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:
The higher rates are for USD (source).
It seems that the difference in interest rates has almost always been well over that the historical 1,5% appreciation of CHF over USD.
So, why would I want to drag down the return of a USD bond by as much as 1/1,5% with hedging into CHF?
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.
I think of it the other way around: Why expand the bond assets to issuers in other currencies?
Having bonds exposed mostly to CHF is a natural thing to do because the role of bonds in a portfolio is to dampen fluctuations, with low volatility and liquidity. For the growth part, I let the stocks do the job and rebalance regularly.
But the number of issuers in CHF is limited and this means a concentration risk. By expanding to USD, EUR and other currencies, I also expand to other governments and companies, which reduces that issuer concentration. Still, to preserve the CHF exposure, I hedge.
Hedging only protects against short term and middle term fluctuations. The graph above goes over 36 years, but on such large periods, the effect of hedging is negligible (the swap rates fully absorb the interest rate difference, and at that scale the evolution of the currencies is mostly the inflation difference: in real terms it’s a flat line).
@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?
You are welcome!
There are two well accepted theories in FX, and the fact that hedging is neutral in the longer term is only a consequence:
- Interest rate parity: real (inflation corrected) interest rates, in the long term, are the same for all (main) currencies
- Conversion rates follow purchase power parity in the long term
It’s important to distinguish between hedging effects and hedging costs. I’m only saying the effects are negligible (in the ideal case that a bank does it without billing any fees).
Hedging has a cost (usually around 70 to 80 basis points). The cost is not the same as the swap rates (which I don’t consider a cost because it’s just the markets) but it is really the fee (via swap rate spreads) that the banks take in order to hedge you. Hedged ETFs may get better deals though (with swap rates closer to the markets) but it’s difficult to know how much they pay.
So if you take into account costs, overall hedging is a loss in the very long term, but this is the price to pay to avoid short term fluctuations and keep the liquidity available at all times (otherwise you can get stuck in a period in which a currency is undervalued, and this can sometimes last many years until it reverts to equilibrium).
I found for example this page, but it’s probably also explained in many other places:
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
Yes, I agree. And even though it’s only a theory and not exact, I don’t think we retail investors can benefit from any distortions of the market compared to the big institutions. The only advantage we have is we invest our own money, so we don’t get outside pressure to sell in bear markets.
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:
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?
I have 2 portions:
- Speculative bonds
- ‘Dry powder’
Dry powder is almost entirely in BIL, XBIL ETFs. I did venture briefly into longer duration (TLT) and got lucky with timing and took profits.
Speculative portion are directly held corporate bonds e.g. Coinbase, MPW.
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?
If you are categorised as a professional investor (>2M assets) and want to invest a larger amount (>1M) in only one fund with a short duration, I like Pictet CH - CHF Short Mid Term Bonds (https://am.pictet/en/switzerland/intermediary/funds/pictet-ch-chf-short-mid-term-bonds/CH0016426881#overview). Pretty cheap for an actively managed fund (0.16%), but the BBB part is relatively large, so that depends on your risk profile.
Puh 1M in 1-3 years bonds is a very bigbthreshold. Doubt I would ever pass it
You’re not missing anything, I also believe funds get much better deals. I was talking about the costs for directly hedging, for example with forward and swap contracts with the bank.
And personally, I do hedge my bonds not denominated in CHF.
You didn’t mention the following ETF from ishares focused on Swiss corporate issuers.
iShares Core CHF Corporate Bond (CH)
Is there a reason why you would prefer Credit Suisse fund over this ishares ETF? Or you believe they are comparable?