Understanding currency risk dynamics
Investing in fixed income outside one’s national currency involves a critical decision: how to handle currency risk. For investors exploring local currency debt in emerging markets (EM), this decision can significantly impact both portfolio returns and volatility.
Over the past decade, emerging market currencies have faced considerable pressure, particularly after the Federal Reserve’s 2013 “taper tantrum” announcement. This event led to a sharp depreciation of EM currencies, complicating the choice between currency hedging and exposure to FX risk.
To hedge or not to hedge?
For euro-based investors, the decision between hedging and retaining currency risk hinges on various factors. Passive hedging of EM currencies can be costly, as it eliminates the carry, the yield advantage of higher interest rates in these markets.
Conversely, the structural characteristics of the euro, a cyclical currency, often result in a positive correlation with EM currencies, helping to moderate volatility. During periods of US dollar strength, euro-based investors may benefit from an unhedged strategy, while in times of dollar weakness, EUR/USD hedging could enhance overall returns.
Insights from historical data
Historical analysis shows that euro-based investors have typically achieved better returns by avoiding passive EM currency hedging. Since the inception of the GBI-EM Global Diversified index, unhedged strategies have delivered superior outcomes in terms of both returns and lower volatility. This highlights the importance of flexible, data-driven currency management tailored to market conditions.
Conclusions
Investing in local currency EM debt demands careful consideration of market conditions and the structural traits of the currencies involved. As emphasized by Peter Becker, the optimal strategy depends on the economic environment and the investor’s portfolio objectives. Do you agree with this analysis? Share your thoughts in the comment form below.
