For euro-based investors wishing to hedge U.S. dollar assets, the return drag from hedging has risen from 0% at the beginning of 2014 to over 2.5% today.
As Figure 1 shows, this has been driven by both diverging short-term interest rates in the U.S. and the eurozone, and a persistently negative currency (FX) basis. The former reflects the different stages in the monetary policy cycles of the European Central Bank and the Federal Reserve, while the latter has been primarily the result of strong net demand for U.S. dollar funding, globally.
Although investors have faced similar hedging costs in the past, an important difference is the starting level of yields: 2.5% hedging drag when 10-year U.S. Treasuries yield less than 3% is far harder to cope with than when they yielded more than 4%, which was the case in previous periods of high hedging costs.
Does this mean investors should stop hedging currency risk in their bond portfolios?
We don’t think so. To understand why, it is important to consider the impact of hedging on risk as well as return. Comparing unhedged and hedged U.S. Treasury investments since the launch of the euro (shown in Figure 2) highlights two key points:
- Leaving high-quality bond allocations unhedged materially increases risk relative to a currency hedged investment. Although a euro-based investor would have improved cumulative returns by not hedging currency exposure, the much higher volatility – driven by currency risk – would have halved risk-adjusted returns, as represented by the Sharpe ratio.
- Although saving over 2.5% per year in hedging costs may sound appealing, these savings can be easily wiped out by currency volatility. Looking at the long run, the U.S. dollar has depreciated more than 2.5% versus the euro almost half of the time, on a one-year rolling basis. This risk has been even more evident in the last 12 months, when the U.S. dollar lost more than 13% of its value1.
The above example refers to the most common high-quality asset (i.e. U.S. Treasuries) but whether or not to hedge currency risk will ultimately depend on many factors, including the volatility and the credit risk of the asset being hedged, whether the decision is made at the asset class or portfolio level, and the specific objectives of the investor. However this highlights that a focus on hedging cost alone could lead to sub-optimal investment outcomes.
For further details, including analysis of higher volatility bonds and partial hedging, read “The FX Dilemma: An Introduction to Hedging Currency Risk in Bond Portfolios”.