Fixed-income investors have been loath to pick up international debt exposure as foreign exchange currency swings can negate the upside potential and increase portfolio volatility. Nevertheless, bond investors can look to currency-hedged exchange traded funds to limit the risks.
Mark McCarron, chief investment officer for Wescott Financial Advisory Group, warned of global diversification when it comes to bonds due to currency risk, CNBC reports.
“Our fixed income exposure is almost exclusively in U.S. dollars,” McCarron, told CNBC. “Currencies are volatile and they represent a much bigger part of bond returns than stock returns. Investors can get wiped out investing in global fixed income if they do it un-hedged.”
For instance, the MSCI Emerging Markets Currency index, a basket of 26 EM currencies, was down 4.5% against the U.S. dollar for the year through Oct. 24, contributing to double-digit losses in EM stocks and a 9.7% drop in EM local currency bonds. The U.S. dollar has also been appreciating against developed market currencies like the euro and Japanese yen.
“The strength of the U.S. dollar has surprised a lot of people,” Peter Wilson, global fixed income strategist for Wells Fargo, told CNBC. “It’s been driven by a number of factors.”
Specifically, the strong U.S. economy has supported the USD. Tax cuts and increased government spending have helped prop up the U.S. economy, which has been expanding faster than it has for years.
“The dollar has been getting stronger because interest rates are going up here versus the rest of the world,” McCarron added. “Even after adjusting for inflation, interest rates in the U.S. market are higher than in Europe, Japan and in many cases emerging markets.”
Nevertheless, if investors could get a handle on the potential currency risks of investing in local currency-denominated debt in international markets, there are some attractive opportunities around the world.
For example, investors can look to something like the Vanguard Total International Bond ETF (NasdaqGM: BNDX), which tracks Bloomberg Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged), a currency-hedged index with global debt exposure.
The iShares Core International Aggregate Bond ETF (NYSEArca: IAGG), which tracks the Bloomberg Barclays Global Aggregate ex USD 10% Issuer Capped (Hedged) Index, also provides broad global bond exposure with a currency hedged component to limit the negative effect of foreign exchange currency swings.
Investors who are interested in the international debt market but are wary of forex risks can also look to the 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 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.
For more information on the fixed-income market, visit our bond ETFs category.