Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 273

The positive FX hedge returns have now gone

Not many investors realise that a decent chunk of their US equities and fixed-income performance over the last 20 years has come from the benefit of hedging, and had nothing to do with the assets' underlying returns.

According to CBA research, hedging your US shares or bonds into Aussie dollars increased your returns by 4% per annum over this period. That is to say, you were paid to hedge, rather than hedging imposing a cost. For lower yielding asset-classes like fixed income, this made a big difference to the realised outcomes.

Between 1999 and 2018, US treasury bonds yielded only 3%, but by hedging into Aussie dollars, the yield increased to 7% while also reducing realised volatility significantly.

Tailwind becomes a headwind

Now the big deal is that this tailwind, which reflected the fact that the RBA’s cash rate was historically situated well above the Fed’s cash rate, has reversed as the Fed has embarked on its hiking cycle.

The chart below shows precisely how this dynamic has changed since 2011. The lower black line is the annualised yield on a US treasury bond while the upper grey line shows the same asset hedged back into Aussie dollars. Observe that in 2011, a US treasury yielding 2.5% morphed into a nearly 7% yield for hedged Aussie investors. The red dotted line represents the benefit or cost from hedging at any point in time.

Click to enlarge

Whereas in 2011 local investors picked-up a return uplift of as much as 4.5% hedging US assets into Aussie dollars, that advantage has fallen away over time to the point now where the red dotted line is slightly negative. In 2018, a 2.94% yielding US treasury paid only 2.86% in Aussie dollars.

Understand the cost or benefit of a hedge

This comes back to the principle known as 'covered interest parity'. If you own a US asset and want to hedge it back into Aussie dollars, the cost will normally reflect the interest rate differential between the two countries for the relevant maturity. For example, if the RBA’s cash rate is above the Fed’s, you should receive additional returns and vice versa.

In practice this relationship can be distorted if there is excess demand or supply for either currency, which can generate a cross-currency 'basis' under which you receive or pay more for the hedge than covered interest parity would otherwise imply.

The Reserve Bank of Australia has been capitalising on this dynamic for years, hedging billions of dollars worth of Japanese government bonds into local currency. While the Japanese bonds have carried a negative yield, hedged into Aussie dollars they deliver a handsome return above many other government bonds because of both the local interest rate differentials and the attractive cross-currency basis the RBA has earned.

It becomes important to recognise this when undertaking long-term performance analysis. I recently saw a presentation for a new, predominantly US high-yield fund that contained historical yields and returns hedged into Aussie dollars over the last five years. The annual yield enhancement from hedging US dollars into our currency over this period was about 1.4%, which is no longer present.

With this benefit the US high yield product outperformed Aussie high yield by 1.3% in total return terms, albeit that US high yield had much higher volatility (4.7% versus 2.8%). But this might not be true going forward as the Fed’s cash rate has risen above the RBA’s equivalent.

Something that appears superficially attractive might be a hedging mirage that has subsequently evaporated. This is, of course, a generalised statement and one should evaluate every investment on its merits on a case-by-case basis and ideally seek the counsel of trusted advisers.

And it is not just about outright returns. Many asset classes, including US high yield, can play a valuable role in portfolios if they are less than perfectly correlated with your existing assets and therefore furnish diversification gains.

 

Christopher Joye is a Portfolio Manager with Coolabah Capital Investments, which invests in fixed income securities including those discussed by this article. This article does not address the individual circumstances of any investor.

 

RELATED ARTICLES

3 reasons the Aussie dollar has not collapsed

Rising interest rates and the impact on banks

The outlook for gold in a post COVID world

banner

Most viewed in recent weeks

Is it better to rent or own a home under the age pension?

With 62% of Australians aged 65 and over relying at least partially on the age pension, are they better off owning their home or renting? There is an extra pension asset allowance for those not owning a home.

Too many retirees miss out on this valuable super fund benefit

With 700 Australians retiring every day, retirement income solutions are more important than ever. Why do millions of retirees eligible for a more tax-efficient pension account hold money in accumulation?

Reece Birtles on selecting stocks for income in retirement

Equity investing comes with volatility that makes many retirees uncomfortable. A focus on income which is less volatile than share prices, and quality companies delivering robust earnings, offers more reassurance.

Is the fossil fuel narrative simply too convenient?

A fund manager argues it is immoral to deny poor countries access to relatively cheap energy from fossil fuels. Wealthy countries must recognise the transition is a multi-decade challenge and continue to invest.

Superannuation: a 30+ year journey but now stop fiddling

Few people have been closer to superannuation policy over the years than Noel Whittaker, especially when he established his eponymous financial planning business. He takes us on a quick guided tour.

Anton in 2006 v 2022, it's deja vu (all over again)

What was bothering markets in 2006? Try the end of cheap money, bond yields rising, high energy prices and record high commodity prices feeding inflation. Who says these are 'unprecedented' times? It's 2006 v 2022.

Latest Updates

Retirement

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, stay connected with friends and the community ... should you defer retirement or just do it?

Retirement

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

Interviews

Why short-termism is both a travesty and an opportunity

On any given day, whether the stockmarket rises or falls is a coin toss, but stay invested for 10 years and the odds are excellent. It's at times of market selloffs that opportunities present for long-term investors.

Investment strategies

Fear is good if you are not part of the herd

If you feel fear when the market loses its head, you become part of the herd. Develop habits to embrace the fear. Identify the cause, decide if you need to take action and own the result without looking back. 

No excuses: Plan now for recession

The signs of a coming recession are building, especially in the US. In personal and business decisions, it's time to be more conservative and engage in risk management until some of the uncertainty is resolved. 

Strategy

The fall of Volt Bank removes another bank competitor

The startup banks were supposed to challenge the lazy, oligopolistic major banks, but 86 400, Xinja and now Volt have gone. Why did Volt disappear so quickly when it had gained deposit support and name recognition?

Strategy

Three main challenges to online ads and ‘surveillance capitalism’

Surveillance capitalism refers to the collection and use of consumer data to further profits. Will a renewed focus on privacy change the online-ad business model, or is it too entrenched?

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.