Managing the cost of currency hedging for fixed income investors

While some investors may choose to invest in unhedged US bond portfolios, some amount of currency hedging is essential for many large institutions. Consider insurance and pension plans, where stable income payouts to policyholders are a requirement. At times of global monetary policy divergence and elevated FX volatility, unhedged currency risks can have a significant impact on portfolio income and growth. However, as global interest rate differentials grow and FX volatility spikes, so can the cost of currency hedging. For example, at current prices, euro area investors switching from German Bunds to US Treasuries will likely receive zero to negative yield premiums after fully hedging the US dollar exposure back to their home currency.² The same is true for UK Gilts. For Japanese investors, the negative yield premium outcome after FX hedging is even greater.

Exhibit 1 illustrates variations in the hedging cost of a US dollar- denominated portfolio, fully hedged to the euro over a period of one year, using standard FX forward contracts. Over the past decade, these costs amounted to an average performance drag of 1.8% a year. Currently, hedging costs for one year onwards are about 2.3% and may rise further.

Exhibit 2 demonstrates the hedging costs of a US dollar-denominated portfolio fully hedged to the Japanese yen. Here we see an average cost of 2.6% over 10 years. Even after a recent pick-up in yields on Japanese government bonds, hedging costs for one year onwards are around 3.6%.

Because of the cost of currency hedging, many institutional investors choose to hedge only part of their FX exposure. The amount of FX exposure that is hedged – the hedge ratio – can have a significant impact on returns, so for large institutions, it makes sense to manage it carefully in response to market events.

Average hedging ratios can vary significantly over time. For instance, the Bank of Japan reported a decline in hedge ratios among major Japanese life insurers from about 60% in 2021 to 40% in 2023³. (The recent US dollar sell-off may have seen those hedge ratios rise.)

It is not always easy to achieve the optimal hedge ratio, however, especially if investors are using only standard hedging practices involving static hedging with FX forward contracts. The main objective of our risklab-powered FX Overlay (FXO) strategy is to help investors solve this problem, by striking an optimal balance between risk reduction and cost savings. We do this using a dynamic currency hedging approach.

The combination of carefully chosen collar strategies is crucial for our hedging approach. In simplified terms, a collar strategy works by paying an upfront premium to “buy” or go “long” a put option that protects against a weakening foreign currency. We have the right not to exercise this option and simply reap the gains in the event of a stronger foreign currency if we wish.

At the same time, we “sell” or go “short” a call option on the same currency pair, usually with the same expiration date and suitable strike price. A call option has the same mechanical features of a put option but offers the right to buy rather than sell a foreign currency. As sellers of a call option, we could lose money if the foreign currency appreciates above the strike price, but we would still be able to participate in the appreciation up to that strike price.

Collar strategies are effective because, as sellers of a call option, we receive an upfront premium which we carefully choose to most efficiently offset the cost of buying a put option. This is possible because the currency derivatives market generally offers similar (or even higher) premiums for call options than comparable put options. This approach can therefore provide more cost-efficient currency hedging over the long run than a standalone FX forward strategy – as long as the interest-rate differential is positive in favour of the hedged currency.

The way we implement this collar strategy is dynamic in that we calibrate the hedge ratio depending on changing levels of volatility and hedging costs associated with the currency pair. The collar provides a range in which the FX exposure is allowed to move freely until a certain loss (“floor”) or gain (“cap”) is reached. A combination of collar profiles with different strike prices and expiration dates can help to reduce hedging costs and improve volatility-adjusted returns.

An example based on US investment grade corporate bonds will illustrate the benefits of this strategy. Our backtest analysis over the past 15 years is based on a widely used US investment grade credit market index and compares the performance of the risklab FXO strategy versus a 100% hedge strategy using only FX forwards (see Exhibit 3). It shows a similar FX risk reduction from both approaches when hedging the US dollar to the euro. However, as the cost of our FXO strategy is significantly lower than the cost of the 100% FX forward hedge, the FXO strategy achieves a superior risk-adjusted return.

We would expect our FXO strategy to reduce hedging costs by about 50% to 60% over a three to five-year period. Over the period analysed in this chart, our FXO strategy even succeeded in fully recouping the associated hedging costs. Exhibit 4 shows similar results for the US dollar versus the Japanese yen.

Asset managers typically offer hedged share classes in various base currencies for their mutual fund strategies. However, these hedged share classes are generally constructed to be fully hedged and managed in an outsourced fashion by custodians, with little to no active input from portfolio managers. This approach presents mutual fund investors with a binary choice – fully hedged or fully unhedged – meaning they are denied the benefits of a more active approach using a managed hedge ratio.

Our risklab-powered FXO strategy solves this problem. We believe it offers a convenient way for investors to invest in US assets while controlling for US dollar volatility in a cost- effective way.