2 Reasons To Notice New Int’l Bond ETF

The newest iShares ETF, the Currency Hedged Global ex USD High Yield Bond ETF (HHYX), launched this week, is noteworthy for two reasons. First, it’s iShares’ first currency-hedged bond ETF, and one of a still-very-small group of strategies that attempt to mitigate currency risk on international bond portfolios. Secondly, it should fill an important void if the performance of its nonhedged counterpart is any indication.

Here’s why HHYX matters:

• HHYX is a first for the largest ETF issuer in the world, and some say the international bond space is where currency hedging is most useful.

Currency hedging in an environment marked by a strong—and strengthening—U.S. dollar has proven popular and effective in the equities space. Some of the biggest asset-gathering ETFs in recent months have all shared a currency-hedging feature that aims to protect U.S. investors from currency risk—a risk that seldom pays off in the form of additional returns.

“Exposure to currency risk is an uncompensated risk,” Betterment’s Ellie Lan said in a recent blog noting that investors need exposure to international bonds, but not to currency risk.

“Changes in exchange rates create return volatility without introducing additional expected returns. While rate changes may randomly add returns in your favor in the short term, the expectation should always be of zero return over the long term,” she said.

Hedging Works Better With Bonds
In the fixed-income space, HHYX is one of a select few ETFs to offer access to a global bond portfolio that mitigates that risk through a currency hedge. The ETF invests primarily in its nonhedged counterpart, the iShares Global ex USD High Yield Corporate Bond ETF (HYXU | C), owning high-yield bonds denominated in euros, British pounds sterling and Canadian dollars, and using foreign currency forwards to hedge exposure to these currencies.

“Whether it's stocks or bonds, currency does not contribute substantial returns; however, it has a substantial risk in terms of volatility, and all the more so when it comes to bonds,” Lan said. “The increase in risk of not hedging bonds is significant and cannot be overlooked.”

Citing Vanguard data, Lan noted that currency hedging is beneficial for bonds but not for stocks.

“This is because of the different volatility characteristics of stocks and bonds, and their correlations with currency moves,” she said. “Bonds, as an asset class, are typically less volatile than both stocks and currencies.”

Is Hedging Worth It?

The issue here is whether the cost of buying that portfolio insurance—or currency hedge—is worth it in the form of additional returns. At face value, HHYX is coming to market with a net expense ratio of 0.43 percent—only 3 basis points higher than its unhedged counterpart HYXU. Time will tell whether investors are being paid for that additional feature.

• The worst-performing high-yield bond ETF year-to-date is HYXU, and that’s thanks primarily to its exposure to currencies, particularly the euro.

The unhedged international bond portfolio has slid more than 6 percent so far this year, as the dollar gains strength due to diverging central bank policies around the world.

That performance stands in stark contrast to other high-yield bond ETFs that are currently in the black for the year. Consider that the Market Vectors International High Yield Bond ETF (IHY | C-76) is up 1.2 percent in the same period because much of its currency exposure is dollars, according to ETF.com Analytics.

Chart courtesy of StockCharts.com

“HYXU is focused on developed international corporate bonds primarily in Europe—Italy, Germany, France, etc,” Todd Rosenbluth of S&P Capital IQ told ETF.com. “The bonds are local currency ones, so they are being hurt by strength in the U.S. dollar versus the euro.”

If this backdrop of dollar strength is to continue, bringing to market a hedged version of HYXU that allows investors to capture the attractive yields while protecting themselves from currency risk seems like a pretty good—and timely—idea.