In November 2023, I wrote a report on home bias in Canadian mutual funds. It examined how mutual funds and ETFs, on average, overweight their regional exposure to Canada and the consequences for doing so. For example, Canadian stocks have long lagged global stocks, so overweighting Canadian stocks was a bad decision. Yet when examining fixed income, I presented an answer that felt incomplete.
The Currency Hedging Conundrum
The ramification for home bias in bonds was conditional on currency hedging – the practice of neutralizing the returns someone receives from currency appreciation or depreciation. So long as the foreign bond content was currency hedged then the investor saw no significant benefit or cost to owning them over Canadian bonds. The difference in returns over ten years per $10,000 invested equates to less than $200.
However, both global and Canadian core balanced indexes are comprised of investment-grade securities only – the safer and bigger fixed-income sector comprised primarily of government debt. But that’s not the only sector fixed income and balanced managers can trade in. High-yield bonds represent another attractive asset class for managers – balanced funds held on average 11% of their bond sleeve in the sector as of this writing. More than nine in ten balanced funds held some level of high yield in their portfolios and more than two-fifths held more than 20% of their bond sleeves in high yield.
Currency Hedging and High Yield Don’t Mix
Due to limited issuance and opportunities in Canada, managers typically look to international markets (namely the U.S.) when trading high-yield bonds, so the question of whether home bias helped here is moot. Instead, currency hedging is the more prevalent question – whether hedging the currency of global high-yield bonds helped reduce volatility as it does with investment-grade bonds. I went back to the end of 1999 to understand the full picture.
The short answer is no. Hedging the currency on high-yield bonds often produced the opposite effect: it raised volatility, especially in extended equity market drawdowns. A ten-year rolling volatility comparison between the Morningstar Global High-Yield Bond index and its hedged version shows that hedging the currency exposure often led to higher levels of risk. This is the opposite case in the Morningstar Core Bond indexes studied in the initial report.
The large drop-off in risk seen above comes from the roll-off of one of the largest drawdowns in market history. The late 2008 market crash saw both the hedged and unhedged versions of the Morningstar Global High-Yield Bond index fall by over 20%. However, the unhedged version lost far less than the hedged version at their troughs – 26% and 39% respectively. History repeated itself in the much briefer 2020 market drop. Between January through March 2020, the unhedged version lost 7%. The hedged version lost 14%.
What Works for Investment-Grade Doesn’t Hold up with High-Yield
A brief look at historical performance in high yield returned some surprising results. Currency hedging heavily impacted the level of risk and return of global bonds over the last ten years, but the question of whether currency hedging provided a benefit depended on credit quality. If the bond is investment-grade, then hedging the currency exposure removed unwanted volatility of the Canadian Dollar’s performance. Conversely, if the bond is not investment grade, then hedging the currency exposure increased the level of risk, especially during large extended drawdowns caused by macroeconomic shocks like those seen in 2008 and 2020.
Pay Attention to Currency Hedging in Your Portfolios
With so many global fixed-income and balanced strategies, currency hedging and its ramifications remains a key, yet underrated mechanism to consider. As Canadian investors, we enjoy and suffer from fluctuations in the Canadian dollar, especially as it relates to how it does against the currency of our Southern neighbour. Understanding this relationship, how fund managers handle this relationship, and how it affects performance are all significant factors to consider when investing.
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