08 July 2014 | Investing

At $29 trillion 1. international bonds represent the worlds largest asset class, but investors considering international bonds for their portfolios must be aware of the effects of currency fluctuations.

Currency fluctuations account for as much as two-thirds of the volatility of the total return of international bonds, making them act more like stocks. Currency risk arises when an investors home-based currency is different from the currency denomination of the bonds he or she holds. Movement in exchange rates can have positive or negative effects on the bonds investment returns.

To minimize the volatility associated with currency risk, Vanguard Investments Canada Inc. hedges currency exposure in its new U.S. and international fixed income ETFs: Vanguard U.S. Aggregate Bond Index ETF (CAD-hedged) and Vanguard Global ex-U.S. Aggregate Bond Index ETF (CAD-hedged) .

Currency-hedged ETFs reflect more closely the performance of international bonds in their local currencies, without the daily ups and downs of exchange rates that would be associated with converting that performance into Canadian dollars.

Hedging reduces risk

In investing, a hedge is simply a form of protection from the effects of a transactionwhether gains or lossesby taking a position in one type of investment to offset the risk of another security, less the execution cost of employing the hedge.

Vanguard research  shows that keeping currency fluctuations to a minimum can provide international bond investors with the benefits of diversification over the long term. Thats because interest-rate and inflation patterns in Canada differ from those in the United States, Japan, Germany and other international bond markets. Those differences cause non-Canadian bond markets to behave differently than the domestic bond market.

Hedging largely removes currency movements from the risks associated with international fixed income investing. Trying to profit from currency movements has proven to be a challenging if not fruitless endeavour for many investors said Christopher Philips, senior analyst at Vanguard. Our research has shown that unhedged international bonds have actually increased the risk of a portfolio over most time periods and countries we studied.

When it comes to investing in a basket of international fixed income securities, you face the prospect of buying a basket of currencies when you choose an unhedged investment fund. Youre taking on what we call uncompensated risk, Philips said. We just dont see tremendous value added from carrying an explicit currency position in a portfolio.

Vanguards hedging strategy

With its CAD-hedged bond ETFs, Vanguard Investments Canada addresses currency risk by using a hedging strategy that involves entering into one-month currency exchange contracts that essentially take the opposite position of the unhedged currency. At the end of the month, when the underlying index rebalances, the contracts are rolled forward to the next month.

Two distinct risks can accompany this type of hedging strategy. First, the ETFs performance may deviate from its benchmark index. Vanguard anticipates that risk to be minimal because we strictly follow the index currency hedging methodology of Barclays, which provides the benchmarks the new ETFs track.

Second, the forward contract may fail to fully hedge the movement of the underlying currency. The purchase of a forward contract locks in a currency exchange rate at a specific date in the future. Because currencies appreciate or depreciate against one another every day, the contract may result in the investment being over- or under-hedged at the end of the month. By following the Barclays methodology, Vanguard can mitigate any resulting foreign currency exposure by rolling forward and adjusting its hedging position each month.

No hedging strategy is perfect. Still, Vanguard has minimized currency risk by using this same hedging strategy since 2008.

All currency hedging involves cost, and those costs can vary depending on the currency being hedged, the types of hedging instruments used and the term of the contract. Vanguard keeps hedging costs to a minimum by trading in the most liquid currencies. Plus, hedging costs have declined over the last decade as technology has opened up international bond markets, making them more transparent and accessible to investors.

Letting bonds be bonds

Vanguard views currency hedging as a prudent way to reduce risk when investing in international bonds. The strategy helps protect foreign bond investments from falling in value whenever the Canadian dollar strengthens. Of course, if the Canadian dollar declines, the opposite will happen and the strategy will offset some of the gains the ETF otherwise would have realized.

By removing currency risk, Vanguard lets international bonds perform as bonds. With ETFs hedged to the Canadian dollar, investors in Canada can isolate the interest rate and credit risks and maximize the diversification benefit that international bonds bring to their portfolio.

Once currency exposure is reduced, Canadian investors in international bonds can benefit more fully from what bonds have typically providedlower volatility and diversification for the riskier assets in a portfolio, Philips said. (Diversification does not ensure a profit or protect against a loss in a declining market.)

1 Source: Vanguard calculations using Barclays indexes. The value represents the market value of international bonds, excluding the U.S. and Canadian bond markets as of March 31, 2014.

Notes: 

All investments are subject to risk. While Vanguard ETFs are designed to be as diversified as the original indexes they seek to track and can provide greater diversification than an individual investor may achieve independently, any given ETF may not be a diversified investment.

Investments in bond funds are subject to interest rate, credit, and inflation risk. Foreign investing involves additional risks, including currency fluctuations and political uncertainty.

Unlike mutual funds, there are no sales loads on Vanguard ETFs. ETFs are priced continuously and bought and sold throughout the day in the secondary market (at a premium or discount to NAV) which entails paying additional costs, such as commissions and bid/ask spreads.