How Vanguard reduces currency risk
February 26, 2014
When a bond fund in America invests in bonds from other countries, it converts U.S. dollars to foreign currencies. For example, if the fund wants to buy British bonds denominated in British pounds, it first converts U.S. dollars to pounds. Then it monitors the market value of its British bonds in U.S. dollars.
So an American fund holding foreign bonds gets its total return from the income from its bonds, the price changes of the bonds, and the changing values of the foreign currencies.
That third factor, the changing values of foreign currencies, can add a lot more volatility to the price of the fund holding foreign bonds.
A bond fund manager can minimize the currency's influence on the value of the fund's holdings by using a standard technique called currency hedging. Here's an example of how it works with British bonds.
Let's say the manager of an American bond fund wants to minimize the currency effects on the dollar value of the British bonds she bought for the fund.
First she checks the value in pounds of the British bonds in the fund. Then she goes to the currency markets to sell that amount of British pounds for U.S. dollars at a future date, say, a month later. The fund manager and another party, such as a currency trader at a large bank, agree on an exchange rate.
Let's say the British pound falls in value against the U.S. dollar.
When it's time to settle the currency contract, the fund's British bonds have fallen in value when priced in U.S. dollars. But the currency contract has generated an offsetting amount of profit for the fund in dollars. So the fund manager uses that profit to buy more bonds. The net effect is that the currency movement has barely changed the dollar value of the fund's British bond holdings.
What if the British pound reverses direction and goes up in value against the dollar?
The hedging strategy would work the same way, but in reverse, with the currency contract realizing a loss for the fund. To settle the currency contract, the fund manager simply sells some of the fund's bonds, which have gone up in value, so that once again, the net effect of the currency movement is close to zero.
The fund enters into these types of currency contracts continually for all its foreign bonds, to maintain protection against currency swings. So investors in a hedged bond fund can expect that their returns will consist of the bond's income and price changes, received in U.S. dollars, minus the cost of hedging. Price changes caused by fluctuations in the currency market are minimized.
The hedge is designed to minimize the risk of losing money from falling foreign currencies. Hedging also takes away the possibility of making money on currency fluctuations. But that's what's intended because, after all, a hedged international bond fund is not a way to speculate on currencies. Instead, it's a way to gain global diversification for a bond portfolio while reducing currency risk.
Visit vanguard.com to obtain a fund prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
International bond funds are subject to currency hedging risk, which is the chance that currency hedging transactions may not perfectly offset the fund's foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies.
Vanguard Total International Bond Index Fund will incur expenses to hedge its currency exposures. Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
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A video from the Vanguard Perspectives series
Some international bond funds, including Vanguard Total International Bond Index Fund, use a traditional hedging strategy to help minimize the risk caused by fluctuations in the value of foreign currencies versus the U.S. dollar. The strategy allows the fund's total return—income plus any principal change—to remain undistorted, for the most part, by changes in the value of foreign currencies against the U.S. dollar.
Want to know how currency hedging works? Vanguard explains in this video.
- All investments are subject to risk, including possible loss of principal. Investments in bond funds are subject to interest rate, credit, and inflation risk. Investments in non-U.S. companies are subject to risks including country/regional risk and currency risk.
- Total International Bond Index Fund is subject to currency hedging risk, which is the chance that currency hedging transactions may not perfectly offset the fund's foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in those currencies. The fund will incur expenses to hedge its currency exposures.