Does currency risk add value in the fixed income markets?

Q: Does currency risk add value in the fixed income markets?

A: As interest rates on high quality bonds have remained relatively low, some investors continue to search for ways to achieve higher returns in the fixed income markets. One strategy that has been in the news frequently is the idea of purchasing non-U.S. dollar denominated bonds. The thought behind this is that taking on currency risk could potentially increase the return of a bond portfolio. The fixed income desk has looked into this strategy extensively, and when isolating for currency risk, returns do not increase, but volatility increases significantly.

The data below illustrates that a portfolio’s risk-return profile does not improve when currency risk is introduced to fixed income. When examining 25 years of data on both the unhedged and hedged versions of the Barclays Global Aggregate Bond Index, returns were essentially the same, while volatility was 42% higher for the unhedged index due exclusively to the currency risk. This leads to a significantly lower Sharpe Ratio (measure of risk-adjusted return) on the index that was exposed to currency risk.

Bottom Line: Adding currency risk to a fixed income portfolio only serves to increase volatility while providing no additional returns. If clients wish to increase the expected return on their portfolios we recommend doing this in a more efficient way by either increasing their overall equity allocation, or tilting more towards small and value stocks.

Data supplied by Barclays. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. Total return includes reinvestment of dividends.

1. The Sharpe Ratio is a measure of the risk-adjusted return of an investment. A higher ratio indicates a greater return for a unit of risk. The Sharpe Ratio is calculated as the average annual portfolio return less the average annual risk-free rate (One-month T-bills) divided by the portfolio’s annualized standard deviation.

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