Fixed-income investors can utilize exchange traded funds to diversify and access global debt markets, but when investing in overseas bonds, investors should consider the negative effects of foreign exchange fluctuations or currency risks.
“Currency has a zero return over the long run and doesn’t bring enough diversification to a portfolio to justify the additional risk,” Rob Bush, an ETF Strategist for Deutsche Asset Wealth, said in a research note.
Bush argued that the case for currency hedging international bonds may be even more compelling than that for stocks, given the low volatility aspect of fixed income securities. Consequently, the additional risk from fluctuating currencies has the potential to make up a greater proportion of overall risk.
“Historically, FX tends not to add return to a portfolio (again, over the long run) but has added risk,” Bush said. “In our view, the only way in which investors might justify the inclusion of currency in a portfolio is if it brings down the risk of the portfolio as a whole.”
[related_stories]However, currencies add risk to a portfolios with international bond exposure. Looking at the rolling volatilities of a hedged and unhedged Barclays Global Aggregate Corporate ex USD Total Return Index since 2002, currency exposure increased volatility in all time periods, notably during the financial crisis.
With a currency hedge, investors may also enjoy the positive cost of carry, or the difference in one-month interest rates in the U.S. versus foreign countries, especially as U.S. rates are higher than those of major developed currencies, including the euro, yen, British pound and Swiss franc.
SEE MORE: Deustche Bank Adds International Bond Currency Hedged ETFs
Consequently, investors who are interested in the international debt market but are wary of forex risks can look to currency-hedged bond ETF options, like the recently launched Deutsche X-trackers Barclays International Treasury Bond Hedged ETF (BATS: IGVT) and Deutsche X-trackers Barclays International Corporate Bond Hedged ETF (BATS: IFIX).
The two funds will enter into forward currency contracts designed to offset their exposure to foreign currencies by selling the applicable foreign currency forward at the one-month forward rate, according to the prospectus sheet.
IGVT will try to reflect the performance of the Barclays Global Aggregate Treasury ex USD Issuer Diversified Bond Index (USD Hedged), which is comprised of investment grade sovereign debt issued in developed and emerging markets denominated in the issuer’s own domestic currency.
IFIX will try to reflect the performance of the Barclays Global Aggregate Corporate Ex USD Bond Index (USD Hedged), which is comprised of investment grade corporate debt issued in developed and emerging markets in the industrial, utility and financial sectors.
For more information on the fixed-income market, visit our bond ETFs category.