Roll Down explained
Fixed income managers always want to have the flexibility to find the best value across their investment sphere and therefore need the capacity to buy bonds in different currencies. However, most will not want to take the associated currency risk, as FX fluctuations can quickly overshadow every other investment theme and become the overriding risk in the portfolio. Hedging the currency risk is relatively simple; you buy the foreign currency that you need today to fund the investment, and then sell it forward at a reasonable date in the future, for example 1 month, and at the end of that period, you buy the foreign currency again, and continue to roll forward every month. Obviously, delta hedging every individual security isn’t practical, therefore a portfolio hedge will be employed to cover each of the non-base currencies and this will be adjusted daily to account for any purchases, sales or changes in market values of underlying bonds.
As an example, if your base currency was £ and you wanted to buy a US$ bond, you would sell £ to buy the required $s today, and then sell $ forward 1 month, buying back £ and locking in the forward exchange rate. However, what you need to remember is that the cost to this, known as the forward points, either add or subtract to the amount of £ you get back in 1 month. Why is this? Very simply, the forward points should equalize the 1 month interest rate differential between the two currencies – if you didn’t have the forward point cost when hedging currencies, money would simply flow into the currency where rates are highest at the expense of lower yielding rates.
The forward points are obviously a very important consideration for fixed income managers but are often ignored (sometimes conveniently) when observers are lauding the benefits of one regime over the other. For example, we often hear that US HY, yielding 6.25% is much better value than European HY, only yielding 2.85% (based on ICE BofAML HY indices). But how much of this is due to forward points? Up until recently, investors would lose approximately 120bps of yield going from a $ bond to a £ bond, and another 120bps going from £ to €. As discussed earlier, this is a consequence of $ 1 month rates being higher than £ 1 month rates and the latter being higher than € 1 month rates. So a $ investor would actually be getting 5.25% from the Euro index – the hedging cost narrows the gap considerable. This doesn’t explain the whole gap in the indices I mentioned, there are other variables to consider as well, for example, the $ index is rated B+, with a 6.2yr maturity, while the € index is BB- rated, with a 5yr maturity, but the main point is that the yield differentials are not as big as the headlines suggest.
As mentioned, the gap from $ to £ and from £ to € was recently 120bps for each leg, but with the Fed on a very well signposted rate hiking cycle, and the ECB still engaged in QE, with a rate rise not on the cards for 2018, and not until late 2019, this gap is only going to get bigger and certainly needs to be accounted for over the life of the bond. If you’re a $ investor, you are being well rewarded for looking at £ and Euros, while investors in the UK and Europe need to carefully evaluate how much they are actually going to get paid for holding $ assets – the headline yields are attractive but could be eroded further as the forward point cost increase over the life of the bond.
So there’s plenty to think about when looking at non-base currency assets, and there’s another consideration as well; the “Turn” is a phenomenon that normally occurs at the end of the year, when dollar shortages can exacerbate the forward points and cause a much bigger yield gain, or loss, as you roll your hedges over the year-end period. For example, at the end of 2017, the peak cost of hedging $ to £ using 1 month forwards was approximately 310bps – it’s just one roll, but it’s too big to ignore and it happens every year. In addition to year-end, this can also happen at quarter-end but the impact is usually much smaller, however, for various reasons (with the increase in Treasury issuance probably having a big impact), the cost for rolling over the end of Q1 has spiked to 220bps for $/£, and continues to increase. Another interesting consideration is the shape of the curve. For example when you buy a 7 year $ bond and you do the FX hedging using monthly forwards, the flatter the curve the more yield you “spend” in the FX hedging. Steeper curves mean that the cost of your FX hedge is lower as proportion of the yield of the bond you are hedging.
When you start to factor in the cost of the turns and the future rate hikes, you can quickly begin to see the attractiveness of € assets for $ investors, and with US rate hikes also likely to run ahead of BoE hikes, £ assets are also attractively priced. It will be interesting to see how far the forward points revert back to a lower level after the quarter-end, but with the Fed expected to hike rates again this week, $ yields are likely to be progressively less attractive.