Global diversification has become an important objective when constructing fixed income portfolios. In the current environment of generally low expected returns, the costs associated with hedging have also become an important concern.
Diversifying from a portfolio’s base currency can provide access to more attractive asset markets and potentially provide higher levels of risk compensation. The shift into foreign assets has demanded an increased focus on hedging strategies aimed at reducing unwanted risks. In this paper, we describe various hedging methods and the costs of hedging fixed income portfolios.
Breaking down global credit portfolio risk
The majority of foreign fixed income assets can generally be thought of as presenting three main risks: currency risk, interest rate risk and credit risk. Depending on an investor’s objectives, some of these risks may be undesirable. Currency and interest rate risk in particular may have an outsized impact on portfolio performance. As seen in Figure 1, currency and interest rate volatility have historically been greater than credit volatility, suggesting that they could dominate returns delivered by foreign credit assets.
Total global credit portfolio risk = credit risk + interest rate risk + currency risk
|Historical volatility of US dollar credit portfolio faced
by euro-based investor (%)
|Interest rate volatility||1.43|
Sources: Invesco and Bloomberg Barclays US Aggregate Credit Index. US dollar based investment portfolio is
represented by the Bloomberg Barclays US Aggregate Credit Index, Jan 20, 2007 to Jan 20, 2017.
Defining portfolio risks
The three main portfolio risks shown in Figure 1 are defined below. Our discussion centers on seeking protection against unwanted interest rate and currency risk. Given that the portfolio under discussion is a global credit portfolio, we assume that it is desirable to hold credit risk.
Credit risk: Credit risk is the risk that a bond issuer will default on its bond payments. The market’s perception of a bond’s credit risk can fluctuate, resulting in corresponding changes in the value of the bond. All else equal, bonds with more credit risk are valued less than bonds with lower credit risk.
Interest rate risk: Interest rate risk is the risk that higher long-term interest rates may reduce the value of a credit asset. As long-term interest rates rise, the value of holding a bond decreases as investors are able to seek higher yields elsewhere.
Long-term interest rates are driven by a number of factors, including investors’ expectations about the path of short-term interest rates. Short-term interest rates are typically determined by central banks which are tasked with managing the balance between growth and inflation. When growth and inflation expectations rise, expectations of higher interest rates also typically rise. This can negatively impact the value of a bond portfolio.
Currency risk: Currency risk is the risk associated with receiving future cash flows in a foreign currency. Over the life of a foreign currency denominated bond, investors face the risk that their bond payments will be converted at a lower exchange rate than when the bond was originally purchased. If the foreign currency depreciates, cash flows received from the bond will be worth less in terms of domestic currency. Currency fluctuations are due to a variety of economic and market drivers, including global and country-specific factors.
Commonly used hedging tools
Investors can seek to protect against interest rate and currency risk by implementing a variety of hedging tools. Below, we describe some commonly used hedging instruments designed to offset interest rate and currency volatility.
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