This stand-alone post is the long form discussion of a topic briefly touched on here. It can be read on its own, however a fuller perspective is possible when read as part of a series which starts here.
FX-hedged bond investments from overseas investors have, as shown in the main post, become an integral part of inflows into U.S. debt markets since 2008, accounting for around $1 tn worth of purchases from Asian liquidity-rich countries (most notably Japan, Taiwan and Korea) and European countries, intermediated through mutual funds.
The phenomenon is not constrained to USD-denominated debt only, although it constitutes by far the largest single currency in such currency-hedged structures, with EUR a distant second.
Estimates of worldwide FX-hedged bond investments (independent of target currency) are hard to come by, but usually exceed $2 tn. The rationale for such investments is usually seen in the search for higher-yielding, but still relatively safe assets.
In relation to the size of these flows, the analytical presentation on which such transactions are based and according to which their profitability is assessed, oftentimes appears superficial. Superficial in the sense that considerations are frequently reduced to easily illustrated rule of thumb shortcuts which at best portray parts of currency-hedged investments accurately and at worst vastly overestimate their return potential.
Most such, usually graphically presented, shortcuts are based on a combination of:
- An assumption that risk-free interest rate differentials alone are reasons enough to invest in FX-hedged “high-yielders.
- A belief that the shape of the yield curve in the target country at trade initiation – where steep is considered positive – is predictive of return potential.
- A notion that once these trades are put on, the prospective return (when held to maturity) is locked in.
As none of these assumptions is fully accurate (at least without a large set of constraints), this post attempts to take a comprehensive look at the mechanics and accounting involved in establishing and evaluating a currency-hedged bond portfolio.
The point of this discussion may at a swift glance not be readily apparent; a brief preview of the consequences should provide some degree of tangibility:
Analyzed in a holistic framework, the rational for existing and possible future currency-hedged bond investments is seriously questioned which
- at the macro level potentially renders one of the largest post-crisis cross-border capital flows as much less profitable, if not outright negatively carrying. The latter option substantially increases the possibility of (at least partial) liquidation of such investments, with considerable upward pressure on bond yields until a new equilibrium is found.
- at the micro level challenges the portfolio composition of the institutional investors allocating clients’ money. Should such investments indeed prove negatively carrying, the clients will absorb losses. These would arguably not be of significant notional scale, but are of significance in that they represent unnecessary opportunity costs which could have been avoided by a different asset allocation.
One final point to settle before commencing with the main body is the level of abstraction at which this problem should be addressed. As with many aspects of financial markets, the underlying concepts involved are quite straightforward if approached incrementally; a nonlinear narrative paired with overdoses of jargon can, however, have the opposite effect. For this reason, the largest portion of the post will be quite detailed; it will put the issue of FX hedging in a broader context and dissect the variables affecting currency-hedged investments individually. This requires some time, so in addition there is also a technical summary for the jargon-savvy reader at the beginning, concisely outlining the main points in ~200 words.
- Why hedge and who hedges
- Hedging instruments: three views (physical vs. FX forwards/swaps vs. cross- currency swaps)
- Dissecting return variables of currency-hedged bond portfolios (in a stylized setting)
- cross-currency basis
- term premia
- libor/swap spread differentials
- credit risk premia
- the real world: the Japanese case
A bond portfolio currency-hedged with short-term FX forwards/swaps is structurally similar to a repo-funded bond portfolio; the only difference is that instead of a repo rate, the funding rate is based on a Libor benchmark, which is nudged up (or down) by the respective cross-currency basis. As with any trade funded at a short-term floating rate and exposed to a fixed-rate instrument on the asset side, the key PnL driver (when held to maturity) is not the differential between the two rates at initiation, but the realized term premium at trade conclusion. Term premia are notoriously hard to forecast; most model estimates for the U.S. during the last number of years however produce negative values, implying losses on currency-hedged investments in the sovereign space. Negative cross-currency bases and disadvantageous Libor–OIS (or rather Libor – T-bill) differentials do their part to further diminish potential returns. Most players are willing to accept some degree of credit risk (usually in the corporate space down to ~A-rated issuers), which acts as a counterbalance, improving potential returns. Still, with credit markets offering limited amounts of spread pickup and issuers already quite levered at this time in the cycle, it appears hard to generate substantial – if any – alpha by this type of investment. Continue reading “FX-hedged yields, misunderstood term premia and $1 tn of negative carry investments”