For a number of years prior to the COVID crisis, U.K.- and EU-based investors viewed currency hedging costs as a massive barrier to investing in U.S. dollar-denominated bonds. These costs, driven by differences in short-term rates between local currencies and the dollar, peaked in late 2018 at 3.6% per annum for euro-based investors and approximately 2.1% for pound sterling. What did that mean in practice? Well, for example, a European investor buying a BBB-rated USD-denominated bond with the yield of 4.5% was forced to give up most of that yield after FX hedging, taking the EUR-hedged yield figure down to 0.9%.
Fast forward to today, and the U.S. Federal Reserve’s multiple rate cuts from early last year have substantially reduced hedging costs for non-U.S. investors. The cost of hedging for U.K. investors is now essentially zero (as USD and GBP short term rates have converged), whereas for EUR investors it comes to a mere 0.7%—nowhere near as prohibitive as it was just a couple of years ago.
This environment creates some interesting relative value opportunities for bond investors who are open to allocating to different regional segments without assuming FX risk. For example, looking at investment grade corporate bonds in different currencies, the EUR credit index currently has an average yield of 0.26%, whereas the USD credit index yield stands at 2.0%. From the position of a European investor, a U.S. IG credit portfolio hedged to euros will have a hedged yield of about 1.3%, providing a meaningful premium in comparison to a similar EUR credit portfolio.
There’s an obvious caveat to this analysis: Hedging costs aren’t meant to stay constant over time and they fluctuate along with the short-term rates market. As of now, though, we don’t expect substantial changes in the Fed’s policy stance in the near term, which means that these subdued levels of hedging costs are likely to persist for a number of years.
Finally, trying to allocate between USD-, EUR- and GBP-denominated bonds in pursuit of relative value can be a daunting task for asset owners. We typically suggest combining bonds in different currencies into one global portfolio, with the flexibility to move across these segments over time. That way, a skilled active manager can rotate exposure over the cycle, as relative value evolves based on the changes in spreads and hedging costs.