Given the US dollar’s recent slump, investors have finally started reaping rewards from international diversification. A big part of that was driven by currency movements: When the dollar is weak, the stronger buying power of other currencies makes gains on non-US assets worth more when translated back into dollars.
Keeping currency exposure unhedged doesn’t always work. For instance, the US dollar enjoyed an exceptionally strong run for most of the period from mid-2011 through late 2022. As a result, exposure to nondollar assets was mostly a net negative.
On balance, though, keeping international-equity exposure unhedged has two major benefits:
- It’s more tax-efficient, as currency hedging can lead to taxable capital gains given the need roll monthly forward contracts or other hedging instruments.
- It also enhances the diversification benefit from investing in non-US assets.
But international bonds are a different story. Here, I’ll explain why.
Why Hedging Works Better With Global Bonds
As with stocks, unhedged bonds have two components to their returns: the security’s gains and the gain or loss in the currency. If the local currency appreciates versus the dollar, the currency effect adds to returns. If the local currency weakens (in other words, the dollar strengthens), unhedged currency exposure has a negative effect on returns.
The chart below illustrates how this works in practice. In both 2023 and 2024, the hedged version of the Bloomberg Multiverse ex-USD Index posted better returns than the unhedged version as the dollar strengthened. The gap in returns was especially dramatic in 2024, when the unhedged benchmark was down about 4%, but the hedged version gained 5%. The following year worked in reverse. As the dollar weakened, keeping currency exposure unhedged had a positive impact on returns, but the hedged version of the benchmark fell behind.
As the bar graph above illustrates, the gaps in returns stemming from currency-hedging decisions can be relatively large. As a result, the volatility stemming from currency movements can swamp that of the bonds themselves. This is important given bonds’ traditional role as portfolio stabilizers—that is, holdings that can offset the higher volatility from stocks.
To illustrate, the graph below shows the rolling three-year standard deviation for the hedged (blue bars) and unhedged versions (green bars) of the same index. On average, the unhedged version has been nearly 3 times as volatile as the hedged version.
What’s more, unhedged foreign-currency-denominated bonds are much more prone to selloffs, as shown in the table below. The unhedged version of the benchmark has suffered a maximum drawdown of more than 29%, compared with just 11% for the hedged version. What this means, practically speaking, is that unhedged bonds can fail you when you need them most—amid market tumult when bonds are normally prized for their stability.
Finally, if you live in the United States, chances are most of your expenses are denominated in US dollars. Keeping foreign bond assets unhedged adds some risk that assets you may need to cover expenses over the next several years could end up being worth less when translated back into US dollars. This is also a risk for non-US equity exposure, but most investors have a longer time horizon for their equity holdings, giving them more time to recover from any adverse currency movements. By contrast, fixed income is often earmarked for nearer-term goals and outlays, making stability even more important. This argues for hedging any foreign-currency-denominated bonds back into the dollar.
The Bottom Line for Investors on Currency Movements
Currency hedging won’t always pay off for global-bond investors, as recent returns for the hedged and unhedged versions of the Bloomberg Multiverse ex-USD Index attest. Over longer periods, though, currency movements tend to eventually cancel each other out. Overall, all but the most risk-tolerant investors are probably better off avoiding currency risk on the fixed-income side.