Monday, 1 June 2015



It isn't uncommon for investors to diversify their stock holdings abroad. Currency fluctuations can of course make international equities a bit riskier than just investing in domestic companies, but they do not significantly alter the risk profile. In contrast, currency risk can make a portfolio of international bonds significantly more volatile than investing in bonds from only one country. For example, over the past decade, the Barclays Global Aggregate Ex USD Index was more than twice as volatile as the Barclays U.S. Aggregate Bond Index.  Hedging currency risk in bond portfolios however can normally reduce volatility more than it lowers performance, in other words increase risk adjusted performance (in extreme cases with currency collapse such as in Iceland or Russia the opposite might turn out)

Currency risk management in fixed income funds:
Currency risk normally would constitute far more to total volatility for fixed income funds than for equity funds. Normal annual FI income performance for investment grade securities are most often below 5% annually (and even 5% is high is the current international low-interest rate era). Normal currency volatility is often in the range of 10-20% even between major currencies like EUR and USD. Thus normal currency fluctuations will often wipe out normal performance from an unhedged bond portfolio for a USD based investor for example. Hence fixed income funds normally either invest only in domestic currency denominated issues i.e. only in the domicile currency of the fund’s investors, or they hedge the currency risk vs the investors domicile currency.

General findings on currency risk in broad global bond funds:
Currency movements can dominate international-bond funds' performance in the short term. This often makes them more suitable as a bet against the home currency of the investor than as a way to share in the bond returns foreign investors enjoy[1]. Hedging currency risk can solve this problem.

Without currency movements, international bonds have historically exhibited volatility comparable to their domestic counterparts. For example the hedged version of the Barclays Global Aggregate Ex USD Index only exhibited about a third of the volatility of its unhedged counterpart over the past decade. The dramatic reduction in volatility that currency hedging offers may allow investors with exposure to one currency only to invest in currency hedged bond funds more comfortably. This will in general better diversify their interest-rate and credit risk than investing only in domestic bond funds (or global unhedged funds).

To illustrate the benefits of currency hedging for global bond funds, consider the period between  Sept 2009-Sept 2014 where total return was almost equal for the hedged and unhedged part of Barclays Global Aggregate Corporate index, see below.

Chart 1: almost similar total return over the past five years

We see from the above chart that the unhedged performance was more volatile and that the best one-year period for the unhedged part was from Jan 31st 2013-Jan 31st 2014 where NOK depreciated 14% vs the local currency composition in the bond index. This boosted the performance measured in NOK by 14% relative to the unhedged part. The chart below shows rolling 12 month performances and we see that the unhedged index rose 18% versus 4% for the hedged index during the 12 months from end of Jan 2013 end of Jan 2014.

Chart 2: rolling 1 year returns for unhedged and hedged global bonds

But was this enough to account for the increased risk?

In general: no, as the two charts below show.

Chart 3 shows that rolling standard deviation (normal variations) during the past 12 months on a rolling monthly basis. The standard deviation is calculated on actual returns only i.e. is “ex-post” and not based on any modelling.

Chart 4 shows a simple Sharp ratio evolution where for each month the return over the past 12 months is divided by the standard deviation (risk) over the same period. This ratio is a common measure of risk adjusted performance.

Chart 3: On average 2.5x as high standard deviation for unhedged bonds

Chart 4 shows it was only in periods where NOK depreciated significantly vs the currency basket of the global bond index that risk adjusted return for the unhedged portfolio exceeded that of the hedged portfolio.

Chart 4: higher-lower-higher, risk adjusted returns for hedged bonds


In other words: only in periods with tail wind from a weaker NOK boosting returns as measured in NOK (Aug 2013-May 2014) the return in the unhedged portfolio is high enough to justify the corresponding risk.

This is a typical result and similar characteristics can be found for SEK vs local currency, DKK vs local currency and EUR vs local currency.

The numbers behind chart 4 tell that considering all weekly rolling 1 year periods for which we have date for, in 1/3 of the cases unhedged Sharpe was higher than hedged Sharpe, but the average help to an unhedged portfolio from a weakening NOK was as much as 7%.  In 2/3 of all periods an unhedged portfolio underperformed a hedged one in risk adjusted returns.

If the unhedged indexes need such a massive tailwind, they are also unlikely to offer better risk-adjusted performance over most periods in the future.

Currency of bonds versus stocks
It might make more sense however to leave currency risk unhedged for international stocks because currency movements contribute to a smaller portion of their total volatility. To evaluate how changes in the strength of the dollar would affect stocks' risk-adjusted returns, Morningstar compared how the hedged and unhedged versions of the MSCI All Country World, MSCI EAFE, MSCI Germany, and MSCI Japan indexes performed during years when the U.S. dollar strengthened and weakened.

They divided these periods into years where the change in the value of the dollar was small (less than 5%) and large (more than 5%). The following charts show the risk-adjusted returns for the four indexes as a function of the strength of the dollar.

Chart 5: Sharpe ratios for equity indices for strengthening&weakening dollar

- Source: Morningstar Analysts

As expected, as the dollar weakened, the unhedged-currency indexes generally provided greater risk-adjusted returns than their hedged counterparts. As we move to a stronger dollar, on average, the hedged index generally provided better risk-adjusted returns. This suggests that whether hedging currency or not is preferable, is dependent on the development of the currency vs the local currency basket of the stock composite. The returns of the stocks are over time strong enough to over- shadow the currency effects.

In contrast, currency hedging almost always makes sense for bonds. The charts below illustrate the risk-adjusted performance of the hedged and unhedged versions of the Barclays Global Aggregate Ex USD Index, Barclays Global Treasury Index, and JPMorgan GBI Global ex-US Index using the same procedure as described above.

Chart 6: Sharpe ratios for bond indices for strengthening & weakening dollar
- Source: Morningstar Analysts

Unlike the equity indexes, the unhedged-currency index did not provide better risk-adjusted returns even when the dollar was weak. This is because of the large volatility that currency movements introduce relative to bonds' total volatility.

Limitations of hedging currency
Hedging currency can increase costs. For funds denominated in low interest rate currencies such as USD, EUR, JPY, DKK, and GBP swapping such currency exposure towards currencies with higher interest rates will add a significant cost (in terms of interest differences from interest rate parity). Swapping between major low interest rate currencies will most often be relatively cheap either by buying currency swaps, by buying non-deliverable forwards (NDFs) or by borrowing foreign currency from a bank equal to the fund currency exposure rendering net currency exposure zero.

Currency hedging does not remove all currency risk. Expected currency movements are priced into forward currency contracts, which funds use to hedge their exposure. Interest-rate parity predicts that currencies with higher local interest rates will appreciate relative to those with lower interest rates. This increase in the value of the higher-yielding currency should offset its yield advantage. While this relationship does not always hold in practice, the market generally uses this principle to set forward prices.

It may also be difficult for portfolio managers to hedge the right amount. Because forward currency exchange contracts used to hedge currency exposure are generally reset each month, portfolio managers must estimate the value of their portfolios when the forward contracts expire at the end of the month. To do so, they must take into account changes in credit spreads, interest-rate movements, and cash flows into and out of the portfolio. Because it is difficult to estimate these variables perfectly, funds may become over- or under-hedged. However, currency hedging should still remove most of the volatility that currency fluctuations create.

All of the above difficulties by rolling good hedges forward are even more relevant for a fund’s  clients. It is too expensive and difficult/cumbersome for a client to hedge on a sufficiently frequent basis to do this in practice. Also it might be confusing for a potential investor knowing what to expect from a particular fund if its mandate is wide – a currency fund, a government bond fund, an emerging market bond fund or some combination of this.

It would probably have been negative on the attractiveness for our equity funds if active currency bets on top of expected stock bets were affecting performances to a great extent.

Currency bets often over shadow the interest rate bets in effect on performance for fixed income funds. It is too difficult to hedge currency effectively and sufficiently accurate for clients to hedge themselves. Most of the fixed income funds in the world thus either hedge currency exposure or invest in domestic issues only.

The information, views, and opinions expressed in this blog are solely those of the author in person and generally do not reflect the views and opinions of SKAGEN Funds.

[1] Since interest rates are «the prices of a monies», if a currency - for example EUR - weakens, this will give a downward pressure on domestic interest rates (in this example euro interest rates) due to interest parity. Falling interest rates will give rising bond prices. Buying a euro denominated bond is thus a bet against EUR.

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