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FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY
In this edition we explore:
The ‘hidden’ cost of hedging the currency risk of overseas bonds
In our previous LDI Newsletter we highlighted the risks that LDI investors are exposed to when they invest in overseas bonds, namely currency (“FX”) risk and overseas rates risk. We explained why we believe LDI investors should consider managing these risks using derivatives, and how this can be done using overseas interest rate swaps to manage the overseas rates risk and either cross-currency swaps or FX forwards to manage the FX risk. In this Newsletter we focus on the practical implications and ‘hidden’ costs of hedging FX risk using cross-currency swaps or FX forwards.
How cross-currency swaps and FX forwards work
A cross-currency swap is an agreement between two parties to simultaneously borrow cash in one currency and lend cash in another. The period, interest rates in both currencies and FX rate between the two currencies are pre-agreed at the outset. An FX forward is simply a short-term (usually 1-year or less) cross-currency swap with no periodic interest payments. The only payments on an FX forward are the exchanges of cash amounts at the outset and at the end of the period, with interest payments over the period applied to each cash amount returned at the end. An FX hedge could be constructed either with a longer-term cross-currency swap to broadly match the maturity of the overseas bonds, or with shorter-term FX forward contracts that are renewed (or “rolled”) at each FX contract maturity date until the maturity of the overseas bonds. We compare each of these hedging approaches later in this Newsletter.
Because the FX rate is contractually agreed in advance, these instruments can be used to remove exposure to changes in the value of an overseas asset caused by changes in the FX rate between the overseas currency and the investor’s local currency.
The chart below illustrates this by showing the cashflows on an example cross-currency swap, used to remove FX risk on USD 130m worth of overseas assets. The agreed FX rate, denoted S, is the same at outset and end of the contract.
Chart 1: Cashflows on an illustrative cross-currency swap
Source: BlackRock, October 2018. For illustrative purposes only.
If a UK LDI investor owned USD 130m worth of US bonds, this swap would provide a hedge against changes in the value of the bond to the investor due to changes in the FX rate. For example, if USD weakened against GBP, and the FX rate rose from 1.3 USD per GBP to 1.4, the value of the USD bond will fall by c. £7m to £93m ($130m / 1.4, assuming the underlying value in USD is unchanged). Since the swap holder is contractually entitled to an FX rate of 1.3, which is better than the market rate of 1.4, the value of the swap will rise by the same amount as the bond falls because the size of the cash exchanged in the swap is the same as the bond market value ($130m).
The cross-currency basis
Like in other markets, prices in the cross-currency swap market are impacted by supply and demand. In this case, the relative supply and demand of the currencies involved impact prices, and changes in price are reflected in the interest rate that each party is willing to pay the other. The market convention is for this adjustment, called the ‘cross-currency basis’, to be expressed for each currency relative to USD and as a percentage adjustment to the interest rate paid on the non-USD currency. This has been denoted by X in Chart 1 above.
For example, if USD was in higher demand than GBP then it should be more expensive to borrow USD than GBP. So, the LDI investor in Chart 1 should expect to 'pay a premium’ as the borrower of USD vs. GBP. This would be reflected by the cross-currency basis, X, being a negative number; the LDI investor would have to pay USD LIBOR interest yet receive interest at a rate lower than GBP LIBOR in return.
There are three major supply and demand forces that drive the cross-currency basis:
The level of the cross-currency basis at longer tenors (beyond 3-5 years) for a given pair of currencies is driven mainly by the relative overseas asset buying vs. overseas corporate issuance between the two currencies. Corporate treasury activity tends to dominate the basis at shorter tenors (up to 3-5 years).
As we saw in the previous section and in the last LDI newsletter, FX derivatives can be used to hedge the currency risk of USD bonds. Through cross-currency swaps or FX forwards, UK investors effectively borrow in USD to purchase USD bonds and swap those cashflows back to GBP. Therefore, foreign asset purchases increase demand for the overseas currency relative to the domestic currency.
Corporate issuance has the opposite effect, increasing demand for the domestic currency relative to the overseas currency.
To illustrate the process of a corporate issuing overseas bonds, Chart 2 sets out the steps required to transform USD debt issued by a GBP corporate using derivatives into domestic currency debt (thus removing FX risk). The steps required are similar, but opposite, to the steps set out to hedge overseas bonds in the previous Newsletter.
Chart 2: Transforming a corporate bond issued in an overseas currency into domestic currency debt using swaps
Source: BlackRock, October 2018. For illustrative purposes only.
Charts 3 and 4 below plot the cross-currency basis over time from the perspective of a UK investor hedging USD or EUR bonds respectively back to GBP. Each chart shows the basis level, or cost of hedging for a 1-year, 5-year and 10-year cross-currency hedge.
Chart 3 – GBP vs. USD cross-currency basis over the last 5 years (1-year, 5-year and 10-year tenors)
Source: Bloomberg, October 2018. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.
Chart 4 – GBP vs. EUR cross-currency basis over the last 5 years (1-year, 5-year and 10-year terms)
Source: Bloomberg, October 2018. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.
From these charts we make a few general observations:
As mentioned earlier, an overseas bond holding could be hedged using either a cross-currency swap with a term in line with the bond, or by using shorter-term (usually 3-month) FX forwards and rolling the contracts every 3 months to maintain the hedge. Both are valid approaches, and when deciding which is more appropriate an investor should consider:
Allowing for the cost of currency hedging when assessing overseas bonds
The illustrative examples below demonstrate the importance of factoring in the cross-currency basis, comparing market data a year ago and today. The cross-currency basis adjustment can have a material impact on the effective credit spread received by investing overseas, after hedging.
From Table 1, comparing USD to GBP credit spreads today vs. a year ago and ignoring the cost of hedging, one might conclude that USD credit has become more expensive than GBP credit to a UK investor since the credit spread difference has increased (from 0.12% to 0.29%). However, once the cost of hedging is factored in, in Table 2, we might instead conclude that USD credit has gotten marginally cheaper to a UK investor, since the spread difference adjusted for the cross-currency basis has decreased (from 0.22% to 0.19%).
Table 1: Comparing GBP vs. USD credit, September 2018 vs. September 2017 – Ignoring the cost of hedging
Table 2: Comparing GBP vs. USD credit, September 2018 vs. September 2017 – Including the cost of hedging
Source: BlackRock, Bloomberg, data as at September 2018. All % spreads are annualised. The credit spread in each currency represents the yield pick-up above domestic LIBOR. Bank of America Merrill Lynch 5-10-year US and Sterling Corporate Indices were used as representative credit market indices. The cross-currency basis level is taken to be the average of the 5-year and 10-year level, approximately in line with the duration of the representative credit indices. In practice, allowing for currency hedging when assessing overseas bonds can be complex, as several factors need be accounted for such as the duration of the bonds and swaps used, interest rate differences between the two currencies, transaction costs and relative liquidity and credit quality.
Conclusion
LDI investors assessing the relative value of overseas bonds versus GBP bonds should factor in the cross-currency basis, as a cost (or benefit) of hedging, to make an accurate assessment of relative credit spreads. The instrument used to hedge, cross-currency swaps or FX forwards, will impact this cost, although there are several other considerations when deciding which instrument is most appropriate. An LDI manager with expertise in global credit markets and derivative risk management can make these assessments when managing global credit portfolios as a part of an integrated UK LDI program.