There is little doubt that the Swiss National Bank’s (SNB) unexpected policy decision to abandon its Swiss franc/euro currency floor on 15 January 2015 came as a shock to the financial world. We believe the consequences will be lasting and far-reaching for investors, particularly Swiss investors, mainly through the impact of negative yields on Swiss government bonds and the rising currency hedging costs associated with the Swiss franc.
By abandoning the currency floor, interest rates have become the SNB's primary policy tool. The decision to pursue a negative interest rate policy has pushed yields of Swiss government bonds into negative territory for maturities up to 10 years, a situation which is unlikely to reverse anytime soon. However, the ramifications of this monetary policy shift are not limited just to government bonds (see Figure 1), as select short-term corporate bonds also have been trading at negative yields. This highlights the challenges for Swiss investors who are forced to invest in domestic assets. At the same time, leaving cash on bank accounts is no longer an attractive alternative, as many investors are now increasingly faced with negative interest rates on their cash holdings.
The abrupt change in the SNB's monetary policy caused severe stress in the Swiss franc currency market. In addition to a significant weakening of the euro and the U.S. dollar against the Swiss franc, there was a significant spike in currency hedging costs following the SNB's policy shift. While market dislocations have partially normalised, rising currency hedging costs have become an additional element in investors´ decisions on top of considerations pertaining to interest rate differentials (see Figure 2).
This is particularly true for Swiss institutional investors, such as pension funds, who are facing increasingly stringent regulations that further constrain their investment universe and their ability to achieve target returns on investments. For example, the more restrictive framework for the classification of receivables under the Swiss Ordinance on Occupational Retirement, Survivors’ and Disability Pension Plans (BVV2), either as traditional or alternative investment instruments, limits the range of potential investments for Swiss pension funds.
Is it time for investors to go global?
In our view, the heightened financial repression in Switzerland remains the key challenge for Swiss investors over the longer term.
At PIMCO, we believe they may want to reconsider their current asset allocation in the context of a globally oriented investment universe to potentially enhance expected returns. In the current low yield environment, however, going global has its challenges. Take global government bonds, for example: They appear to provide an obvious alternative to Swiss government bonds by offering a diversified, high quality issuer base. However, yields are low globally as major central banks across the developed world pursue ultra-low interest rate and quantitative easing policies. Add to that the elevated currency hedging costs, and we find that the yield on the Barclays Global Treasury Index, hedged to the Swiss franc, is also negative at the moment (Barclays, as of 31 March 2015). Among the developed market government yield curves, there are currently only a handful of markets where we see the potential for a positive, albeit meagre, return that can be earned on a currency hedged basis.
Simply going global by itself may not be sufficient. In our view, Swiss investors ought to consider moving selectively further out what PIMCO calls the “investment concentric circles” into investment grade credit, high yield, bank loans, emerging markets, distressed debt and real estate to complement the overall portfolio´s risk factor exposure and to enhance returns (see Figure 3), within the framework of their risk/return objectives.
Yields, however, are only a snapshot of current market pricing, and are not the same as prospective returns; returns are also determined by a number of additional factors, such as future changes in global yield curves, spreads and currency hedging costs. At PIMCO, we use 10-year expected returns that incorporate current yield levels, historical risk premia and our longer-term views on expected market movements, rather than yields, to evaluate strategic investment decisions.
To illustrate this point, let us take a look at the yields and expected returns for several model portfolios, as well as their estimated volatility (see Figure 4). The mid-point of the expected return range is positive, although modest, for Swiss government bonds, despite the current negative yields. This reflects our expectation for Swiss yields to rise over time, leading to a positive running yield and consequently to a modestly positive total return.
For example, a global investment grade credit strategy provides higher expected returns and a positive hedged yield against a volatility that is not much higher than that of Swiss government bonds, while a diversified global credit portfolio lifts the yield to over 2% and also increases the expected return for a 50% increase in volatility compared with that of Swiss government bonds.
When we plot the mid-point of the expected return for these four model portfolios against the estimated volatility, which is based on PIMCO’s proprietary risk factor model, we see that global treasuries have a lower volatility than Swiss government bonds due to the lower average duration and diversified issuer base (see Figure 5).
Should investors fully hedge their currency risk?
Swiss investors have historically been reluctant to accept currency risks within their fixed income allocation; however, our analysis suggests that some currency risks can exhibit diversifying characteristics in an overall portfolio context and increase expected returns over the long term. We believe that this is due to two reasons: hedging costs and currency valuation.
- Hedging costs: Swiss interest rates are among the lowest of all the major currencies. This means that when hedging currency risk, investors continually pay away the difference between the foreign and Swiss interest rates. At the moment, the interest rate differentials are about 1% versus the U.S. dollar and 0.8% against the euro (Bloomberg, as of 31 March 2015). We expect this to increase going forward, especially versus the U.S. dollar as we expect the U.S. Federal Reserve to increase interest rates well ahead of the SNB.
- Currency valuation: The Swiss franc is now one of the most overvalued currencies based on fundamentals.
We therefore expect that hedging back to the Swiss franc will likely reduce portfolio returns since investors would end up paying away more than 1% per annum to buy an expensive currency.
However, leaving currency unhedged is not without risk. The estimated volatility of global treasuries nearly doubles when leaving the currency unhedged, while volatility for global investment grade credit is more than 50% higher. We believe a partial hedge that modestly reduces the hedge ratio from 100% to 80%–90% for government bonds and 70%–80% for global investment grade credit may increase expected portfolio return without meaningfully increasing risk (see Figure 6).
Our assumptions for the difference in hedged and unhedged returns are based on a combination of the expected interest rate differential and the expected spot price change. For example, for the U.S. dollar, we expect an interest rate differential of 1.4% per year and a Swiss franc depreciation of 1.1% per year, resulting in a 2.5% difference in the expected return on a hedged versus unhedged U.S. dollar-denominated investment.
And what about the spike in currency hedging costs on top of what interest rate differentials between currencies would suggest? We expect this to be a temporary dislocation that will eventually normalise – either the SNB will work to close the negative basis or value investors will arbitrage it away over time.
The SNB's monetary policy shift has created significant and lasting challenges for Swiss investors; however, the good news is that economic and monetary policy divergence may provide attractive opportunities for value investors with a broad investment horizon to enhance returns and reap the benefits of a globally diversified portfolio. Importantly, we believe that bonds continue to play an important role for investors as a diversifier as well as an income generator. Taking a global investment approach alongside an expanded investment universe provides structural benefits that may outweigh the costs incurred by currency hedging.