Bonds & Interest Rates · Intermediate · 4 min

Foreign-currency bonds

You can explain why a higher yield in a foreign currency can turn into a loss, and what currency hedging does and costs.

5% abroad, 3% at home

Bonds in your home currency pay 3%. Bonds of similar quality in another currency pay 5%. Two extra points a year, for the same kind of risk, it seems.

Many investors have learned that this extra yield comes with a catch. The interest and the repayment arrive in the other currency, and exchange rates move. For bonds, with their modest returns, that movement can matter more than everything else.

Yield + currency

A foreign-currency bond pays its coupons and repays its principal in another currency. Your result in your own currency depends on two things:

the bond's own return, its yield and price changes, and
the change in the exchange rate between the two currencies.

The problem is scale. A bond's yield might be a few percent a year. Exchange rates between major currencies can easily move 5 or 10% in a year. A currency move of that size can wipe out several years of extra yield, or add to it.

Interest rate gaps between currencies are rarely free money. A higher yield often reflects higher inflation, higher risk or expectations that the currency will weaken. Markets price those expectations in, as you have seen with news and expectations.

Currency hedging is a way to reduce the exchange rate effect. A hedged bond fund uses currency contracts, such as forwards, to lock in exchange rates for its foreign holdings. What remains is mostly the bond's return in its own currency. Hedging is not free: it usually costs roughly the difference between the short-term interest rates of the two currencies. When hedging a higher-yielding currency back into a lower-yielding one, that cost often eats most of the extra yield.

For many investors, the decision comes down to this: hedged foreign bonds behave more like home bonds with more diversification, unhedged ones add a currency bet on top.

+3% vs. −1.3%

A fictional investor compares two bonds for one year.

Home bond: yield 3%, no currency effect. Result: +3%.
Foreign bond: yield 5%. During the year, the foreign currency falls 6% against the investor's currency. Result: 1.05 × 0.94 ≈ 0.987, about −1.3%.

The extra 2 points of yield turned into a loss of more than 4 points compared with the home bond. In a year when the foreign currency rises instead, the same bond would have beaten the home bond by a wide margin.

Common mistakes

Comparing yields across currencies directly. The currency decides much of the result.
Assuming hedging is free. It costs roughly the interest rate gap.
Treating a high-yield currency as a bargain. Higher yields often reflect higher risk.
Forgetting the fund's hedging policy. Check whether a bond fund is hedged or not.

The takeaway

A foreign bond can pay more interest, but the currency can move far more than the extra yield. Hedging removes most of that, at a cost.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the bond that ended up with the worse result.

Tap the chart.

1.05 × 0.94 ≈ 0.987. The currency fall wiped out the extra yield and more.
2Why are currency moves especially important for bonds?

A few percent of yield is small compared with currency moves that can reach 10% in a year.
3What does a currency-hedged bond fund do?

Hedging targets the currency effect. Interest rate and credit risk remain.
4What does hedging usually cost?

Hedging a higher-yielding currency often costs about the interest rate gap, which eats much of the extra yield.

of 4 correct.