for U.S. Treasuries and U.S. HY are based on PIMCO 10-year Capital Market Assumptions as of 4Q 2017. Direct hedging costs are assumed to be around 1.9%/year (around 1.6% short-term rate differential and 0.3% FX basis), while the EUR/USD exchange rate is assumed to be around 1.20 by the end of the ten year period.

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Giacomo Bonetti

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Past performance is not a guarantee or a reliable indicator of future results.

FORECAST: Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

HYPOTHETICAL EXAMPLE: No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.

ESTIMATED VOLATILITY: We employed a block bootstrap methodology to estimate volatilities. We start by computing historical factor returns that underlie each asset class proxy from January 1999 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. For each asset class, index, or strategy proxy, we will look at either a point in time estimate or historical average of factor exposures in order to determine the total volatility.

PIMCO’s Capital Market Assumptions, August 2021
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