A basic rule of thumb is that if you want to reduce risk,
you should hedge. And if you want return beyond the yield and
capital appreciation of your bonds, you may want to leave your
currency exposure unhedged at times. For a dollar investor, of
course, that would mean when the dollar is weakening.
Over the past two years, the dollar has shown volatility,
with the U.S. dollar index soaring from July 2014 to March
2015, then bouncing up and down and declining so far this year.
All that movement brings into relief the issue of hedging the
currency exposure of an international or global bond
Currency tends to be the most important variable in
international bonds, says Robert Tipp, head of global
bonds and foreign exchange for Prudential Investments in
Newark, New Jersey. The volatility of currencies is
typically higher than the volatility of bonds.
Indeed, currencies accounted for about half of the
volatility of the
Barclays global aggregate bond index from 2011 to 2015,
according to data from Goldman Sachs Group. That index,
unhedged, had an annualized volatility of 4.7 percent during
that period, but the hedged version of that index had
volatility of only 2.3 percent.
Over long periods of time, hedged portfolios and unhedged
portfolios have similar performances, as the dollars
moves largely balance out. But volatility is higher in unhedged
portfolios. Over time, the dollar is perhaps the largest
mean-reverting asset in the world, says
Douglas Peebles, chief investment officer and head of fixed
income at AllianceBernstein in New York. You get a lot of
volatility but no extra return by investing in foreign
exchange. He points out that the dollar index, at its
current level of 95.11, is not far off from its 97.1 average
since the indexs 1973 inception.
Fund managers may easily be able to stomach the volatility
of an unhedged currency exposure. Their customers, maybe not so
much. Over the long term for multicurrency funds, hedging
would have little effect on returns, but it can have a lot of
influence on clients experience, says Simon Arrata,
CEO of Harvest USA, the U.S. division of $101 billion
Beijing-based asset management firm Harvest. Having
currencies bounce around worries them. Hedging might thus
be necessary to placate customers.
Fund managers say they view currencies as assets in their
portfolios that are distinct from the bonds. We look at
the credit component, the interest rate component and the
currency component separately, Tipp says. If the currency
risk gets hedged away using forwards, which reflect interest
rate differentials, whats left is the slope of the yield
curve for your income, he continues.
Options offer another way to hedge currency exposure. When
spot currency prices move away from forward prices, however,
options can be more difficult to use than forwards. This aspect
arises because the options position then needs to be adjusted
in what is known as delta hedging, points out Michael Goosay,
senior portfolio manager at Goldman Sachs Asset Management in
Currency movements also give fund managers a chance to
deploy whats called dynamic hedging: increasing or
decreasing their hedges to match short-term currency moves.
Opportunity abounds there, of course, as currencies frequently
fluctuate. If you can capture a big trend, you can make a
lot of money, ABs Peebles says. But this isnt
an easy game.
Arrata and his Harvest colleagues have had success with
intermittent hedging in Harvest Funds Intermediate Bond, the
firms Chinese bond mutual fund. Their hedging of the
funds yuan exposure helped prevent losses for the fund
when Chinas government devalued the currency last year,
and their lack of hedging over the past three months enabled
the fund to benefit from the yuans strength. Our
hedging is designed for risk mitigation first, and might be
additive to returns second, he says. We dont
always need to use it.
So what should U.S. bond fund managers do about their
currency exposure now? The dollar may well be headed lower,
money managers say. This period is the first time in many
years the Fed has focused on the dollar, says
Rick Rieder, chief investment officer of global fixed
income at BlackRock in New York. Thats why we think
exposure out of the dollar is important.
BlackRock recently bought Mexican bonds in its Strategic
Global Bond Fund. We think Mexicos currency and
debt are attractive, so we would leave 25 to 50 percent of the
exposure unhedged, Rieder says. Mexicos ten-year
government bond yields 5.9 percent, compared with 1.89 percent
for ten-year U.S. Treasuries.
So at least for the time being, an unhedged portfolio
may outperform a hedged one, Prudentials Tipp
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