How does currency hedging of foreign bond UCITS ETFs work?

Over the long-term, currency hedging tends to make foreign bonds have similar returns to comparable domestic bonds. Given this, is it worth investing in currency hedged foreign bond ETFs? How does currency hedging actually work?

The Portfolio I prefer includes two investments:

  • An index fund tracking global equities. This fund should not be hedged.
  • A fixed income investment denominated in your local currency. Ideally this would be an index fund tracking investment grade government bonds denominated in your local currency.

Eurozone government bonds currently have abnormally low yields. Therefore, as an alternative for the fixed income investment, I’ve been suggesting either getting a savings account if it has better yields. Or investing in a hedged index fund tracking global investment grade bonds.

Impact of exposure to assets denominated in a different currency

A foreign bond ETF is an ETF that holds bonds denominated in a currency different than yours.
Note that I’m talking about the currency of the assets held by the fund and not the fund currency. The fund currency mostly matters for financial reporting of the fund therefore, it isn’t relevant for this article.

Investing in a foreign bond ETF exposes you to foreign currency fluctuations.

A domestic bond ETF return can be described the following way:

your total return = total bond ETF return

A (unhedged) foreign bond ETF return can be described the following way:

your total return = total bond ETF return + currency return

The currency return of a foreign bond ETF can be positive (if your currency depreciates in relation to the foreign bond’s currency) or negative (if your currency appreciates in relation to the foreign bond’s currency). Note that, if you hold a global bond ETF (e.g. iShares Core Global Aggregate Bond UCITS ETF), the fund is actually exposed to multiple foreign currencies therefore, you would have to do an average weight of the return of all currencies.

The purpose of the bond index fund in the recommended portfolio is to lower the overall risk of the portfolio. Investment grade government bonds have lower risk than global equities. As a consequence, investment grade government bonds also have lower expected returns. Additionally, investment grade government bonds have low correlation with global equities which increases diversification.

An unhedged foreign bond ETF is exposed to higher volatility/risk than a domestic bond ETF due to foreign currency fluctuations. This additional volatility disrupts the desired goal we have for bond ETFs in our portfolio: low risk. Therefore, the common recommendation is only to hold foreign bond ETFs if hedged to your currency.

A hedged foreign bond ETF return can be described the following way:

your total return = total bond ETF return + hedge return

A foreign bond ETF will always have an additional return component: the currency return if unhedged or the hedge return if hedged.

The graph below compares the contribution of this additional return (hedging or currency) to the total return. It highlights how the hedge return is significantly less volatile than the unhedged foreign currency return. The magnitude of the changes of the hedge return is significantly lower. Hedging helps the foreign bond ETFs maintain the low volatility aspect which is needed for the recommended portfolio.

Source: Vanguard Research

How currency hedging works?

Currency hedging is usually implemented using currency forward contracts. A currency forward contract allows the ETF fund manager to exchange currency in a future date at a pre-determined exchange rate. The currency forward contracts used in ETFs have a short term: 1 month or less.

Let’s use a few examples to see how currency forward contracts work. In all scenarios below we have an ETF that holds bonds denominated in USD ($). We want to calculate the fund’s returns in EUR (€).

Example 1: Unhedged ETF with foreign currency exposure

We have an unhedged ETF.

To convert from USD to EUR we use the current exchange rate which is also known as spot rate.

On January 1st, the assets are worth 150 million $. For a spot rate of 1.2$ per €, the fund is worth 125 million € (150 / 1.2).

Scenario 1.1: Euro becomes weaker (each euro buys less dollars)

On February 1st, the value of the bonds in USD does not change. The fund is still worth 150 million $. Yet the spot rate changes to 1.15$ per €. Therefore, the fund is worth 130.43 million € (150 / 1.15).

Over a period of 1 month, the value of our fictional fund in EUR increased (from 125 M to 130.43 M). We had a gain even though the value of the assets in USD didn’t change. The total gain is 5.43 million € (130.43 - 125).

Scenario 1.2: Euro becomes stronger (each euro buys more dollars)

A similar but inverse thing happens if the spot rate had changed from 1.2$ per € to 1.3$ per €. Our fund would have decreased in value to 115.38 million € (150 / 1.3) even though the value of the assets in USD didn’t change. The total loss is 9.62 million € ( 115.38 - 125).

Calculating returns of unhedged foreign bond ETF

Note that a real scenario would be more complicated than these because we would need to also account for changes in the value of the underlying bonds.

Foreign currency exposure affects our returns even if the value of the assets does not change.

Example 2: Hedged ETF with foreign currency exposure

We have a hedged ETF.

On January 1st, the assets are worth 150 million USD. For a spot rate of 1.2$ per €, the fund’s value is 125 million € (150 / 1.2).

To mitigate currency risk we are going to buy a 1-month forward currency contract. This forward currency contract allows us to exchange 150 million USD into EUR at an exchange rate of 1.25 $ per € in 1 month (February 1st). The exchange rate of this contract is called a forward exchange rate.

Scenario 2.1: Euro becomes weaker (each euro buys less dollars)

On February 1st the value of the underlying bonds does not change. The bond assets of the fund are still worth 150 million $. Yet the spot rate changes to 1.15$ per €. The assets are worth 130.43 million € (150 / 1.15). We had a gain of 5.43 million € (130.43 - 125) due to changes in spot rates.

We also need to calculate the financial returns of the forward contract. To do that we compare the forward rate (1.25) with the new spot rate (1.15). The value of the forward contract had a financial loss of 10.43 million € ( 150 million / 1.25 - 150 million / 1.15).

The total returns of the fund need to consider the returns due to currency fluctuation and the returns due to the forward contract. The total loss of the fund is 5 million € 5.43 million - 10.43 million.

If you compare this scenario with scenario 1.1 you will notice that in scenario 1.1 we had a gain of 5.43 million € and in scenario 2.1 we have a loss of 5 million. The forward contract, not only cancelled the currency fluctuations but also caused a loss. This happened because of the difference in the original spot rate and the forward rate. If the forward rate had been the same as the original spot rate, the loss of the forward contract would have been 5.43 million € (150 million / 1.2 - 150 million / 1.15) and total losses of the fund would have been 0 ( 5.43 million - 5.43 million).

The forward contract cancels currency fluctuations yet it leads to a cost in returns due to the differences in spot and forward rates.

Scenario 2.2: Euro becomes stronger (each euro buys more dollars)

A similar but inverse thing happens if the spot rate had changed from 1.2$ per € to 1.3$ per €.

The bonds would have decreased in value to 115.38 million € (150 / 1.3). The loss due to spot rate changes is 9.62 million € ( 115.38 - 125).

The value of the forward contract would have a financial gain of 4.62 million € (150 million / 1.25 - 150 million / 1.3).

The total losses of the fund would be 5 million € - 9.62 million + 4.62 million. If you compare this scenario with scenario 1.2 you will notice that this scenario had a smaller loss than scenario 1.2 (9.62 million €). The forward contract mitigated the impact of currency fluctuations when compared to a unhedged scenario.
There is still a loss of 5 million due to the difference in original spot rate and forward rate though. If the forward rate had been the same as the spot rate the forward contract gain would have been 9.62 million € (150 million / 1.2 - 150 million / 1.3) and the total losses of the fund would have been 0 (9.62 million - 9.62 million).

Calculating returns of hedge foreign bond ETF

Calculating the Hedge Return

The differences in spot rate and forward rate lead to what we call the “hedge return”. It is a return you’ll always have independently from the cancellation of currency fluctuations. On Example 2 this return component lead to fixed losses of 5 million € irrespectively of the variation in spot rates.

The hedge return can be calculated using the formula:

hedge return = (( spot rate - forward rate ) / (spot rate * forward rate))

In Example 2 the hedge return would be -0.033 = ((1.2 - 1.25) / (1.2 * 1.25). Multiplying the hedge return by the initial value of the investment gives us the losses we observed 5 million € = -0.033 * 150 million $.

If you are using 1-month forward rates, you can annualize the hedge return by multiplying it by 12.

annualized hedge return = hedge return * 12

Follow these steps to calculate the annualized hedge return for EURUSD using real-world data:

  • Get the exchange rates (i.e. spot and forward) from a site like this one:
    • the spot rate is shown in black above the “Forward Rates” table (e.g. 1.11030 $ per €).
    • look at the “1-Month forward” row. The forward rate is specified in forward points. You add the forward point to the spot rate in order to get the forward rate. The forward points are specified in basis points (i.e. 1/ 10 000). For a forward point of 26.445 and a spot rate of 1.11030 we get a 1-month forward rate of 1.1129445 = 1.11030 + (26.445 / 10 000)
  • Use the exchange rates to calculate the hedge return. At the time of writing the annualized hedging cost for hedging between EUR/USD is 2.57% = ((1.11030 - 1.1129445) / (1.11030 * 1.1129445 ) * 12.
Calculating hedge return using spot/forward rates

You can also calculate the hedge return by comparing interest rates of the involved currencies. To calculate the cost of hedging USD to EUR you can use the 1-month LIBOR rate.

hedge return = EUR 1-month LIBOR rate - USD 1-month LIBOR rate

At the time of writing this yields 2.63% = - 0.46457% - 2.16663% which is very similar to the value we obtained by using forward rates.

Note that the hedge return is calculated from short-term factors (e.g. 1-month interest rates) therefore, you should periodically look at it because short-term interest rates change often..

If you want to know more, the existence of a hedge return is explained by interest rate parity.

The hedge return is only a part of the costs of hedging

The hedge return is determined by the difference in spot and forward rates. That is only one of the costs of hedging.

Currency forward contracts have transaction costs which will further increase the cost of hedging and decrease your returns.

Also, hedged ETFs may have a higher TER than a comparable non-hedged ETF.

Currency hedging is not precise since forward contracts won’t account for the full value of the fund. An ETF will be under-hedged in case the value of its assets increase before a new forward contract is made. An ETF will be over-hedged if the value of its assets decreases before a new forward contract is made. This is highly dependent on the duration of the forward contract (e.g. 1-month forward contract vs. daily forward contract).
The shorter the duration of the forward contract the higher the transaction or operational costs in maintaining them.

An aside: I think this imprecision of hedging is one additional reason to avoid hedged equity ETFs. Equities fluctuate so much that 1-month currency forward contracts feel inappropriate. Some ETFs have daily forward contracts but equities fluctuate a lot even in a single day.

Is it worth investing in hedged foreign bond ETFs?

Vanguard Research has concluded that the “hedge return” causes foreign bond ETFs to have total returns which are similar to comparable domestic bond ETFs. You should not expect higher returns by investing in hedged foreign bond ETFs. We don’t know exactly how those returns will look like though.

Source: Vanguard Research

The only advantage hedged foreign bond ETFs have over domestic bonds is their diversification. That is, foreign bond ETFs may help you reduce your concentration risk.

Here are the aspects you should consider when deciding between hedged foreign bond ETFs and domestic bond ETFs:

  • do you want additional diversification?
  • do you prefer a bond investment which is more predictable? For a domestic bond ETF you can simply look at the yield to maturity to understand its expected returns.
  • is the implementation of hedging expensive? What is the hedge return? What is the TER of the fund?

How to analyze the impact of the hedge return in ETFs?

Different ETF providers provide different information that can help us assess the impact of hedging.

We can look at past performance to understand how the hedge return varied in the past. To assess the future impact of hedge returns you have to calculate the hedge return using spot/forward rates.

iShares – Global Aggregate Bond ETF

For iShares you want to compare the return of the “unhedged ETF” with the return of the “hedged ETF”. The difference in both returns is mostly due to the “hedge return”. You can find that information on the fund’s website under the “Performance” section.

Below is the performance table for the iShares Core Global Aggregate Bond UCITS ETF EUR Hedged (ISIN IE00BDBRDM35). This was taken from the site of the fund.

Source: iShares

The unhedged/hedged funds have a difference of -1.28% from 30th June 2018 to 30th June 2019. We can assume that difference is due to the hedge return. Unfortunately for this fund we don’t have much historical data since it is rather new.

It is worth noting that the hedged/unhedged versions of this fund both have a TER of 0.10%. If they had a different TER you’d have to account for that differential in your estimate of hedging return.

Xtrackers Global Government Bond UCITS

For the Xtrackers funds you want to compare the returns of the (hedged) “share class” with the returns of the “unhedged share class”. You can find that information in the fund’s factsheet.

Below is the performance table for the Xtrackers Global Government Bond UCITS ETF (ISIN LU0378818131). This was taken from the fund’s factsheet.

Source: Xtrackers

This fund has data until 2014. You can get a sense of how the hedge return varies over time. Between July 2014 and July 2015 the hedge return was -8.71% and from July 2106 to July 2017 the hedge return was 4.13%. These differences happen due to variations in interest rates in both currencies.