Why do countries buy US Treasuries

Anyone toying with US bonds must be able to tolerate the currency risk

And it's getting easier and easier to do that. While currency-hedged fund tranches were a rarity until a few years ago, fund providers have increasingly started bringing hedged fund tranches onto the market in recent years. Our database now shows a good 5,000 fund tranches that exclude foreign currency risks for euro investors.

With a currency hedge, volatility drops by up to 50 percent 

But what is understandable at first glance has a big catch. A currency-hedged fund does not deliver the performance adjusted for the currency risk, but that for the currency risk andthe interest rate differential between the currency areas adjusted performance. That’s a huge difference.

Many investors are unaware that currency hedging can come at a high price. This is currently the case for investors from the euro zone and Switzerland. Because the price of the hedge is inextricably linked to the difference in interest rates between the various currency areas. In the euro zone, the main refinancing rate of the ECB has remained unchanged at zero percent since September, and the deposit facility was even pushed further into negative territory to minus 0.5 percent. The Fed funds rate in the US is currently between 1.5 and 1.75 percent.

Interest parity theory provides the glue that connects currency markets and interest rates 

This has consequences for investors who want to hedge the dollar risk. The hedging costs roughly correspond to the difference between the interest rates between the different currency areas. That has to be the case, because otherwise investors would enter into unlimited arbitrage deals. The theory of interest rate parity states that the interest rate differential between two countries is equal to the difference between the forward rate and the spot rate. Interest rate parity defines important parameters of the foreign exchange markets by linking interest rates, spot rates and foreign exchange rates.

If the risk-free interest rate is higher in one country than in another, the currency of the country that offers investors the higher risk-free return is exchanged for a more expensive future price than the current spot price. Interest rate parity is based on the assumption that there is no possibility of arbitrage in the currency markets. Accordingly, investors cannot enter the current exchange rate in one currency at a lower price and then buy another currency from a country with a higher interest rate.

Hedging costs remain at a high level

Because the euro / franc versus dollar interest rate gap is likely to persist for a long time to come, the hedging costs for foreign currency bonds will likely remain high for local investors - as long as the ECB does not raise interest rates or the Fed does not continue to raise interest rates lowers.

The loss of returns due to currency hedging for fund investors can be illustrated quite easily using simple examples. To this end, we have identified some large bond funds that are involved in the US bond market and that also offer currency-hedged tranches for local investors. In the tables below you will find flexible USD bond funds such as the AB American Income or the JPMorgan Income Opportunities, diversified USD bond funds such as the PIMCO GIS Total Return Bond or USD government bond funds such as the Vanguard US Government Bond Index.

In the top of the two lines you will find the performance of the secured EUR tranches, in the second line we have calculated the performance in dollars because this corresponds to the performance that the asset would have achieved in dollars, i.e. on the fund's home market . Since the movements of the euro are hedged against the US dollar, the euro tranches would, according to a naive assumption, have a performance that is almost identical to the dollar performance of the unhedged tranches. In fact, the performance of the fund tranche pairs diverges significantly, as a comparison of the performance figures shows (as I said, this is only a calculation example. Investors who hold these tranches have a different performance as a result of the currency conversion into EUR achieved - they have benefited from the rising dollar exchange rate in the past twelve months.)

The dollar performance of AB American Income was up 13.99 percent over the past twelve months to the end of October. The currency-hedged tranche of the fund in the line above shows a performance of only 8.9 percent. Since the fund costs of both tranches are identical, the difference primarily corresponds to the costs of currency hedging over the twelve-month period. In the case of PIMCO Total Return, the original version in dollars rose 11.79 percent in the past 12 months, while the hedged version of the same fund gained only 6.78 percent. The Vanguard index fund, which is based on US government bonds, gained 5.79 percent in dollars and 1.01 percent in the currency-hedged variant.

Table: What Was Left of the Dollar Performance: The Cost of the Interest Rate Differential

Our example leads us to the conclusion: As is well known, there is no free lunch on the capital market. Temptingly simple ideas that secure investors supposedly risk-free additional income are either figments or they are not exactly that: risk-free. This also applies to currency hedging.

Even if currency-hedged tranches reduce volatility, that does not mean that investors who have eliminated the currency risk will achieve returns that correspond to the conditions of the home market of the asset. In other words: if you absolutely want to eliminate the foreign currency risk, you run the risk of missing your profit targets.

As an alternative, investors from low-interest regions remain the following options:

- Pay the hedge costs (and consequently reduce the return claims);

- Take the currency risk (and live with the increased volatility);

- Avoid high-yield regions and deal with the higher-yielding options on the home market, even if these seem rather modest;

- Cut the costs. There are often inexpensive alternatives for existing investments, mostly in the form of ETFs;

- Put the investment strategy to the test and rethink the return targets, the risk-bearing capacity, the investment period or the liquidity premises.

This post is part of the topic week on bonds and bond funds 2019. Here you can find the overview article, which also links to all articles.

The analysis in this article is based on our professional investor tool. For more information on Morningstar Direct, please visit here.



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