Fixed Income 101: Inflation-linked bonds
Fixed income managers always want to have the flexibility to look for the best value across their investment universe, and in our view they therefore need the capacity to buy bonds in different currencies.
However, most will not want to take the associated currency risk, as exchange rates tend to be volatile and can quickly become the overriding risk in a portfolio, even having the potential to overwhelm every other investment theme.
Hedging the currency risk of a bond denominated in foreign currency can be done simply by using an FX forward. As an example, if your portfolio’s base currency is GBP and you want to buy a $1,000,000 bond denominated in USD, you would sell approximately £873,576.241 to buy the USD you need to buy the bond today. With an FX forward, you sell that same amount of USD forward one month and buy back the GBP to lock in the forward exchange rate, before simply rolling the trade every month while you hold the $1,000,000 bond.
Obviously, applying this currency hedge to every individual bond you hold often isn’t practical, so instead the hedge is typically applied at the portfolio level to cover each of the non-base currencies held. The hedges can then be adjusted daily to account for any purchases, sales or changes in market value of the portfolio’s holdings.
The forward exchange rate in this transaction will be determined by the ‘forward points’, which is shorthand for the amount that is added to, or subtracted from, today’s spot exchange rate. The forward rate will be based on the difference in interest rates between the two currencies involved (in our example the difference between US interest rates and UK interest rates), and it should more or less result in the two interest rates equating to each other.
If this was not the case, money would simply flow away from regions with lower interest rates as investors looked to collect the higher rate on offer elsewhere.
The forward points are thus a very important consideration for fixed income managers, but they are often ignored (sometimes conveniently) when observers are lauding the benefits of one region over another.
For example, the US high yield bond index has a yield of 8.9% and the European high yield index yields 7.8%2, which is the better value?
The only way to know is to convert the EUR yields to a USD yield. To do that we consider the forward points, which (using rates as of 1 November 2022) adds 275bp to the EUR yield, meaning the true USD yield on the European index is 10.55% – far more attractive than the US index. If you were to look at GBP denominated bonds, there would be a yield pick-up of around 100bp when hedging into USD.
With central banks hiking rates aggressively across 2022, interest rate differentials between regions have widened; following the US Federal Reserve and Bank of England monetary policy decisions at the start of November 2022, for example, base rates were 3.75-4.00% in the US, 3% in the UK and 2% in the Eurozone.
Changes in monetary policy and exchange rates are constantly altering the forward points for hedging bonds denominated in a portfolio’s non-base currency, which means it is important for fixed income investors to take these into account when comparing relative value across different markets.
1. Based on exchange rate as of 1 November 2022
2. ICE BofA Indices data as of 1 November 2022