Currency basis: Hardly small change

Have you ever considered how much money you lose down the back of your sofa each year, or how much you save by using retailers’ coupons? Probably not very often; small change accounting isn’t regarded as a good use of our time.

Most investors treat the cost of currency hedging (or in market speak, ‘currency basis’) in much the same way. The issue is - the actual cost is no longer the equivalent of losing the odd bit of loose change.

A foreign asset can look attractive because of its risk premium (the return in excess of the risk-free rate), but the cost of hedging that asset might well be larger than that risk premium, leaving the investor with a net loss. That is why assessing and managing the cost of hedging can have a material impact on a portfolio.

How currency basis works

When investors buy assets in a foreign currency, for example government bonds, it often makes sense to hedge the currency risk back to their home currency. The reason, at least in theory, is that the exchange rate will have a disproportionately higher volatility (usually 7-20%) that is not compensated for by higher returns. For bonds and other asset classes with lower volatility (typically 3-6%), this difference may seem disproportionate - the additional risk could easily swamp the portfolio.

The usual approach to hedging out the currency risk is to purchase a currency forward. Theoretically, the price of the currency forward should be the difference between the risk free rates in each currency region; otherwise there would be an obvious arbitrage opportunity.

However, in practice this isn’t the case. This difference between the actual price of the currency forward and its theoretical price is called currency basis.

Chart 1 illustrates this. It shows the 12-month currency basis for the yen, the euro and the pound against the dollar. Over the past five years, the currency basis against the dollar has largely been negative for all three, averaging 8 basis points for the pound, 25 basis points for the euro and 40 basis points for the yen. This means that when a European investor buys a dollar asset and hedges it back into euros, there is an average additional cost of 25 basis points. At the extreme, the cost can be considerably larger.

However, one investor’s loss is another’s gain. For a dollar-based investor, hedged investments come with the equal and opposite kicker; those 25 basis points are their gain.

One year currency basis versus the US dollar, in basis points. Source: Bloomberg, Fidelity International, February 2018.

Watch out for crises

Why does this happen? And are basis developments predictable? We think there are two main drivers for currency basis:

• Crises - Currency basis can change materially when crises occur. Chart 1 shows the dramatic response of euro basis swaps during the European crisis of 2011-12. Concerns about the strength of the currency union triggered a move out of euro-denominated assets and foreign investors sought to hedge their exposure to the euro.This unusually strong demand for hedging instruments pushed up their cost.
• Relative interest rate conditions - In normal times, it’s the stable interaction of financial markets that guides currency basis. In 2016, for example, higher interest rates in the US raised the cost of basis swaps in other currencies. (Chart 1). But the relationship is not straightforward: it isn’t simply the differential in current interest rates that determines currency basis, but the change in the implied interest rates (the rates that are implied by the difference between the spot and forward exchange rates) - that guides basis pricing. Basis prices also often move when companies issue bonds in foreign currencies, as the future cash flows of such bonds are often hedged back into the domestic currency.

When to consider currency basis

If currency hedging can indeed be costly, the question is how and when investors should consider currency basis. Our view is that it should be thought of both strategically and tactically.

Over the long term, currency basis is relatively persistent. It’s fair to say that investors whose home currency is the yen can expect the cost of currency basis to remain negative over the next ten years. (The average currency basis since 2012 would serve as a reasonable estimate for this.) If they are building a portfolio for the next ten years and using an expected returns/risk framework, any hedged foreign investment returns should be discounted by the basis costs.

Tactically, when considering bonds in different currencies, the basis cost should also be included. If the currency basis is not considered, there is currently a small pickup in the yield available for euro-based investors in US corporate bonds. However, when the currency basis is taken into account, the yield on offer is in fact below that of the domestic.

Conclusion

In short, currency basis matters. It is easy to overlook, like coins down the back of the sofa, but it should form part of the investment decision for all global investors, both tactically and strategically. If it’s not taken into account, the investment’s return might not meet expectations. That premium that was meant to be the yield hunter’s trophy could then, quite possibly, morph into an unwelcome loss.