With this blog, we share our assessment on hedge ratios for fixed income portfolios invested in global credit (investment grade and non-investment grade). In summary, we recommend lower hedge ratios for U.S. investors and higher hedge ratios for Japanese, European and British investors.
Many drivers of hedging decisions have changed over the last 12 months. With major central banks now pinning interest rates at historical lows for years ahead, it is more likely that relative economic fundamentals will be reflected through currencies. Therefore, we believe that investors should review the rationales for their current hedging policies, and also consider dynamic currency hedging strategies to take into account these issues.
To put the assessment into context, our dynamic currency hedging strategy aims to integrate currency exposures into portfolio construction by solving for the hedge ratio that maximises forward-looking return-to-risk ratio for the overall portfolio. We do this by focusing on three pillars: valuation of foreign currencies, cost of hedging foreign currencies and the diversification effects that foreign currencies bring to the portfolio.
Starting with valuation, we continue to believe that the U.S. dollar is overvalued versus foreign currencies despite the depreciation in 2020. Conversely, the euro, Japanese yen and British pound are still undervalued versus foreign currencies. All else equal, this suggests that U.S. investors should maintain a lower hedge ratio, whereas European, Japanese and British investors should maintain a higher hedge ratio.
Arguably, the biggest change compared to the end of 2019 is the cost of hedging. Since the Federal Reserve began its hiking cycle in 2015, largely in contrast to other central banks, hedging cost have detracted from return potential for non-U.S. investors. However, following the rate cuts during the pandemic, the cost of hedging now subtracts very modestly from returns for non-U.S. investors, whereas it adds very modestly to returns for U.S. investors. This further reinforces the bias to higher hedge ratios for European, Japanese and British investors while suggesting a slightly higher hedge ratio for U.S. investors.
Finally, there are the diversification benefits of foreign currencies. As often happens following global recessions, the U.S. dollar has become negatively correlated to risky assets. Because of this, foreign currencies have less appeal from a diversification perspective for U.S. investors. Similarly, foreign currencies have modest diversification effects for Japanese and European investors. However, foreign currencies are attractive from a diversification perspective for British investors.