Let us discuss how hedging can enhance low local yields. Yields on the German bund remain stuck below 50 basis points while the Japanese government bonds yield virtually zero basis points. U.K. gilts on the other hand yield only 125 basis points. Does this mean non-U.S. bonds such as the ones mentioned above hold any value to dollar-based investors?
For a dollar-based investor, hedging foreign currency exposure on lower yielding global bonds may potentially result in higher yields than U.S. Treasuries. Simply put, investors are getting paid to hedge the currency risk back to the U.S. dollar. Other potential benefits for those who invest internationally and hedge their U.S. currency risk exposure include improved diversification and defensive strategies against rising U.S. interest rates. Hedged yields may be quite attractive for U.S. dollar-based investors despite low bond yields in many countries outside the U.S. It might surprise you, but the yield to maturity of hedged global bonds was 3.16% as of June 2018, which is close to 3.27% for the main U.S. bond index. This is the case because hedging foreign currencies back to the U.S. dollar currently adds more than 200 basis points of “carry” because of favorable short-term interest rate differentials. In order to hedge foreign currency risk exposure in a foreign bond, investors effectively pay the short-term rate in the foreign currency and receive short-term rate in their home currency.
If short term rates for U.S. dollars are higher than those for the target currency, the cost of hedging may be negative. This means investors could get paid to hedge. This dynamic could continue over the cyclical horizon as the Federal Reserve continues to raise rates while most other developed market central banks remain on hold.