TO HEDGE OR NOT TO EMERGING MARKET DEBT FROM AN AUSTRALIAN - NOVEMBER 2018
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H E A LT H W E A LT H CAREER TO HEDGE OR NOT TO HEDG E? EMERGING MARKET DEBT FROM AN AUSTR ALIAN PERSPECTIVE NOVEMBER 2018
INTRODUCTION
Emerging market debt (EMD) has been an increasingly popular asset class for investors, typically
providing higher yields and arguably the potential to participate in emerging economy growth through
currency appreciation. There is a large body of research arguing the case for emerging markets,
including superior economic growth and demographics1. Often the research is written from a United
States dollar (USD) perspective.
However, Australian investors who usually invest through AUD feeder funds into USD products, face
quite different dynamics. With deep ties to emerging economies and the higher reliance on commodity
production, there is a strong correlation between the Australian dollar (AUD) and an emerging market
currency basket (EMFX) based on the JP Morgan GBI-EM index. This correlation results in a different
return profile for Australian investors in unhedged EMD compared to USD denominated investors.
In this paper, we explore the impact of this currency exposure and the implications for Australian
investors and whether the one-size-fits-all approach provided by managers is appropriate.
WHY DO INVESTORS HEDGE DEVELOPED
MARKET DEBT?
For Australian investors, the most common treatment of fixed income investments, especially those
in Developed Markets, is to hedge the currency exposures. There are a number of reasons for this,
such as reducing the level of “risk” from fixed income investments by removing currency volatility,
and in addition, benefitting from the hedge pickup, especially from lower yielding regions like Europe
and Japan. Figure 1 below shows a stylised representation of the first point.
Figure 1. For developed market bonds, hedging the currency risk currently improves return
and reduces risk
Currency hedging of fixed income holdings | Stylised risk-return deviation chart
100% hedged
Return
100% unhedged
Risk
Source: Mercer
1 Refer for example: Investing in Emerging Market Debt, Mercer, July 2018 for the fundamental characteristics of this asset
class, albeit from a USD perspective.
2W H Y D O A U S T R A L I A N I N V E S T O R S T Y P I C A L LY
NOT HEDGE EMERGING MARKET DEBT?
Investors typically access local currency EMD investments on an unhedged basis. There are a few
arguments as to why this is the case:
1. The level of carry paid for hedging is costly, given that EM interest rates are often higher than
Australia’s rates, as shown in figure 2, and liquid hedging instruments are not always available.
Figure 2. Cost of hedging an EM FX basket will set you back around 3% per annum
JPM GBI-EM Global Diversified Index | Cost of Carry: Interest rate differential to AUD
20%
15%
10%
5%
0%
-5%
Nov-07 Jul-08 Mar-09Nov-09Aug-10 Apr-11 Dec-11 Aug-12 May-13 Jan-14 Sep-14 May-15 Feb-16 Oct-16 Jun-17 Jan-18
Source: Mercer
2. The potential for gains through (real) currency appreciation of EMFX in light of the Balassa-
Samuelson effect, which suggests higher productivity countries should in the long run have
appreciating currencies in real terms. Whilst this theory provides a framework for considering
currency movements over time, the evidence in practice is mixed. Figure 3 shows the real change
in EMFX (versus the USD) against the real change in GDP per capita (as a proxy for productivity)
from 1990 to 2017 based on IMF data.
There may be impediments to the hypothesis holding in practice, such as tariffs on free trade
resulting in no one global price for tradeable goods, the difficulty and/or lags associated with
changes to production and capital controls, and the lack of freely traded exchange rates.
Figure 3. The Balassa-Samuelson effect in practice
Real appreciation against USD versus real GDP per capita growth versus US | 1990 to 2017
2.5
2
1.5
% Real appreciation versus USD
1
0.5
0
-0.5
-1
-1.5
-1 -0.5 0 0.5 1 1.5 2 2.5 3 3.5 4
% change in real GDP per capita (in local currency) versus US
Source: IMF, Mercer
33. Downside protection. Australian investors face an additional consideration when considering an
investment in local currency EMD: the correlation of EMFX to AUD. Figure 4 below shows the USD/
AUD spot exchange rate versus a basket of currencies in the JP Morgan GBI-EM Global Diversified
Index.
Figure 4. The correlation between EMFX and the USD/AUD is strong
USD/AUD spot (LHS) vs GBI-EM Currency Basket Index (RHS)
1.2 1.6
1.5
1.1
1.4
1 1.3
1.2
0.9
1.1
0.8
1
0.7 0.9
0.8
0.6
0.7
0.5 0.6
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
USD/AUD USD/GBI - EM GLOBAL DIV
Source: Bloomberg, JPMorgan, Mercer
Figure 5 illustrates the experience from local currency EMD investment has therefore been quite
different for a US investor compared to an Australian investor. For example, during the Global
Financial Crisis (GFC), local currency EMD unhedged in USD produced negative returns, whilst
from an unhedged AUD perspective, it produced positive returns.
Figure 5. The EMD LC UH experience for USD and AUD investors is quite different!
12 month rolling return of JPM GBI-EM Global Diversified | Unhedged in AUD vs USD
50%
40%
30%
20%
10%
0%
-10%
-20%
-30%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
IN AUD IN USD
Source: JPMorgan, Mercer
4Thus, hedging emerging markets would not only mean the EMFX basket would need to appreciate
by 3% a year to make up for the cost of carry, but also would potentially increase the downside
risk, as both EMFX and the AUD are “risk off” currencies, and during situations like the GFC the fall
in the AUD would offset the decline in local currency bond values. This is shown in Figure 6.
Figure 6. The AUD investor experience versus a 100% USD perspective
JPM GBI-EM Global Div Index Drawdowns | Unhedged vs USD/AUD hedged
0%
-5%
-10%
-15%
-20%
-25%
-30%
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18
UNHEDGED USD/AUD HEDGED
Source: JPMorgan, Mercer
5W H AT O T H E R F X A P P R O A C H E S C A N B E
ADOPTED BY AU STR ALIAN INVESTORS?
An intuitive outcome of the above, if hedging the EMFX to AUD is too costly, is to introduce a USD/AUD
hedge (short USD and long AUD through FX forwards) instead. This brings the investment closer to
that of a USD investor and hence arguably the way the manager manages the portfolio. Indeed, this
would be further supported by the fact that Australian interest rates have in the past typically been
higher than US interest rates and one would have been paid to hedge.
However, if the AUD is correlated to EMFX and therefore translated back offsets the EM currency
risk, then installing an USD/AUD hedge is basically taking an active currency position on the USD, and
thus increases risk. Figure 7 shows historic evidence. Note, at 30% hedged, returns have historically
increased with risk slightly lower/ stable. The current condition however is that US interest rates are
higher than Australian interest rates, and consequently the addition of a USD/AUD hedge results in the
negative carry (shown in the 0%, -1% and -2% carry environments in Figure 7), if the Fed continues
raising and the RBA stays on hold.
Figure 7. The AUD investor EMD experience – past and future(?) environments
JPM GBI-EM Global Div return versus Standard deviation (annualised) (Jan-03 to Jun-18) |
Different AUD-USD cash rate differentials
100% hedged, historical (actual)
10%
9%
Return %p.a.
8%
7%
6%
5%
0% hedged
4%
6% 7% 8% 9% 10% 11% 12% 13%
Standard Deviation p.a.
HISTORICAL (ACTUAL) AUD-USD = 0% AUD-USD = -2% AUD-USD = -1% AUD-USD = +2%
Source: Bloomberg, JPMorgan, Mercer
6CONCLUSIONS
In this paper, we have sought to address the different issues faced by AUD investors compared to
USD investors in investing in EMD. Specifically, we have sought to address the issue of the one-size-
fits-all approach or EMD given the correlation in currency between EMFX and AUD and the different
implications it has for Australian investors.
In a “typical” environment where Australian interest rates are higher than US interest rates (as we
have higher inflation targets), hedging the USD/AUD would be intuitive as this could increase the level
of expected return, although at an increase in risk. Historical experience suggests a 30% hedging
point could reduce risk and increase return. In the current environment however, the carry between
Australia and the US is negative and consequently adding a USD/AUD hedge to a local currency EMD
investment reduces the expected return and potentially increases risk.
Consequently, our findings suggest that leaving EMD investments unhedged for Australian investors is
preferred at this point in time. However, in an environment whereby AUD rates are substantially higher
than USD rates again, a (partially) hedged allocation could potentially become beneficial.
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