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Consider Hedging Your Global Bond Currency Risk

Long-term investors haven't historically been rewarded for taking on currency risk.

Morningstar, 01/18/2017

On the heels of rate hikes in 2015 and 2016, the Federal Reserve has signaled that additional increases are likely. Rising rates could put a dent in U.S. bond returns, at least in the short term. But investors could reduce their U.S. interest-rate exposure by diversifying into international-bond funds. True, yields in most developed markets are low, but it is not prudent to ignore the diversification benefits international bonds can offer, especially if the actions of central banks around the world diverge. Investors who decide to take the plunge must determine whether to hedge their foreign-currency exposure. While the answer will not be the same for everyone, bond investors have historically not been compensated for taking currency risk in the long run, and this risk dramatically increases volatility. However, an investment in an unhedged bond fund allows investors to express a bullish view on the U.S. dollar.

Hedged Versus Unhedged
Whether hedged or unhedged, investors would have earned similar returns from portfolios of international bonds in the long run. In other words, currency movements have not added substantial returns to international bond portfolios over long investment horizons. Any outperformance from appreciating currencies was inevitably followed by underperformance stemming from currency depreciation, erasing prior outperformance in the long haul.

To investigate the effect of currency hedging in international-bond funds, I compared the historical performance of the hedged and unhedged versions of the Citi World Broad Investment-Grade Bond Index, or WorldBIG, and the Citi World Government Bond Index, or WGBI. Exhibit 1 illustrates the annualized five-year rolling returns of hedged and unhedged WorldBIG from January 1999 to December 2016. The dotted lines are the averages of these returns. On average, the unhedged broad index posted a five-year trailing annual return of 6.0%, outpacing its hedged counterpart by 0.4%. This return pattern persists in the global government market. Exhibit 2 shows that the unhedged WGBI has generated an average five-year rolling return of 6.8%, beating the hedged government index by 0.2% from January 1985 through December 2016.

There are many factors affecting the performance of international bonds. One of the biggest is the value of the U.S. dollar. For example, when the dollar depreciated against most major currencies from 2002 to 2007, the unhedged international bonds, represented by Citi WorldBIG Unhedged, outperformed its hedged counterpart (shown in the Falling USD line in Exhibit 1). To illustrate, assume $100 equal EUR 100 today. Now suppose the U.S. dollar loses half of its value against the euro in the following year. So, if an investor purchased widgets worth EUR 100 a year ago, now the widgets are worth twice that, or $200. Similarly, unhedged international bonds were worth more after the U.S. dollar depreciated. The same principle works in reverse when the dollar strengthens. From 2014 to 2016, the U.S. dollar appreciated against several major currencies, and the hedged international bonds, represented by Citi WorldBIG Hedged, outperformed its unhedged peer (shown in the Rising USD line in Exhibit 1). As economic conditions across different markets ebb and flow, currency values fluctuate, but over the long run the impact is largely washed out. 

  - Source: Morningstar Direct. Effective date Dec. 31, 2016.

However, investors would experience significantly more volatility from unhedged international-bond portfolios than hedged portfolios. Exhibit 3 shows USD-hedged and unhedged WorldBIG’s historical volatilities measured by annualized five-year rolling standard deviation from January 1999 to December 2016. On average, the unhedged broad bond portfolio exhibited 50% larger fluctuations than the U.S. dollar-hedged fixed-income index. This risk is more pronounced in the global government market. From January 1985 through December 2016, the unhedged sovereign index’s volatility was twice the hedged WGBI’s, as shown in Exhibit 4. The sovereign bonds tend to have lower credit risk than the corporate bonds, and thus, fluctuations from foreign currencies are more accentuated.

  - Source: Morningstar Direct. Effective date Dec. 31, 2016.

Currency fluctuations contribute more to the total risk of an unhedged bond portfolio than they do for an unhedged stock portfolio because bonds are much less volatile. Exhibit 5 illustrates how much market and currency each have contributed historically to five-year trailing returns and volatilities for both international stocks (measured by the MSCI EAFE Index) and bonds (measured by the WGBI) from 1985 to 2016. The graph shows that currency exposure has greatly contributed to international bonds’ risk without offering meaningful compensation. Currency risk looks more modest relative to international stocks’ volatility in their local currencies.

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