With euro-area bond yields hitting new lows, higher yields in US fixed income look increasingly tempting. But high hedging costs and a weak euro are enticing investors to leave US dollar exposure unhedged. In today’s environment, we think that’s a high-stakes gamble.
As growth forecasts have reduced across the eurozone, European bond yields have tumbled. The euro-area AAA government bond yield curve is now completely negative out to 30 years maturity, while the yield on the Bloomberg Barclays Euro Aggregate Bond Index is close to zero*. In this challenging environment, income investors are inevitably looking further afield for worthwhile yields.
While US bond yields may appear to be attractive, the cost of hedging US currency risk effectively wipes out their extra yield. Currently that cost is approaching 3%—leaving euro-area investors with negative yields on virtually any US investment-grade asset, net of hedging expenses.**
Meanwhile, the euro shows no sign of strengthening. Weak growth in the eurozone, combined with a new round of European Central Bank (ECB) asset purchases and the risk of a no-deal Brexit are all holding the euro back. So why hedge a currency risk that seems remote, when the rewards from unhedged US bond exposure look so juicy? How likely is it that currency fluctuations could wipe out a 3% yield from high-quality US bonds?
Unhedged Exposure Is Much More Volatile
Leaving currency unhedged adds volatility to an allocation. For example, the unhedged returns of the US Aggregate Bond Index are over three times riskier than the hedged returns (Display). In fact, the return pattern from the unhedged index behaves more like an equity investment than a bond investment. From a portfolio construction perspective, the heightened volatility of the unhedged return stream undermines the normal function of fixed income as a portfolio anchor.