Investors who hedge their dollar bond holdings to euros do so at a huge cost: the interest rate differential in favour of the US dollar means euro investors often pay more than 100 basis points to hedge the greenback back to euros. Add to that the fact that the dollar has appreciated by 25% against the euro over the past three years, and this leaves a particularly sour taste.
But there is another, more intrinsic reason not to hedge all your fixed-income currency risk: excessive hedging will increase your so-called base currency risk. Ironically, risk-averse investors with large (currency-hedged) fixed-income holdings have the biggest exposure to base currency risk.
They are hit a lot harder in terms of lost purchasing power when their base currency devalues than investors with larger allocations to equities. This became clear after the UK’s Brexit referendum. UK equity investors were compensated for sterling’s devaluation by a rise in equity prices but bond investors were not.
Most European investors pay precious little attention to base currency risk, but just ask any investors from an emerging market country with an unstable currency about the impact a depreciating base currency can have on their purchasing power, and they will warn you.
After all, there is a good reason for the tradition among rich Russians to stock up on London property and other foreign assets: the Russian rouble is a highly volatile currency correlating strongly with the oil price.
A first consequence of a currency devaluation will be a hike in inflation, which was indeed observed in Russia after its currency lost more than half of its value against the dollar in the second half of 2014. The same is happening now in the UK, as the costs of imported goods increase following sterling’s fall after the Brexit referendum.
Inflation does not kick in right away; it’s a slower, less visible process. An investor’s base currency might have lost a lot of value on the international currency market while inflation-adjusted returns in the base currency still look reasonable. However, the portfolio may not have protected purchasing power in a context where an investor wants to buy international assets that are instantly priced higher because of the exchange rate.
For example, sterling investors may have realised handsome profits in their base currency in 2016. In dollar or euro terms, however, most investors will have lost money because of their sterling (-hedged) fixed income and cash holdings.
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