Savvy global core bond investors—those who invest in bonds as an offset to risk assets—came into Brexit currency-hedged. It paid off. During the flight to safety, currencies close to the center of the storm took a beating.
We’ve been ringing the warning bell for some time that volatility would spike—and now it has. And like it or not, volatility is likely to continue to be, well, volatile. But currency hedging isn’t just a strategy for the here and now and for times of high volatility when the US dollar rallies. For core bond investors, it’s always essential.
Why Some Core Bond Investors Resist Hedging Currency
In addition to return from income (coupon payments) and return from changes in price, non-US bonds provide a third source of potential return: currency exposure.
Some investors assume that currency hedging is expensive and complicated. Some choose not to hedge away the impact of currency fluctuations in the hope that currency exposure will boost global bond returns over the long run. Some assume that multiple sources of return—income plus price plus currency—will reduce their overall risk because of a diversification effect.
Let’s look at each of these assumptions in turn.
Hedging: Neither Expensive nor Complex
Hedging is conducted through the currency forward markets, which are among the most liquid markets in the world. Because the foreign exchange markets are highly liquid, the transaction cost of executing a hedge is very little—on the order of one to two basis points to initiate a hedge from a developed-market currency into US dollars, then an eighth to a quarter of a basis point to roll that same hedge forward as needed.
For example, when we purchase a German Bund, it’s denominated in euros. We have to pay for the Bund in euros, but we have US dollars in hand. So we go into the currency forward market and buy the euros we need with our dollars. We then sell forward those euros two or three months, back to the US dollar.
While executing this hedge is inexpensive, there is often a noticeable yield differential between a hedged and an unhedged portfolio. Depending on the relative levels of short-term interest rates—which affect the cost of hedging a bond from one currency to another—sometimes the unhedged portfolio has a lower yield, while at other times the hedged portfolio has a lower yield. That difference is sometimes mistaken for the cost of hedging. But, in fact, the long-term historical return for hedged global portfolios is favorable.
Hedging Doesn’t Hurt Returns
Over long periods, hedged global bond portfolios have beaten unhedged in terms of historical returns. For the 20 years ending December 31, 2015, a US dollar–hedged global bond portfolio, represented by the Barclays Global Aggregate Bond Index, generated an annualized return of 5.5%, versus 4.5% for its unhedged counterpart. The Barclays US Aggregate Index returned 5.3% over the same period.
The Sharpe ratio, a measure of return per unit of risk, climbs from global unhedged at 0.4 to US bonds at 0.8, to global hedged at 1.1. And a major reason for that? Hedged bonds’ lower volatility.
Hedging Significantly Reduces Volatility
Although currency exposure might have been viewed by some investors as a diversifying risk, in the long run it has not reduced overall volatility. Instead, as shown in the Display below, currency-hedged global bonds have consistently been far less volatile than unhedged global bonds, and even less volatile than US bonds—thanks to the benefits of economic-cycle diversification.
We didn’t need Brexit to serve up a reminder that currency is almost twice as risky as fixed income. Currency exposure has detracted from unhedged global bond returns over the past 20 years, while contributing an astonishing three-fourths of overall volatility.
It’s true that in some cases it may be appropriate to take on currencies opportunistically. But for core bond investors—investors using bonds as a strategic offset to the volatility of risk assets—a fully hedged portfolio should be the default position.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.