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International Bond Investing: To Hedge or Not to Hedge Currency Risk?

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As with international equities, bonds issued in foreign currencies constitute more than half of the taxable bond market, and adding international bonds to a U.S.-only portfolio provides a diversification benefit that results from exposure to the yield curves and the economic factors of other countries that drive bond returns. With increasing globalization, foreign bonds have become much more accessible than they were a few decades ago. A fixed income investor who decides to diversify internationally faces a choice of whether to take on currency risk or hedge it away. Vanguard Research recently published an article that addresses this question in an elegant manner.

The first thing for any American investor to understand is that if bonds in another country have higher yields than American bonds of equivalent duration and credit quality, it does not mean that buying those bonds will result in a higher rate of return. For example, as of today (8/19/2014 according to Bloomberg), the Australian 10-year Treasury bond has exactly a 1% higher yield-to-maturity than the 10-year U.S. Treasury bond. An American investor who converts her U.S. dollars into Australian dollars buys the bond, holds it to maturity, and then re-converts her Australian dollars back to American dollars does not have an expectation that her total return will have been 1% higher compared to buying the U.S. Treasury bond. The key point is that a major part of her yearly return will derive from the changes in the currency exchange rate between the U.S and Australian dollar, and currency exchange rates tend to be highly volatile in the short-term. Investors who wish to exclude the volatility of currency exchange rates would engage in hedging (or more likely, use a bond fund that hedges). However, hedging merely replaces the return on the foreign currency with the return on the hedge. Either way, our hypothetical American investor in the Australian bond will likely capture a return that is closer to what she would have received with an American bond rather than the 1% higher return ostensibly offered by the Australian bond. Even if she plans on moving to Australia and spending her bond proceeds on boomerangs and vegemite sandwiches, she will likely find that higher inflation in Australia has made her purchasing power roughly the same as if she had bought the American bond.

Currency hedging normally involves the use of forward contracts which are agreements to exchange pre-determined amounts of currency on a given date. For example, if today’s spot price for one Australian dollar is $0.93, then the forward price for one year from now might be around $0.92, reflecting the higher interest rates in Australia which is equivalent to an expectation that Australian dollars will depreciate relative to American dollars. In fact, the price on the forward contract is completely determined by the interest rate differential so that any arbitrage opportunity is eliminated. Naturally, there is a cost to hedging which should be fully considered relative to the benefit received. The authors of the Vanguard article estimate this cost at less than 0.20% per year. To see the benefit in risk reduction, we ran the returns of the Citigroup World Government Bond Index with and without currency hedging:

The fact that the annualized returns were 0.86% lower for the hedged index is explained by the overall depreciation of the US dollar during this time period. For us, the bigger story is that the standard deviation was essentially cut in half, implying that if you are adding international bonds to a portfolio, it makes a great deal of sense to hedge currency risk. This is exactly what was demonstrated in an earlier Vanguard study where the authors showed that adding any amount of unhedged international bonds results in increased risk because the currency volatility overcomes the diversification benefit, while adding hedged international bonds lowers the risk of a diversified portfolio while not adversely affecting its expected return. Another important question answered by this Vanguard study is how much additional foreign currency appreciation (beyond what is already expected by the market) is needed for unhedged bonds to be a viable investment—at least 1.75% per year. Since foreign currency markets trade in extremely large volumes (about 50 times the volume of equities traded on the New York Stock Exchange, according to the Bank for International Settlements), we can safely assume that they are efficient. Thus, the likelihood of an investor identifying an underpriced currency is negligible

The important takeaway from these Vanguard studies, aside from the desirability of incorporating hedged international bonds into a portfolio, is to recognize that bond yields quoted in other countries are largely irrelevant for American investors. If you would like to learn more about how you can benefit from IFA’s approach to global bond investing, please give us a call at 888-643-3133.