William J. Bernstein
The Forward Currency Premium
Have you ever wondered why anyone buys Japanese bonds? Consider that the 30-year Japanese government bond yields only 2.25%, and that the 6-month security yield is nearly zero (0.064%). Who invests in this stuff?
Actually, lots of smart foreigners do. Hereís why; consider that yen-denominated bonds can easily be hedged back to US dollars by "selling forward" yen futures contracts. Since the futures contract value moves in exactly the opposite direction of the currency portion of the yen-denominated bonds, what we now have is a dollar-denominated security. So what, you say? Itís still got a miserable yield.
Wrong. Since the futures contract youíre selling forward has a higher value than the spot currency rate, youíre actually being paid to hedge the yen. For example, as of January 28 the spot value of the yen was $0.009335, the March futures contract $0.009405, and the June contract $0.009562. So if the spot rate stays the same, youíll make a profit that amounts to about 6.8% per year. If the yen falls/rises youíll make a profit/loss which exactly counterbalances the currency loss/profit in the amount of your bond. So no matter what happens to the yen your Japanese 6-month security will yield 6.80% + 0.0624% = 6.8624%.
Letís take a look at the calculus for US, German, Japanese, and UK 6-month hedged government bonds:
As you can see, the hedged investor in Japanese government paper actually makes a higher return than the US bill buyer. (I calculated the annual forward premium as the annualized difference between the March and June contracts. Slightly different values are obtained depending upon where one takes the "sampling points." And, if the bond and the currency contract have the same maturity/expiration date, the return should be the same as that of the US security.) There is a similar, but smaller phenomenon affecting the mark, and forward pound rates are about the same as the spot rates.
So, there really is no free lunch hereóthe annualized forward premium is in fact calculated from the difference in risk-adjusted interest rates.
Hedged bonds represent the simplest case, then, where the hedged foreign security should have the same risk-adjusted return as domestic bonds.
But what of the other 3 possibilities: unhedged foreign bonds, hedged foreign stocks, and unhedged foreign stocks? Here things become much stickier.
Letís first consider the 6-month Japanese bill with its puny yield. What the forward currency rate seems to be saying is "Donít worry. In 6 monthís time the yen will appreciate by 3.37% (6.85% annualized), so youíll make up for the lousy yield with currency appreciation." Thereís only one problemóit likely will not happen. It turns out that forward rates are not predictive of future spot rates. Interestingly, some of this work was done by none other than Gene Fama. If this isnít an inefficiency, then Iím Frank Lloyd Wright. Think about it. If the direction of the value of the yen in 6 monthís time is not predictable, then its expected value in 6 months is todayís value. And if thatís the case, then the unhedged bond has an expected return of 0.064%, and the naked currency hedge (that is, a hedge unaccompanied by a yen-denominated asset) has an expected return of 6.85% per year. The hedge return is not riskless, of courseóthe yen is a notoriously volatile currency, and you could easily have your head handed to you. But clearly, owning the unhedged bond is a lousy idea, with a minuscule expected return and enormous currency risk.
So what does this mean to the global bond investor? Basically this; hedge those currencies with low yields and positive expected hedge returns, and do not hedge those currencies with high yields and negative expected hedge returns. Since at the present time the US has about the highest (except for the UK) interest rates in the developed world, this means completely hedging most global bond portfolios. Unfortunately for small investors, there are precious few hedged global or international bond portfolios that have reasonable expense ratios. The DFA 2-year and 5-year global portfolios have expenses of 0.29% and 0.41%, but require you to use a qualified financial advisor. The Standish International Fixed Income Fund has 0.53% expenses but high minimumsóeither $100,000 for direct accounts or $10,000 for supermarket purchases associated with a transaction fee.
With stocks things are even stickier. Since there is no relationship between stock returns and forward currency rates why not hedge your entire portfolio and collect the forward premium? Because there are no hedged indexed international stock funds. Period. So if you want a hedged international stock portfolio youíll have to go with an actively managed international fund with its higher fees and trading costs. And, as weíve discussed before in these pages a little bit of foreign currency in your portfolio is often the only item with a positive return in a global bloodbath, as occurred in 1973-4, 1987, 1990, and 1994. Still, if you must have hedged international stock exposure the Tweedy Browne Global Value Fund is not a bad choice.
So, at the end of the day, youíre stuck. Yes, in todayís global interest rate environment it pays to hedge your foreign stock and bond exposure. There just arenít any decent vehicles available to the independently-minded small investor. And in the long-term, it seems quite likely that the global yield gap will narrow, resulting in a falling dollar. In which case youíll be glad you didnít hedge in the first place.
Copyright © 2000, William J. Bernstein. All rights reserved.