Do You Want Currency Risk in Your Bond Fund?

A version of this article originally appeared in the March 2017 edition of Morningstar FundInvestor.

The past few years have been tough for bond funds with sizable non-U.S. dollar currency exposures. Relative to other developed-markets currencies, the U.S. dollar has mostly been on a winning streak since 2012. And although many emerging-markets currencies bounced back versus the greenback in 2016, that resurgence hasn’t made up for the precipitous depreciation many experienced during the commodity sell-off of 2014 and 2015. For the five years ended Jan. 31, 2017, the unhedged Bloomberg Barclays Global Aggregate Bond Index--which has sizable exposures to the euro and Japanese yen, along with a smattering of other currencies--delivered a paltry annualized gain of just 0.1%, much less than the 3.3% produced by the index’s U.S. dollar-hedged version.

There are several reasons to think the U.S. dollar will remain strong relative to other developed-markets currencies for the time being, including diverging monetary policy between a rate-hiking U.S. Federal Reserve and still-dovish central banks in other developed markets. But betting that the recent dominance of the U.S. dollar relative to other currencies will continue isn’t the best reason for a U.S. bond-fund investor to hedge out her currency risk. Indeed, there have been prolonged periods where unhedged global-bond exposure has resulted in higher returns. That was the case from 2003 through 2008, when the unhedged Global Aggregate Index delivered an annualized gain of 6.2%, beating the hedged version of the index by 175 basis points per year, on average.

Rather, the main reason for a U.S. investor to avoid foreign-currency exposure is because currency fluctuations tend to be much more volatile than bond price swings. In 2016, for instance, U.K. gilts were the strongest-performing country in the Global Aggregate Index purely from a rates perspective, returning 10.7% thanks to a midyear rally after U.K. citizens voted to leave the European Union. But the British pound’s 16.2% depreciation against the U.S. dollar overwhelmed gains from falling bond yields, and the country was the worst performer in the unhedged index with a 7.2% loss for the year. During longer trailing periods, the standard deviation of returns on the unhedged Global Aggregate Index has historically been roughly twice as high as the unhedged version’s, and it has experienced larger drawdowns. Emerging-markets currencies have been even more volatile and have tended to be highly correlated with equities. That’s an unappealing profile for investors who rely on their bond exposure to hold up when equities and other economically sensitive assets are flagging.

Nevertheless, some skilled world-bond portfolio managers have used active currency bets effectively through the years, not only as an added return source but as a risk-management tool. In 2008, for instance,  Templeton Global Bond’s (TPINX) manager Michael Hasenstab built a sizable exposure to the Japanese yen (30%) and Swiss franc (13%) while hedging the fund’s exposure to certain emerging-markets currencies, a move that helped the fund deliver a 6.3% gain despite underlying exposure to emerging-markets debt in what proved to be a punishing climate for risk-taking. Over the long term, the fund’s currency positioning has produced an above-average level of volatility while also rewarding its investors with category-topping returns.

Even some in the comparatively cautious intermediate-term bond Morningstar Category have made good use of modest helpings of foreign-currency exposure (typically in the single digits). For instance,  Loomis Sayles Core Plus Bond (NEFRX), which has often taken more corporate credit risk than its peers, wouldn’t have avoided losses in 2008 if its management team hadn’t held as much as 9% in unhedged Japanese yen denominated bonds. Although currency bets have worked against the Loomis Sayles fund at times, most noticeably in 2015, this and other bold intermediate-bond funds run by firms like BlackRock, PIMCO, and Western Asset have incorporated small active currency bets to reasonably good effect over time.

Still, given the volatile nature of currencies, even a small helping in an otherwise conservative portfolio can derail a fund, particularly in categories where fractions of a percentage point separate the best- and worst-performing funds. That was the case for the conservative  T. Rowe Price Short-Term Bond (PRWBX) in 2014: Just a few percentage points of exposure to the Mexican peso and the Chinese renminbi, while hardly disastrous, caused the fund to lag its typical peer. The team has avoided non-dollar exposure since eliminating the peso in the spring of 2015.

Predicting currency moves is a complex enterprise that’s notoriously hard to pull off consistently. For bond investors who prize safety and capital preservation above all else, it’s best to steer clear of currency exposure altogether. While there are firms that have used currency bets effectively, such exposure courts additional risk and the potential for added volatility. There are other exceptional intermediate-bond funds--such as  Baird Core Plus Bond (BCOSX),  Fidelity Total Bond (FTBFX), and  Metropolitan West Total Return Bond (MWTRX)--that have generated successful track records without dipping into the currency till.