Many European institutional investors broaden their investment choices beyond their own domestic markets into other countries’ financial markets. One of the crucial factors in assessing an investment opportunity in a foreign market is the hedging cost of the currency associated with that investment. In particular, European insurers who diversify their portfolios into assets denominated in currencies other than the euro, tend to hedge the underlying currency risk because the Solvency Capital Requirement (SCR) is higher for currency exposure and thus reduces the assets’ attractiveness in terms of the SCR buffer requirements compared to the expected returns. Pension funds with future liabilities denominated in euros also tend to hedge the currency risks in their portfolios. An additional risk-related aspect that may be relevant to some investors is the tracking error against the portfolio’s benchmark; simply put, how correlated the foreign investment is to its domestic counterpart within the benchmark.
In this paper, we focus our currency hedging analysis on investments in foreign bonds, primarily for two reasons. Compared with equity investors, bond investors tend to hold their bonds for longer, thus the foreign exchange (FX) hedging cost for a potentially longer period of time becomes more pronounced. More importantly, as the total return from bonds is in general much smaller than that from equities, the FX hedging cost takes up a larger proportion of the total return from a bond investment than that from an equity investment. For eurozone and non-eurozone government bonds of the same duration and with the same sovereign risk, the only differences are their yields and their respective currencies. In such cases, we can estimate a breakeven between the ‘pick-up’ in yield vs. the currency hedging cost. In other words, how far the currency hedging cost can increase until an investor loses the yield ‘advantage’.
Here, we first look at the principal concept linking the foreign exchange forward price to fixed-income markets, as expressed in an equation. Next, we explain our recommended approach to estimating the FX hedging cost by applying this equation on swap and FX forward markets. We then use this approach on selected major government bond and credit markets. The results from our analysis show that currency hedging does indeed play a crucial role in the total return of a foreign bond investment. After taking into account the FX hedging cost, it appears that there are no compelling investment choices from the selected foreign government bonds, and that only Asian credit stands out as attractive among Asian, UK and US credit choices.Download to read more