Fixed income securities play an integral role in almost every investor’s portfolio. It is common to see a fixed income allocation mostly denominated in the investor’s home currency, as foreign currency denominated bonds can add unwanted volatility to a portfolio. Limiting a fixed income allocation to bonds denominated in the home currency creates limitations on opportunities for diversification. Currency hedged globally diversified fixed income allocations are the logical solution.
Currency hedging has limited benefits in equities because equities and currency tend to have similar volatilities, and imperfect correlation. Maintaining currency exposure can actually decrease equity volatility due to currency diversification. Adding a currency hedge to an equity allocation removes the currency diversification benefit and can increase volatility.
Like with equities, currency has imperfect correlation with fixed income, resulting in a similar positive diversification benefit. However, currency is much more volatile than fixed income, and as a result the positive effect from currency diversification is not enough to offset the relatively large volatility introduced by currency fluctuations. Adding a currency hedge maintains the low volatility that makes fixed income attractive.
A currency hedge is executed in practice with forward exchange contracts. This entails entering an agreement to exchange CAD for a foreign currency at a predetermined rate, on a predetermined date. The following example involves a Canadian investor buying a USD denominated bond, and hedging their currency exposure.
- The Canadian investor converts their CAD cash to USD, purchases the US bond in USD, and simultaneously sells short a corresponding amount of USD in the forward market.
- At the maturity of the forward contract, if the currency has increased (decreased) in value relative to CAD, the investor will be at a loss (gain) when they deliver the USD they have sold short to the counterparty.
- Any loss (gain) on the currency contract will be offset by a corresponding gain (loss) on the CAD value of the US bond.
- The effects of currency are being removed from the picture, resulting in pure exposure to the returns of the fixed income security.
The hedge-bond maturity mismatch
Currency hedged fixed income results in smooth pre-tax returns, but can result in lumpy after-tax returns. It is common to use one-month forward contracts to hedge currency exposure. In a bond fund, most securities will have maturities longer than one month. The result is a maturity mismatch between the hedge and the bond. If a bond is held for four years before it is sold, forty-eight forward contracts are required to hedge the currency exposure over the bond’s holding period. Each time a forward contract matures, the resulting gain (loss) is booked as a realized gain (loss) while the corresponding bond carries an unrealized loss (gain) until it is sold or matures.
Over the long-term, the currency related gains and losses will negate each other. It is the requirement for funds to annually distribute realized gains that makes the maturity mismatch noticeable to taxable investors. In years where there are net realized capital gains, the fund must make a taxable capital gains distribution. In years where there is a net realized capital loss, the fund carries the loss forward to offset future realized capital gains.
This perspective can be applied to the apparent trend of increasing tax efficiency in DFA231. The fund has mostly maintained a decreasing tax cost ratio for the past 10 years.
After-tax returns of DFA231
Source: Dimensional Fund Advisors Canada, CanadianPortfolioManagerBlog.com
The trend has been caused in part by fortunate timing of capital loss carry forward due to currency fluctuations. This effect occurred randomly, and cannot be counted on as a continued trend. It is still expected that DFA231 will maintain relative tax efficiency as it aims to hold low-coupon bonds in any environment, but the current level of tax efficiency is exceptional.
Taxable investors should take note of this effect as currency-hedged global fixed income products become more popular.