Fixed Rate Currency Hedging
4 April 2017 by Mark Holman
Over the last 12 months the costs and gains of currency hedging have changed quite dramatically. The ECB has continued to ease, the Bank of England had a “pre-emptive “ cut in July, but the Federal Reserve has now managed to hike 3 times by 25 basis points.
When we look at bonds from a particular borrower we always look at relative value across all major currencies, but a 5% yield in $ is not the same as a 5% yield in either £ or € once currency hedging is taken into consideration.
When hedging, one of the questions is always, “how long should I hedge for?”. There is no right or wrong answer to this question as long as the hedge is in place, covers the precise amount and is rolled periodically. At TwentyFour we typically roll our hedges monthly but add and subtract to them as new bonds enter or leave portfolios. However, a forward looking component to the price of hedging does also affect our relative value decisions.
So let’s look at an example of current monthly hedging costs, and let’s assume that the fund base currency is £.
To give an equivalent hedged back yield to a sample 3 year £ bond with a yield of 3%, a 3 year $ bond needs a yield of 4.06%, while if the bond was € denominated it only requires 2.08%.
The difference in yields is reflected in the ”forward points” which are added or subtracted to the FX hedge which then create a natural gain or loss to compensate investors for investing in a different currency. As you can see from the example, a $ investor would gain almost 2% on their currency hedges when buying bonds in €, which is the largest that this has been since rates were plunged to zero.
This rate is also likely to widen as the Fed embarks on further likely hikes this year, while the ECB stands still. Consequently making $ bonds marginally less attractive relative to both £ and €.
Transposing this on to high yield indices where there have been some big moves in spread over the last year, and again assuming one month’s hedging, the following results would be currency neutral.
|Currency||Unhedged Yield to Worst||Hedged (back to £) Yield|
The US does have the highest yield currently, but with further rate hikes and a higher default rate, this relative value quickly disappears now.
In € the yields are lowest, but the index is potentially the best quality, however there is Draghi tapering risk.
£ has Brexit risk, but one can argue that this is now well reflected in the yield on a currency adjusted basis, especially as the default experience is going to remain low for the time being.
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