With the Federal Reserve hiking and US rates on the rise, there’s never been a better time to reposition into global bonds as your core mandate. But when you do, it’s crucial to fully hedge against currency risk.
Here’s why. Bonds have two main sources of return: income (the return from coupon payments) and change in price (the return from capital appreciation). Most of a bond’s return comes from its income, which is stable. A smaller contribution comes from the change in its price. The contribution from change in price is small since, unlike equities, bonds have limited upside; eventually, all bonds mature at par.
Global bonds provide a third source of potential return: currency exposure. Many investors choose not to hedge away the impact of currency fluctuations in the hope that currency exposure will boost returns over the long run. They also assume that multiple sources of return—income, price and currency—will reduce their overall risk. Some simply assume that currency hedging is expensive.
It turns out that none of these assumptions is correct.
Hedging Is Cheap and Easy
To begin with, currency hedging can be implemented cheaply and effectively with currency forwards and futures. In fact, the currency forward markets are among the most liquid markets in the world, making transaction costs very small—on the order of one to two basis points to initiate a hedge from a developed-market currency into US dollars, then an eighth to a quarter of a basis point to roll it forward as needed.
Hedged Global Has Outperformed Unhedged…
Furthermore, over long periods, hedged portfolios have beaten unhedged in terms of historical returns. Over the 20 years ending October 31, 2017, a US dollar–hedged global bond portfolio, represented by the Bloomberg Barclays Global Aggregate Bond Index, generated an annualized return of 5.0%, versus 4.5% for its unhedged counterpart.