Let’s consider USD as a foreign currency to simplify matters.
The cost of hedging USD into CHF is roughly equal to the difference in interest rates of USD and CHF.
In mid 2022 the difference in interest rates was 3%, and historically, CHF has appreciated over USD by 1,5% annually (source). Assuming these dummy figures, we lose 3-1,5 = 1,5% by hedging USD into CHF.
Here are the historical interest rates, excuse the rather sketchy plot:
When investors hedge bonds, they typically enter a currency forward—a binding contract between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a specific future date .
This gives you certainty of getting a certain amount of currency in the future. e.g. in your example, you will get X amount of CHF. Without the hedge, adverse movements in FX may mean you get fewer CHF than you expected at the outset.
@ProvidentRetriever Nice! Thanks for your answer.
The last part is especially interesting: do you have any source for the fact that over decades, hedging effects are negligible?
Or are you saying that hedging costs are negligible over the long run?
Exactly. If one is attracted by higher nominal returns from USD bonds vs. comparable CHF bonds - the discussion has come up several times on the forum - my personal view is you should ask oneself it is a case of too good to be true
Q) Suppose USD bonds are momentarily offering a higher return in CHF than it is possible to earn on CHF bonds, after applying forward interest rates
What will happen?
A) Market participants will act and the price of USD bonds and FX rate will move until the arbitrage opportunity closes
As I understand it (please correct me) interest rate parity theory implies that FX and interest rates are in an equilibrium set by supply and demand of market participants. It should not be possible to earn higher returns by investing in USD bonds in comparison to investing in CHF bonds of the same duration and with similar risk profile. Exception: if you believe you have better knowledge about FX rates than other participants in the market (which includes highly educated people working in big financial institutions) .
For private investors resident in Switzerland I believe you should even expect to earn LESS on an after tax basis by investing in USD bonds than comparable CHF bonds. Interest is taxable and capital losses due to FX loss is not. However as you say the number of issuers in CHF may be limited
Many interesting thoughts @ProvidentRetriever . Thinking about Bonds quite a lot as I feel it was time to (re) enter Bonds. At the moment, my conclusion is that for:
CHF Disaster Protection: If we feel super careful and want to insure against a CHF catastrophy, an Unhedged Global Aggregate Bond should do the trick, like: iShares Core Global Aggregate Bond UCITS ETF | AGGG
But this leads to a situation where my Bond Exposure requires a bunch of Products already, like e.g.:
40% SBI AAA-BBB: Up to the max exposure we want against CHF Creditors
25% Hedged Global Corp Bonds: To diversify onto Non-CHF Creditors
25% SBI AAA-AA: To offset the Global Corp Hedged with No Credit Risk Exposure
10% Unhedged Global Aggregate: To ensure we somewhat survive disastrous CHF Events
Overkill? Or how would you invest a sizeable Bonds Allocation?
Is the cost really not much lower for funds? E.g., if I look at USDCHF - U.S. Dollar/Swiss Franc Forex Forward Rates - Barchart.com, the spreads are not that large. With rolling 3-month forward contracts, it might be a cost of maybe 3bp p.a. over the mid price. While a retail investor might pay more, I wouldn’t expect funds to pay much more than that for hedging. Some hedged funds have an excessive TER but that’s an issue of particular funds, not a general cost of hedging. Or what am I missing or miscalculating?
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