Currency Hedging Makes International Bonds Easier To Own

Includes: BNDX
by: Morningstar

By Thomas Boccellari

It isn't uncommon for investors to diversify their stock holdings abroad. Sure, currency fluctuations can make international equities a bit riskier than their domestic counterparts, but they do not significantly alter the risk profile. In contrast, currency risk can make international bonds significantly more volatile than U.S. bonds. 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. Currency movements can dominate international-bond funds' performance in the short term. This often makes them more suitable as a bet against the U.S. dollar than as a way to share in the bond returns foreign investors enjoy. Hedging currency risk can solve this problem.

Without currency movements, international bonds have historically exhibited volatility comparable to their domestic counterparts. 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 conservative investors to invest abroad more comfortably and better diversify their interest-rate and credit risk.

To illustrate the benefits of currency hedging for bond funds, consider the period between January 28, 2002, and March 18, 2008, when the dollar experienced a 40% decline. During this period, the returns of the unhedged-currency indexes were more than twice those of their hedged-currency counterparts. However, the unhedged-currency indexes experienced much greater volatility, which translated into less-attractive risk-adjusted performance.

If the unhedged indexes didn't offer better risk-adjusted performance when the depreciation of the dollar offered such a massive tailwind, they are unlikely to offer better risk-adjusted performance over most periods.

Currency Hedging: Bonds Versus Stocks
However, it might make more sense 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, I 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. I further 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 charts below show the risk-adjusted returns for the four indexes as a function of the strength of the 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.

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 described above.

- 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. However, most bond index fund holdings are denominated in the largest, most-liquid currencies like the British pound, Japanese yen, and euro, which are relatively cheap to hedge.

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 depreciate relative to those with lower interest rates. This decline 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 underhedged. However, currency hedging should still remove most of the volatility that currency fluctuations create.

Investment Options
Currently, the only currency-hedged ETF is Vanguard Total International Bond Index (NASDAQ:BNDX). Based on the Barclays Global Aggregate ex-USD Float Adjusted RIC Capped (USD Hedged) Index, this fund offers a mix of international treasury and corporate bonds for a low fee of 0.20%.

PIMCO Foreign Bond (U.S. Dollar Hedged) (PFORX), which has a Morningstar Analyst Rating of Silver, offers actively managed currency-hedged exposure to foreign government bonds. It charges a 0.50% expense ratio.

Key Takeaways

  • International-bond funds are a great way to diversify a bond portfolio, but investors need to manage currency risk appropriately.
  • Currency movements often account for most of foreign bond portfolios' volatility.
  • While hedging currency does not completely eliminate currency risk, it gives investors purer exposure to the underlying bonds in the fund.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.