Investor Thinking - Managing the FX basis risk
There are good reasons why UK pension schemes should look to diversify their sterling corporate bond portfolios into foreign corporate bonds.
However, this introduces currency risks and non-sterling interest rate exposures into the portfolio. In this paper we show how these challenges can be managed and the resulting impact on the bond portfolio yield.
UK pension schemes and credit investments
As the trend to de-risk continues for UK pension schemes, investing in corporate bonds as efficiently as possible will grow in importance. Currently, UK pension schemes invest c.20% of their assets in corporate bonds and c.90% of the corporate bonds held are sterling denominated1. By comparison, only 30% of schemes’ equity portfolios are allocated to UK equities. One way to improve the efficiency of UK pension schemes’ credit holdings is to increase the proportion held in foreign corporate bonds. Such a move would offer:
- A larger opportunity set - the UK is only 6% of global corporate bond market
- Better diversification by sector, region and currency
- Deeper liquidity – traded volume, issuance activity and lower transaction costs
Hence investing in foreign corporate bonds as opposed to only sterling corporate bonds, offers better risk-adjusted rewards for taking similar credit risk. However, for a UK pension scheme, investing in non-sterling credit gives rise to the ‘wrong’ interest rate exposure as well as currency risk. Typically the main currencies involved are the US Dollar (USD), Euro (EUR) and Japanese Yen (JPY). The diagram overleaf shows the components of yield for an unhedged foreign currency bond portfolio.
Typically, pension schemes will not expect to be rewarded for taking foreign interest rate and currency risks, so how can these unwanted risks be managed and what is the impact on portfolio yield?
Managing the FX basis risk
Hedging interest rate risks
One of the first considerations is to minimise the foreign currency bond portfolio’s sensitivity to foreign interest rate risk. Using LDI techniques the scheme will enter into USD, EUR or JPY interest rate swaps as required, agreeing to pay a fixed rate and receiving a floating rate in those respective currencies. This is designed to eliminate the exposure to long-term foreign interest rates. The scheme could then build the appropriate GBP interest rate exposure to hedge its liabilities.
N.B. Using swaps introduces counterparty credit risks and the need to collateralise positions.
Hedging currency risks
Primarily, this is about ensuring that the GBP value of a foreign currency bond portfolio does not fall as a result of that currency depreciating relative to GBP. The standard approach to hedging currency risks is to implement a programme of rolling forward foreign exchange (FX) contracts. Schemes can hedge the GBP value of foreign currency bond portfolios by selling the foreign currency value of the portfolio forward for GBP, at an agreed forward FX rate. In doing so, the impact of changes in FX rates is offset by the value of the forward FX contracts. Therefore, the GBP value of the foreign currency bond portfolio, together with the value of the forward FX contracts, remains constant. The forward FX contracts would be rolled at expiry to maintain the hedge.
Ideally schemes will want to ensure a 100% currency hedge through time. In practice, the foreign currency value of the bond portfolio will change due to changes in foreign interest rates or credit spreads and not all cash flows arising from coupons and redemptions will be re- invested. Hence the currency hedge will not remain at 100% unless there are periodic adjustments to the number of forward FX contracts.
Consequently, to keep the hedge close to 100%, it is necessary to rebalance the hedge at sufficiently frequent intervals. This can be achieved by staggering the hedge, initially choosing a mixture of one to six month contracts to initiate the hedging programme so that contract roll dates are spread out over time. This will afford the scheme opportunities to rebalance the currency hedge as the foreign currency value of the bond portfolio fluctuates.
From the discussion so far, a forward FX hedging programme looks to be a robust way of locking down currency risk. However, there is a potentially significant risk embedded in this approach that can be easily overlooked: FX basis risk.
1 Mercer European Asset Allocation Survey 2017