You can't talk about currency hedging in bond funds without first touching on the merits of investing in bonds issued outside Canadian borders. Compared to the rest of the world, the investment universe of bonds in Canada is very small, and stable cash-flow-generating bond issuers are concentrated in a few sectors. Investing in outside Canada broadens Canadians' opportunity set.
Investing only in Canada exposes investors to the actions of a single government or central bank. Investing across countries diversifies that exposure. There's also the potential of earning higher interest by investing in bonds of other countries where yield may be more attractive.
Impact of currencies on global stocks versus global bonds
Global stocks and bonds are denominated in currencies other than the Canadian dollar. This means that, along with fluctuations in the prices of those stocks and bonds, Canadian investors will face fluctuations in the value of currencies in which these assets are denominated. Compared to stocks, bonds are seen as lower-risk investments, and their volatility has borne that out. ( Click here to read Salman Ahmed's article on hedging for equity funds.)
Looking back, the annualized volatility of the Citi World Government Bond Index with foreign currency exposure has been 150% to 300% higher than the version where the foreign currency exposure is hedged. However, the results are opposite for global stocks, where the volatility of the MSCI World with foreign currency exposure has been 20% to 33% lower than its hedged version. The tables below indicate that currency exposure has reduced volatility for global stocks but not for global bonds.
| Volatility (standard deviation) of global bonds | |||||
| 1 Year | 5 Year | 10 Year | |||
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| Citi WGBI (Global bonds - unhedged) | 7.29 | 9.10 | 10.66 | ||
| Citi WGBI (Global bonds - hedged) | 2.98 | 2.65 | 2.83 | ||
| DEX Universe (Canadian bonds) | 4.10 | 3.27 | 3.31 | ||
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| Volatility (standard deviation) of global stocks | |||||
| 1 Year | 5 Year | 10 Year | |||
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| MSCI World CAD (Global stocks unhedged) | 6.34 | 9.27 | 11.26 | ||
| MSCI World LCL (Global stocks hedged) | 9.47 | 12.64 | 14.10 | ||
| S&P TSX Composite | 7.34 | 11.56 | 13.81 | ||
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The argument can be made that currency impacts returns on the short term but that over the long term this impact washes out because of diversification. But that argument is more applicable to equities than bonds. Bonds and currencies are driven by many common factors like government policies and interest rates, which make diversification difficult when investing in foreign bonds. The returns of equities on the other hand are driven by numerous factors that may or may not share commonalities with currencies.
Can currency hedging add value for bonds?
Fully hedged global bond funds have less uncertainty associated with expected returns because a large factor that impacts returns has been effectively eliminated. However, the return and risk characteristics of these funds will be closer to domestic bond funds as the cost of hedging is partially based on interest rate differentials between two countries. Over the last 10 years, the correlation between the DEX Universe Bond Index and the hedged Citi WGBI has been 70% higher than the correlation between the DEX and the un-hedged Citi WGBI. Hence, it may be argued that hedging undermines the rationale behind investing in global bonds for diversification.
However, the fact remains that investing in global bonds gives investors access to a deeper market of bonds, and hedging currency risk helps investors isolate and exploit other sources of risk like sovereign risk and credit risk.
Options for investors
Some global bond funds come in hedged and unhedged versions, and the volatility of these versions can be significantly different. As an example, Fidelity Global Bond has a version that is fully hedged and one that maintains the same currency exposure as its benchmark 
versions. Over the past five years to April 30, 2014, the volatility for the unhedged Fidelity Global Bond has been 7.9%, while the volatility of the currency neutral version has been 2.9%.
Templeton Global Bond , which actively manages its currency exposure, has generated risk-adjusted returns that fall between the hedged and unhedged versions of Fidelity Global Bond. Although the hedged version of Fidelity Global Bond offered investors the best return for the level of volatility among these three global bond funds, it hasn't outperformed the DEX Universe Bond Index on a risk-adjusted basis.
| Risk-adjusted returns (Risk measured by standard deviation) | |||||
| 5-Yr Return | 5-Yr Risk | 5-Yr Risk-Adj. Return | |||
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| Templeton Global Bond | 8.07% | 8.38% | 0.96 | ||
| Fidelity Global Bond – Hedged | 4.41% | 2.91% | 1.52 | ||
| Fidelity Global Bond | 3.27% | 7.89% | 0.41 | ||
| Barclays Global Aggregate | 4.35% | 7.82% | 0.56 | ||
| DEX Universe Bond Index | 5.43% | 3.28% | 1.67 | ||
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| Data as of April 30, 2014. | |||||
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Conclusion
Investing in any fund depends on an investor's risk tolerance level. But investors should always account for how a fund will interact with their overall portfolio. When choosing between hedging and unhedged global bond funds, investors need to remember the trade-offs.
Hedged strategies will have a lower level of uncertainty because you're getting rid of one of the drivers of volatility -- currency return. However, they can also have higher correlations to domestic bonds than unhedged strategies. This limits the diversification potential and may make hedged strategies less attractive when building an overall portfolio.
On the other hand, unhedged global bond funds can exhibit higher volatility, but their lower correlation with other asset classes can help build more diversified portfolios and may even lower the volatility of an overall portfolio. Between these two, hedging simply gives investors the option to choose what risk they want to take on.
Historically, the diversification benefits of unhedged global bonds have not been strong enough to compensate for their higher volatility. A hypothetical portfolio of Canadian bonds (represented by the DEX) and hedged global bonds (Hedged Citi WGBI) did better on a risk-adjusted basis than a portfolio of Canadian bonds and unhedged global bonds (Unhedged Citi WGBI). The risk-return profile improved with progressively higher allocations to hedged global bonds.
| 10-Year Returns of a hypothetical portfolio of Canadian and Global bonds | |||||
| Return | Standard Deviation |
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| 10% Global Bonds (Hedged) | 5.3% | 3.2% | |||
| 10% Global Bonds (Unhedged) | 5.1% | 3.6% | |||
| 25% Global Bonds (Hedged) | 5.2% | 3.1% | |||
| 25% Global Bonds (Unhedged) | 4.7% | 4.4% | |||
| 50% Global Bonds (Hedged) | 5.0% | 2.9% | |||
| 50% Global Bonds (Unhedged) | 4.0% | 6.2% | |||
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Strategies that make calls on the direction of currencies, like Templeton Global Bond, are a different beast altogether. With funds like these, it's necessary to understand whether the manager can add to risk-adjusted returns by making the right currency decisions. Getting these decisions right or wrong can have a significant impact on returns and volatility and will determine the fund's likelihood of success or failure.
