Currency and foreign bonds for euro investors

What you will learn

• How to split a foreign bond's euro return into bond return and currency return
• Why currency swings can be larger than the yield advantage of a foreign bond
• Why the cost of currency hedging is roughly the short-term rate difference
• How to compare unhedged, hedged and euro bonds on the same basis

Explanation

Currency risk for euro investors and simple hedging ideas are covered in the forex course. This lesson applies them to bonds, where the effect is particularly strong because bond returns are small compared with currency moves.

Two sources of return

An unhedged foreign bond is a bond held without any protection against currency moves. Its return in euros is:

(1 + euro return) = (1 + return in foreign currency) × (1 + change in the foreign currency against the euro)

A foreign bond with a 4% yield earns about 4% in its own currency if yields stay unchanged. If that currency loses 5% against the euro, the euro investor loses about 1%. Exchange rates of major currencies can move by several percent in a year, while the yield difference between government bonds is often only one or two percentage points. Unhedged, a high-quality foreign government bond therefore behaves partly like a currency position, and its value can swing much more than a euro bond of the same duration.

Hedging and its cost

A currency hedge removes most of the exchange-rate effect, usually by selling the foreign currency forward. A forward contract fixes today the exchange rate for a future date. Many bond ETFs offer "EUR-hedged" share classes that roll such forwards, often monthly.

The forward rate is not free of cost. By covered interest parity, a basic relationship in currency markets, the forward rate reflects the difference in short-term interest rates between the two currencies. Approximately:

Hedged yield ≈ foreign bond yield + (euro short-term rate − foreign short-term rate)

If foreign short-term rates are higher than euro rates, hedging costs money and removes much of the yield advantage. If they are lower, hedging adds to the yield. This is why a higher foreign yield does not mean a higher return for a euro investor after hedging.

Other points

• Diversification: foreign government bonds react to their own central bank and economy, so hedged foreign bonds can still diversify euro rate risk.
• Emerging-market local-currency bonds add currency, inflation and political risk; hedging is often expensive or unavailable.
• Bonds in euros from foreign issuers (for example a US company issuing in euros) carry no currency risk for you, only the issuer's credit risk.
• Hedges are rolled at short intervals, so they are never perfect: small differences in timing and costs remain.

Worked example

Hypothetical example: A euro investor compares a 5-year US Treasury yielding 4.0% with a 5-year Bund yielding 2.4%. US short-term rate: 4.3%; euro short-term rate: 2.4%. EUR/USD is 1.10 (1 euro = 1.10 US dollars). Assume bond prices stay unchanged for one year; fees and taxes are excluded.

1. Invest €10,000 → €10,000 × 1.10 = $11,000.
2. After one year with 4.0% income: $11,000 × 1.04 = $11,440.
3. Case A, the euro strengthens to 1.15: $11,440 ÷ 1.15 = €9,947.83, a return of −0.52%.
4. Case B, EUR/USD stays at 1.10: $11,440 ÷ 1.10 = €10,400, +4.0%.
5. Case C, the euro weakens to 1.05: $11,440 ÷ 1.05 = €10,895.24, +8.95%.
6. Hedged: 4.0% + (2.4% − 4.3%) = 4.0% − 1.9% = about 2.1%, which is below the Bund's 2.4% in this example.

Common mistake

Practice activity

You invest €20,000 in a US dollar bond at EUR/USD 1.10. The bond yields 4.5% and its price stays unchanged for one year. (a) What is your position in dollars after one year? (b) What is it worth in euros if EUR/USD is 1.16? (c) And if EUR/USD is 1.06? (d) If the US short-term rate is 4.4% and the euro short-term rate 2.4%, what is the approximate hedged yield?

Key takeaways

• An unhedged foreign bond's euro return combines its local return and the currency move.
• Currency moves of major currencies are often larger than yield differences, so unhedged foreign bonds are much more volatile.
• Hedging costs or earns roughly the difference between short-term interest rates.
• Compare hedged foreign yields with euro bonds of similar duration and quality before choosing.

Next step

Next, you will bring the whole course together and build the fixed-income part of a portfolio.