Since late March, the dollar has undergone a reversal in popularity among global investors. The DXY index of broad dollar strength against major developed economy currencies is down nearly 10% from its recent peak during the height of the Covid-19 induced global market rout.
A question worth considering is how this impacts a dollar-based global fixed-income manager?
This is particularly relevant since this weakening is coupled with a very constrained opportunity set for stable, positive real yields, which is encouraging managers to explore foreign fixed income alternatives. Foreign bonds and credit expose investors to generic fixed income risk factors – interest rate fluctuations, inflation and economic cycles, and issues associated with changing or unstable political regimes – that are relatively uncorrelated to the same factors in their domestic bond market.
Hence, a portfolio diversification benefit has generally resulted. Importantly, investors are also exposed to foreign currency movements, which have an important role in determining the risk and return of foreign assets.
There are a variety of approaches to currency management, ranging from trying to avoid all currency uncertainty in a portfolio, to actively seeking foreign exchange risk in order to manage it and enhance portfolio returns.
Clearly, there are assets for which the asset volatility is likely to outweigh currency volatility, such as single volatile stocks, or, at an extreme, low-delta out-of-the money options. For these, the currency risk becomes a secondary concern, and hedging is usually not done at all.
The general situation for fixed income assets is different. The historical volatility of regional currency has been significantly higher than that of each local fixed income market. For example, the Japanese yen has been almost six times more volatile than the Japanese fixed income market in local terms.
Unless managers are purchasing ultra-long dated bonds or issues of very low credit quality, currency volatility tends to dominate overall volatility of return for foreign fixed income assets. This usually sways fixed income managers (and particularly those with a low-duration, capital preservation mandate) to hedge the currency side, and only focus on the asset side – where their actual expertise is located.
Would a global income investor hedge the dollar?
At the risk of over-simplifying, some broader reasons to hedge foreign currency exposure are the views that the foreign (target) currency will weaken relative to the local (home) currency, or alternatively, that there may be an opportunity to exploit forward currency pricing to one’s advantage.
Academic research has estimated that the transaction cost to hedge a foreign bond portfolio is less than 0.2% a year for investors hedging back to a liquid, developed-market currency.
Currency hedging often involves the use of forward contracts, in which two parties agree to exchange a set amount of one currency for another at a predetermined exchange rate at some future date, typically one week, one month or three months ahead. These contracts allow investors to trade the risk that a currency will move in the future, effectively ‘locking in’ a set exchange rate today and eliminating the volatility of currency movement from their portfolio.
The key driver of the agreed forward exchange rate (F) relative to the spot exchange rate (S) will be the difference in the prevailing short-term interest rates. This relationship is known as covered interest rate parity (CIP) and is a textbook no-arbitrage condition, according to which interest rates on two otherwise identical assets in two different currencies should be equal once the foreign currency risk is hedged.
If the foreign market has a higher short-term interest rate than the domestic market, the forward price of the foreign market’s currency will be weaker than its spot price, reflecting a depreciation to offset the higher interest rate earned in that market. For foreign markets with a lower interest rate than the domestic market, the opposite will be true.
By locking in a set forward rate, investors are also locking in a set return from hedging activity: No matter which direction a currency moves over the course of the hedge, the investor will receive (or pay) the difference between the purchased forward exchange rate and the spot exchange rate at the time the hedge was initiated.
Technically, matters are not quite as simple as this. Forward prices are not just a function of interest rate differentials. In practice, the relationship between F and S is read off market transactions in currency instruments, notably cross-currency swaps. These would contain what is known as the “currency basis” which reflects practical, real world strains in currency funding markets.
Since hedging is typically implemented over shorter time horizons, the relevant interest rates for hedging are short-term interest rates. Across most developed markets, short-term interest rates are targeted by central banks with the aim of managing inflation and economic output. As these rates shift across markets over time, the impact of the hedge return will also shift, and both positive and negative contributions to an investor’s return are possible.
The current example
Based on the theoretical considerations detailed above, the current situation for a USD based fixed income manager is an interesting one.
The US (still) offers higher short-term interest rates than sovereigns in the Eurozone. Based on covered interest rate parity (and taking into account the cross-currency basis) this means that relative to the euro, the USD would be trading at a forward discount i.e. would be priced weaker in the forward market to offset the starting yield advantage it has in short-term interest rate markets.
For a US investor, the question of whether to hedge one’s euro exposure back into dollars would therefore depend on the view as to whether the dollar is likely to weaken (and euro strengthen) by a quantum greater or less than what is priced into the forward market. When the forward discount of the dollar is reasonably sizeable, as it was prior to Covid-19, it means that nominally negative yielding eurozone bonds could potentially offer positive yields when hedged back into dollars – a very under-appreciated fact.
For instance, at the time of writing, the dollar was trading at an implied forward yield of around 0.6% against the euro for the next 12 months, i.e. the forward price of the dollar would be 0.6% weaker against the euro in a year’s time relative to spot exchange rates.
For the US investor considering a euro-based asset, they would likely only hedge their euro currency exposure if they believed the USD would weaken by less than this quantum of 0.6% over the next year. Conversely, if they thought the USD would weaken by say 1% (or more) relative to the euro over the year, they may choose the leave their euro exposure un-hedged and reap the currency translation benefit in a year’s time.
This article was written by Reza Ismail, a portfolio manager at Prescient Investment Management.