Turning a Negative Into a Positive: Finding Yield Where There Is None Through Currency Hedging
Author: AGF Fixed Income Team
November 6, 2019
The amount of negative-yielding debt has been piling up so far this year and could reach new highs if central banks around the world continue to cut interest rates and ease monetary policy further in the coming months.
But that doesn’t mean investors should be resigned to a growing pool of bonds with yields that necessarily earn less than nothing. In fact, with the right currency hedging strategy in place, many of today’s negative rates can still result in positive returns.
This is particularly true of those hedging back to the currency of a country that has a domestic bond market with a favourable interest rate differential compared to another nation’s bond market.
Take for example, the scenario of a Canadian investor who is considering the purchase of a German bund. A euro-denominated 10-year bund yields around -0.40% , while the yield on a Canadian-dollar-denominated Canada 10-year bond is closer to 1.5%. Because this differential is expressed in the foreign exchange market between the two currencies, it’s possible for this investor to buy the 10-year German bund hedged back to Canadian dollars and earn around 1.9% (calculated based on a 3-month F/X forward contract).
In other words, the investor would earn more from a bond, which on the surface is earning a negative yield, than they would by simply owning the Canada 10-year bond equivalent in their home currency. And this isn’t an isolated case. The same shift from negative to positive yield would also be true to varying degrees for an investor who hedged the same German bund in U.S. dollars or the currency of any other nation boasting a favourable—and sufficient enough—interest rate differential.
Of course, this works in reverse as well. A U.S. 10-year Treasury, which yields roughly 1.7%, would earn only 1.4% for an investor who hedged it back in Canadian dollars because of the extent the interest rate differential is currently in favour of the U.S. Treasury market over Canada’s.
It’s also important to remember that interest rate differentials are constantly changing and won’t always work in the same favour or to the same degree as they may have previously. U.S. Treasury rates, for instance, could fall from current levels and close the gap with other countries if the U.S. Federal Reserve cuts rates further.
Ultimately, a currency hedging strategy that takes these differentials into account can help investors navigate today’s bond market and even find yield where it seems there is none.
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