Time to Hedge USD in EM Local Currency Bond Exposure

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Insights
Fixed Income
                        Time to Hedge USD in EM
Q1 2021                 Local Currency Bond Exposure
                        James Binny
                        Global Head of Currency
                        State Street Global Advisors

                        Mandy Chiu, CFA
                        Head of EMEA/APAC SPDR Product
                        SPDR ETFs

                        Simon Hutcheson, CFA
                        Senior Product Developer
                        SPDR ETFs

                        • Given that currency can contribute significantly to
                          the risk of emerging market local currency bonds,
                          investors need to consider whether or not to hedge
                          their currency exposure.
                        • It is possible accept the exposure to undervalued
                          emerging market currencies while removing the
                          exposure to US dollar.

Currency                Currency represents a substantial amount of the risk in emerging market local currency
Considerations for      bonds. For instance, since 2010, the historical volatility of the Barclays Bloomberg EM Local
                        Currency Liquid Index has been 10.6%. The volatility of the currency component alone is 7.2%,
Investors in Emerging
                        so over 67% of the risk can be due to currency.1 This means that accepting or removing the
Market Local            currency exposure can be an important decision when investing in emerging markets.
Currency Bonds
                        The currency risk can be split into two parts:

                        • The risk of emerging market currencies: arguably, currency provides part of the risk
                          premium investors are seeking when investing in emerging markets. These currencies can
                          also be expensive to hedge.

                        • US dollar (USD) risk: most emerging market currencies are measured against the USD —
                          indeed, many emerging market monetary authorities and governments explicitly manage
                          their currencies against the USD.

                        Therefore, if an investor’s base currency is something other than USD, an investment in
                        emerging market local fixed income can create exposure to both the emerging market
                        currencies and USD. It is not necessarily the case that both emerging market currencies
                        and USD are appealing at the same time.
SPDR Bloomberg Barclays Emerging Markets Local Bond USD Base CCY Hdg to EUR UCITS
                             ETF1 employs a “base currency hedging” methodology, where only the base currency of the
                             portfolio is hedged. Thus it enables investors to accept the emerging market currency risk
                             without also being burdened by USD risk. This differs from the majority of currency hedging
                             methodologies, which employ “portfolio hedging,” where underlying portfolio currencies are
                             hedged (for further information on methodologies, please see the table on page 4).

Are Emerging Market          In USD terms, according to estimates from State Street Global Advisors, the currencies in the
Currencies Currently         Barclays Bloomberg EM Local Currency Liquid Government Index are undervalued by -3.4%
                             (as at 31 January 2021). That does not mean that they cannot fall further (the same currencies
Good Value?
                             became -21.5% undervalued in March 2001).

                             However, as Figure 1 shows, the same emerging market currency basket is a long way from the
                             peak of 27.8% before the Global Financial Crisis or 19.0% before the Taper Tantrum in 2013.

                             On that basis, we believe emerging market local bonds look relatively attractive on a long-term
                             basis, especially when combined with the enhanced yield on the index (3.68% yield to worst as
                             at 31 January 2021, according to Bloomberg).

Figure 1               40     Currency Overvaluation Against USD (%)
Valuation of                                                                         GFC 27.8%
                       30
Emerging Market                                                                                                       Taper Tantrum 19.0%
Currencies             20
Against USD
                       10

                         0

                       -10

                                                                                                                                 31-Jan 2021
                       -20
                                                                                                                                    -3.4%

                       -30
                               Jan                        Oct                         Jul                            Apr                 Jan
                              1990                       1997                        2005                           2013                2021

                             Source: Bloomberg Finance L.P., State Street Global Advisors, as of 31 January 2021.

                             Most emerging markets are considered relative to USD and many of the currencies are
                             managed relative to USD. However, as discussed above, if an investor has a different currency
                             base, then the value of USD also matters. Is it possible to make a similar valuation case in
                             EUR or GBP? As Figure 2 shows, a similar pattern can be observed and emerging market
                             currencies are cheaper than in 2008 or 2013. Nevertheless, the undervaluation may be
                             less compelling — in the case of GBP emerging market currencies appear overvalued by a
                             considerable amount; EUR is closer to fair value but such moves have overshot in the past as
                             the chart shows.

                             So here is the challenge: emerging market currencies are cheap relative to USD but expensive
                             for GBP and around fair value for EUR investors. To express this another way, USD is
                             expensive relative to not only emerging market currencies, but also EUR and GBP.

                             Investors do not necessarily want to accept more USD exposure with an emerging market
                             exposure, especially when developed market equity portfolios are often already biased
                             towards the USD.

                             Time to Hedge USD in EM Local Currency Bond Exposure                                                              2
Figure 2                    40     Emerging Market Currency Overvaluation (%)
Valuation of
                            30
Emerging Market
Currencies Against          20
EUR and GBP
                            10
   Barc Bloomberg EM
    Local Currency vs GBP     0
   Barc Bloomberg EM
    Local Currency vs EUR   -10

                            -20

                            -30
                                    Jan                        Oct                         Jul                            Apr           Jan
                                   1990                       1997                        2005                           2013          2021

                                  Source: Bloomberg Finance L.P., State Street Global Advisors, as of 31 January 2021.

                                  SPDR Bloomberg Barclays Emerging Markets Local Bond USD Base CCY Hdg to EUR
                                  UCITS ETF tries to make sense of these valuation differences by obtaining exposure to the
                                  undervalued emerging market currencies without being exposed to the overvalued USD.

                                  Looking at Figure 3, which shows the value of USD relative to EUR and GBP (i.e. excluding any
                                  emerging market impact), it is possible to see that currency valuations rise and fall according
                                  to estimates from State Street Global Advisors. But ultimately, historically they have not only
                                  returned to fair value, but also overshot on the other side (i.e. the figures cross over the 0% line
                                  on many occasions).

                                  Common sense seems to imply that investors might be better off not accepting the USD risk
                                  when it is towards the top end of valuations (conversely, one might want to switch into the
                                  unhedged version of the ETF when the dollar is undervalued). It is worth noting the timescale
                                  on the figure — currency valuations can take time to revert, but from a long-term perspective,
                                  reversion to the mean has always occurred.

                                  What is clear from the figures is that the USD would currently appear slightly overvalued
                                  against EUR and more significantly against GBP. Now may be an opportune time to hedge
                                  USD exposure using a base currency hedged ETF.

Figure 3                    50     Overvaluation of US Dollar (%)
Valuation of USD
                            40
Currencies Against
EUR and GBP                 30

                            20
   USD vs EUR
   USD vs GBP              10

                              0

                            -10

                            -20

                            -30
                                    Feb               Mar               May                Jul               Sep                 Nov    Jan
                                   1990              1995              2000               2005              2010                2015   2021

                                  Source: Bloomberg Finance L.P., State Street Global Advisors, as of 31 January 2021.

                                  Time to Hedge USD in EM Local Currency Bond Exposure                                                        3
Figure 4                                         Hedging                     Base Currency Hedging                                      Portfolio Hedging
                                                 Methodology
Base Currency Hedging
vs. Portfolio Hedging                            Also known as               “NAV hedging” or “share class hedging”                     “Full-look-through hedging”
                                                 Description                 Base currency hedged share classes                         Portfolio hedging means that any currency
                                                                             simply hedge the currency risk of the share                exposures other than the base (share class)
                                                                             class relative to the fund’s base currency.                currency are hedged. In this way, the value of
                                                                             Consequently, the value of the fund in its share           the fund in its share class currency is protected
                                                                             class currency is protected from currency                  from currency fluctuations.
                                                                             fluctuations between the share class and the
                                                                             fund’s base currency but not from any other                For these hedged shares classes, typically most
                                                                             underlying currency exposure.                              currencies in the portfolio are hedged into the
                                                                                                                                        share class currency, minimising unhedged
                                                                             For these hedged share classes, currencies in              currency exposures.
                                                                             the portfolio are not hedged into the share class
                                                                             currency, leaving exposures to the underlying              This approach involves entering into several
                                                                             currencies unhedged.                                       one-month FX forward contracts to sell each
                                                                                                                                        currency in the portfolio in exchange for receipt
                                                                             This approach involves selling a one-month FX              of the share class currency.
                                                                             forward contract of the fund’s base currency in
                                                                             exchange for the currency of the share class.              The majority of hedged classes offered by
                                                                                                                                        SPDR ETFs implement portfolio hedging.
                                                 Example SPDR ETF            SPDR Bloomberg Barclays Emerging                           SPDR Bloomberg Barclays Global Aggregate
                                                                             Markets Local Bond USD Base CCY Hdg to                     Bond EUR Hdg UCITS ETF3
                                                                             EUR UCITS ETF2
                                                                                                                                        SPDR Refinitiv Global Convertible Bond EUR
                                                                                                                                        Hdg UCITS ETF4

                                                 Source: State Street Global Advisors, as of 30 November 2019.

Endnotes                                         1    Source: Bloomberg Finance L.P., State Street Global                   3    USD, GBP, CHF and SGD hedged share classes
                                                      Advisors, as of 31 January 2021.                                           also available.

                                                 2    GBP and CHF hedged classes also available.                            4    USD, GBP and CHF hedged share classes
                                                                                                                                 also available.also available.

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                                                 Time to Hedge USD in EM Local Currency Bond Exposure                                                                                           4
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                                                     Time to Hedge USD in EM Local Currency Bond Exposure                                                                                                5
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