The goal of income investing is to ensure that your portfolio generates a steady source of revenue regardless of market conditions.
Hedging currency or foreign exchange (FX) risk is a key decision for any manager running a diversified fixed income portfolio. Currencies are inherently volatile, so whether and how FX risk is managed can have a material impact on a portfolio’s risk and return profile.
Most, though not all, traditional long-only asset managers choose to hedge this risk away, so it is worth understanding the mechanics of hedging as well as its potential impact on portfolio performance and yields.
In a long-only, global fixed income portfolio, investors generally expect the majority of their returns to come from income (collecting the yield on the bonds held) and hopefully some capital gain (the bonds held rising in value).
Such a portfolio would typically hold some combination of credit assets, with varying levels of duration and credit risk, along with some exposure to government bonds. In building this asset allocation, the portfolio manager would typically apply a “top-down” macro view (monetary policy, inflation, growth etc.) alongside “bottom-up” views on specific sectors and companies to allow for stock-picking bonds that they think will provide an attractive level of income for the risk being taken.
In most cases, introducing FX risk to this portfolio would make it more volatile than a hedged portfolio with identical holdings. Even if the correlation between the unhedged portfolio and the FX rate is not 1, and therefore there is a diversification benefit, the standalone volatility of the FX rate is usually higher than that of a fixed income portfolio, thereby negating the diversification effect.
Put simply, you might have nailed your macro investment thesis and your credit analysis only for one unfriendly currency move to wipe out a substantial portion of your total return. It goes without saying that there will be points in time when the unhedged FX exposure will have a positive impact on returns, but FX rates are notoriously unpredictable (see Exhibit 1) and generally speaking this isn’t the kind of risk investors would expect to be exposed to in a long-only fixed income portfolio.
Of course, it is possible to avoid the FX risk by only investing in bonds denominated in the portfolio’s base currency, but that can be sub-optimal. As an example, in the aftermath of Brexit, the sterling denominated bonds of many issuers traded at considerably higher yields than equivalent euro and dollar denominated bonds from the same issuer, an opportunity many European fund managers were unable to take advantage of since they couldn’t hedge the sterling exposure and didn’t want to hold the currency.
There is more than one way in which FX risk can be removed from a fixed income portfolio, but the most common approach is periodic FX forwards that get rolled at expiry date.
As an example, let’s assume that today a US-based investor buys 100,000 notional value of a five-year euro bond with a euro yield of 6% at par for €100,000. In order to settle the purchase and hedge the position for a month, the investor would buy €100,000 at the spot EUR/USD rate (1.05 at time of writing) in exchange for $105,000, and at the same time agree to sell €100,000 in one month’s time at the forward EUR/USD rate (1.0514 at time of writing).
Assuming the investor wants to continue holding the five-year euro bond on a hedged basis, they would roll the forward contract into a new one at its expiry date. The investor must buy €100,000 to settle the existing forward and sell €100,000 forward again for one month.
With the forward EUR/USD rate from a month ago being 1.0514, the dollar cash amount required to settle €100,000 from the previous hedge is $105,140. However, let’s imagine the spot EUR/USD rate has moved in the last month from 1.05 to 1.10. The investor now needs $110,000 to settle the €100,000 forward entered into a month ago. This apparent “loss” of $4,860 is covered by the fact that the five-year euro bond, which was worth $105,000 a month ago, is now worth $110,000. At the same time, the investor would enter into another forward contract to hedge the €100,000 bond for another month; if not much has changed in forward EUR and USD rates, then the one-month EUR/USD forward rate should now be close to 1.1014.
As an example, let’s assume that the day after the investor buys and hedges their five-year euro bond, the euro depreciates by 10% against the dollar, which sees the EUR/USD spot rate move from 1.05 to 0.945. Let’s also assume that the price of the bond remains unchanged.
The effect on the dollar denominated portfolio of the US-based investor is two-fold. First, the bond is still worth €100,000 (since its price hasn’t changed), but its dollar value declines by 10% from $105,000 to $94,500. Second, the FX forward contract stipulates that the investor will sell €100,000 at a price of $1.0514 in one month. But if the investor was to enter this contract after the FX move then the rate would not be 1.0514, it’d be very close to 10% lower than that at 0.9462. Having a contract that allows the investor to sell €100,000 at 1.0514, when the market price for that same contract is now 0.9462, has a positive mark-to-market value on the portfolio, which is equal to the €100,000 notional times the difference in the FX rates. This is the same amount that the euro denominated bond lost as a result of the euro depreciation. Therefore, the effect on the portfolio is zero.
The forward contract in this example is hedging a euro position back to dollars. This means the investor is selling (i.e. shorting) euros against buying dollars. Intuitively, and given that there is a cost of money, shorting an asset that has a low yield and going long an asset that has a high yield should be a trade that has positive carry.
Here's what happens in our hypothetical example. The one-month euro rate in money market funds is approximately 2.61% at time of writing, whereas the same rate in dollars is 4.30%. In consequence, if this interest rate differential does not change for the next twelve months and the investor keeps on rolling the forward contract, then the yield of the forward position for the year will be 1.69%, the difference between the two rates. The dollar yield of the bond will therefore be 6% + 1.69%, so 7.69%. The way in which this is realised in the portfolio is that every month the investor buys €100,000 to settle the forward and at the same time sells €100,000 forward at a slightly higher price.
In the first month of our example above, the spot dollar amount was $105,000 while the one-month forward was $105,140. If we take that $140 difference and multiply it by 12 months, we get $1,680. This amount as a percentage of the $105,000 initially invested equals 1.6%, which is practically the same as the difference in the money market rates mentioned in the previous point.
Currencies are notoriously unpredictable, and a truly global and diversified fixed income portfolio would be exposed to the ebb and flow of multiple exchange rates over any meaningful investment period.
For most long-only, income-oriented fixed income managers and their investors, FX risk is often an unwelcome source of potential volatility. Hedging removes the impact of currency volatility in a portfolio’s non-base currency holdings so that the main contributor to total return is the performance of its underlying securities.
Important Information
The views expressed represent the opinions of TwentyFour as at 28 February 2025, they may change, and may also not be shared by other members of the Vontobel Group (collectively “Vontobel”). The analysis is based on publicly available information as of the date above and is for informational purposes only and should not be construed as legal, accounting, tax, investment, financial or other such advice or as a personal recommendation.
Any projections, forecasts or estimates contained herein are based on a variety of estimates and assumptions. Market expectations and forward-looking statements are opinion, they are not guaranteed and are subject to change. There can be no assurance that estimates or assumptions regarding future financial performance of countries, currencies, markets and/or investments will prove accurate, and actual results may differ materially. The inclusion of projections or forecasts should not be regarded as an indication that Vontobel considers the projections or forecasts to be reliable predictors of future events, and they should not be relied upon as such. We reserve the right to make changes and corrections to the information and opinions expressed herein at any time, without notice.
Past performance is not a guarantee of future results. Investing involves risk, including possible loss of principal. The value and income received are not guaranteed and one may get back less than originally invested. Derivatives entail risks relating to liquidity, leverage, and credit that may reduce returns and increase volatility. Neither asset allocation nor diversification assure a profit or protect against loss in declining markets.
The goal of income investing is to ensure that your portfolio generates a steady source of revenue regardless of market conditions.
Fixed income managers always want to have the flexibility to look for the best value across their investment universe, and in our view they therefore need the capacity to buy bonds in different currencies.
