The Case for Hedging Currency Exposure in Fixed Income Portfolios

Author:
Haibo Chen
Portfolio Manager and Head of Fixed Income Quantitative Strategies

9 April 2018

To hedge or not to hedge? That is increasingly becoming the question as central banks begin to pull back on extraordinary monetary policy accommodation. Currency volatility has risen as a result, with the US Dollar Index (DXY) weakening 9.8% against major world currencies in 2017.

To many, not hedging seems to be the best approach. Investors who go this route do so for several reasons: They see currency exposure as a risk diversifier as well as a source of return, and they view currency hedging as unnecessarily costly. Indeed, the dollar’s slide has been welcome news for investors who use unhedged global bond indexes, which benefit from the strength of non-US-dollar currencies. The Bloomberg Barclays Global Aggregate Index returned 7.39% in US dollars in 2017, while same index returned only 3.04% for the period if non-dollar currencies were fully hedged to the dollar.1

So it appears obvious that unhedged global bond indexes are a better choice for US dollar investors. And, indeed, many investors do choose not to hedge: A survey on global fixed income benchmarks used by institutional investors on eVestments revealed that almost half of them are unhedged. A similar survey on Morningstar’s retail-oriented UCITS funds has most of their benchmarks unhedged.

But is unhedged really the best approach? Not according to our research, which found that a currency-hedged benchmark delivers a return similar to that of an unhedged benchmark but with a much smaller decline from peak to trough (drawdown). It also generates excess returns more consistently, as measured by the information ratio. For investors looking to take currency exposure, we found that a currency overlay on top of a hedged portfolio – rather than taking passive currency exposure in an unhedged benchmark – is the better approach.

Does currency exposure diversify global bond risks?

The volatility of the total return of global bonds, which is the sum of the returns of both local bonds and currencies, depends on the volatilities of the currency return and the bond return as well as the correlations. For developed market investment grade benchmarks, currency volatility dominates, and unhedged risks are always larger than hedged risks. When looking at the historical returns of a global bond index measured in G4 currencies, both hedged and unhedged, unhedged returns clearly are much more volatile than hedged returns. In fact, across all currencies, unhedged return volatilities more than double hedged return volatilities.

Unhedged Returns Are Much More Volatile Than Hedged Returns
Bloomberg Barclays Global Aggregate Index Cumulative Return Measured in G4 Currencies

Source: Bloomberg Barclays, as of 31 December 2017. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Unhedged Return Volatilities More Than Double Hedged Return Volatilities Across All Currencies
Bloomberg Barclays Global Aggregate Index Annual Return Volatility

Source: Bloomberg Barclays POINT. As of 31 December 2017. USD data since 30 January 1987, EUR data since 28 February 1999, GBP data since 28 February 1990, and JPY data since 28 February 1990. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

For high yield and emerging market benchmarks, currency volatility and bond volatility are similar in magnitude. However, two equally weighted assets with identical volatility need a -50% return correlation to make aggregate volatility the same as individual volatility. While it is true that the correlation between the returns of high yield/EM and currencies is low, it is nowhere close to -50%. As a result, even for high yield and EM benchmarks, currency exposure adds to the risk, not reducing it. Regardless of which currency the return is measured in, the unhedged high yield return volatilities are higher than those of hedged returns.

Currency Exposure Adds Risk, Even for High Yield and EM Benchmarks
Bloomberg Barclays Global High Yield Index Annual Return Volatility

Source: Bloomberg Barclays POINT. As of 31 December 2017. Data since 28 February 1999. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Does currency exposure provide a source of return?

When looking at both hedged and unhedged returns for the Bloomberg Barclays Global Aggregate Index measured in US dollars, British pound sterling, euro, and yen, hedged and unhedged returns are very close. That is, in the long run, currency does not contribute additional return. The only exception is the yen, whose hedged return is lower than the unhedged return.

Most Currency Exposure Does Not Contribute Additional Return
Bloomberg Barclays Global Aggregate Index Average Annual Return

Source: Bloomberg Barclays POINT. As of 31 December 2017. USD data since 30 January 1987, EUR data since 28 February 1999, GBP data since 28 February 1990, and JPY data since 28 February 1990. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

In general, currency exposure in the long run does not have a risk premium. There is one exception, however: Higher yielding currencies tend to outperform lower yielding currencies – the so-called currency premium puzzle. The reason why hedged and unhedged returns are so close in dollars, pounds, and euro is because, in this period, their average yields are not that different. In the last 20 years, the sterling two-year yield is about 55 basis points (bps) higher than the US two-year, while the euro two-year is about 42 bps lower than the US two-year.2 On the other hand, the yen’s average yield over the period is significantly lower than the yields of other currencies (about 2.15% lower than the US two-year yield.3 Hedging currencies to the yen consistently shorts higher yielding currencies, which makes the hedged return compare unfavorably with the unhedged return.

So exposure to higher yielding currencies is one source of return. But is passive exposure in an unhedged benchmark the best way to gain such exposure? We’ll come back to that later.

In the meantime, even for low-yielding currencies such as the yen, the hedged risk-adjusted return and drawdowns are much better than those for an unhedged benchmark. When looking at the maximum drawdown and information ratio (annual return/annual volatility) for the Bloomberg Barclays Global Aggregate Index measured in G4 currencies, hedged returns have much smaller drawdowns and much higher information ratios, which is true regardless of which currency the investor is based in.

Hedged Returns Have Much Smaller Drawdowns and Much Higher Information Ratios

Bloomberg Barclays Global Aggregate Index Maximum Drawdown Bloomberg Barclays Global Aggregate Index Information Ratio

Source: Bloomberg Barclays POINT. As of 31 December 2017. USD data since 30 January 1987, EUR data since 28 February 1999, GBP data since 28 February 1990, and JPY data since 28 February 1990. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Is currency hedging too costly?

The transaction cost of currency hedging should not be much of a concern in today’s market. Currency is among the most liquid instruments in the world, with the transaction cost for major pairs as low as 1 bp to initiate a hedge and as low as 0.25 bps to roll the hedge forward. Even for nonmajor currency pairs, most currencies – including emerging market currencies – cost less than 5 bps to initiate a hedge and 1-2 bps to roll.

In the meantime, currency-hedging operations are very easy to set up. Managers can choose to use currency futures, which are listed on exchanges and can be set up and traded in a same way as other listed securities like equity index futures. More sophisticated managers can use currency forwards, which require International Swaps and Derivatives Association (ISDA) master agreements with brokers. These agreements are quite standard across brokers and easy to negotiate if the purpose is to hedge, not speculate.

There’s a better way to take currency exposure

We noted that the Barclays Global Aggregate index hedged to the yen has a lower average return than an unhedged exposure because hedging to the yen is a negative currency carry trade. What if we want to make up the return difference by taking currency exposures?

We argue that a better way to do that is to overlay a currency strategy, instead of simply taking whatever currency exposure is in the unhedged benchmark. As an example, let’s take the Deutsche Bank Currency Excess Return Index (DBCR) as a currency overlay (the index is not funded; it consists of equally weighted carry, momentum, and valuation strategies). Since the yen is about 20% of the index, we can take 80% of the DBCR and add it to the hedged benchmark. With the currency overlay, we achieve similar a return as the unhedged benchmark with risks similar to the hedged benchmark.

Hedged Plus a Currency Overlay Achieves Higher Returns Than Unhedged or Hedged Alone
Bloomberg Barclays Global Aggregate Index Historical Cumulative Return Measured in JPY

Source: Bloomberg Barclays, as of 31 December 2017. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

The Currency Overlay Also Generates Less Risk Than the Unhedged Benchmark
Statistics of Bloomberg Barclays Global Aggregate Index Historical Returns Measured in JPY

Source: Bloomberg Barclays, as of 31 December 2017. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Besides better long-run return and risk characteristics, the hedged benchmark with a currency overlay has other advantages compared with the unhedged benchmark:

  • It clearly separates the currency decision. An investor’s view on a foreign bond may be positive in terms of yield curve movement but negative on currency outlook, or vice versa. Separating the currency makes it easy to make the best investment decisions.
  • It allows you to size the currency exposure optimally. Investors tend to have different convictions on yield curve and currency. This separation allows them to size their exposures to each view according to their convictions.
  • It has the added benefit of equalizing bond yields of different currencies. When an investor shorts a currency forward to hedge a foreign bond, the currency forward has a carry that, in general, offsets the interest rate differential between the foreign and domestic yields so that the total yield of the hedged bond (the bond yield plus the interest rate differential) is about the same as that of a domestic bond. As a result, when making investment decisions, investors can take the yield level out of their consideration and focus their attention on future price changes.

The answer is always hedge

The dollar weakness continues into 2018, so now is a good time for many investors to reconsider their position on hedging in their fixed income portfolios. We believe global fixed income investors should always hedge their portfolios to their base currency to start with. If they wish to take foreign currency exposure, we believe they should adopt a currency overlay on top of the hedged benchmark for that purpose, rather than taking passive currency exposure in an unhedged benchmark. The results: comparable or higher long-run returns, but a much lower drawdown and much higher information ratio.

Notes

1 Bloomberg Barclays POINT, as of 31 December 2017.
2, 3 Bloomberg, as of 28 March 2018.