LDI newsletter – Cross-Currency Basis

FOR PROFESSIONAL CLIENTS / QUALIFIED INVESTORS ONLY

In this edition we explore:
The ‘hidden’ cost of hedging the currency risk of overseas bonds

1. Introducing the cross-currency basis
2. Why does the cross-currency basis exist, and what drives it?
3. Current and historic cross-currency basis levels for various hedge tenors
4. FX forwards vs. cross-currency swaps
5. Implications for LDI investors

1. Introducing the cross-currency basis

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

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.

2. Why does the cross-currency basis exist, and what drives it?

There are three major supply and demand forces that drive the cross-currency basis:

• Foreign asset purchases: Investors buying overseas bonds and using a cross-currency swap to hedge FX risk
• Corporate issuance: Corporates issuing debt in an overseas currency and using a cross-currency swap to hedge the FX risk
• Corporate treasury currency management: For example, corporates hedging FX risk from foreign currency revenue streams

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

3. Current and historic cross-currency basis levels for various hedge tenors

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)

Chart 4 – GBP vs. EUR cross-currency basis over the last 5 years (1-year, 5-year and 10-year terms)

From these charts we make a few general observations:

• The size of the basis can be significant and it should not be ignored
• The size of the basis can vary considerably depending on the term of the hedge
• Today, a UK investor would gain on the cross-currency basis hedging both USD (0.05%-0.15% p.a.) and EUR bonds (0.20%-0.30% p.a.) back to GBP (all else equal)
  • Just a year ago, a UK investor would have paid10%-0.20% p.a. on the cross-currency basis to hedge USD bonds to GBP

4. FX forwards vs. cross-currency swaps

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:

• Basis level: As the charts above show, the basis varies depending on the term of the hedge. The shorter-term basis (e.g. 1-year in the chart) has generally been lower than the basis for 5-year and 10-year swaps, meaning a higher cost of hedging when the basis has been negative and a lower gain from hedging when it has been positive. Although there is no guarantee that this trend will continue in the future.
• Roll risk: FX forwards introduce ‘roll risk’, as the basis loss/gain changes each time the hedge contract expires and is rolled. The changing basis could move in favour as well as against the investor. Using a longer-term swap fixes the basis for the term of the swap.
  • A GBP investor hedging USD assets choosing a 5-year cross-currency swap 5 years ago (to the end of September 2018) would have locked in a basis of c.-0.085% p.a. If instead they rolled 3-month FX forwards over the same period, they would have experienced an average basis of -0.074% p.a.
• Flexibility: FX forwards are more flexible, as they offer a natural roll point at which the size or term of the hedge can easily be amended, or the hedge can be exited entirely. This flexibility might be valuable if, for example, a UK pension scheme expects to transact a buy-in or buy-out of their liabilities with an insurer.
• Liquidity: 3-month FX forwards are the most liquid market for FX hedging, and so trading costs tend to be lower using these instruments vs. more tailored longer-term swaps.

5. Implications for LDI investors

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

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.