How does EUR hedging of US Treasury bills work?

[lemandas]

I'm trying to understand bond market.

Let's say in my broker account I have a choice between two types of the same US government bond ETF, let's call them:

- US Bond USD ETF

- US Bond EUR Hedged ETF

So, the same product (US gov. bonds), same issuer (iShares), but one is EUR hedged. Both are priced in EUR (on Xetra).

What are the practical difference between the two? (let's assume both yield positive 1% over year)

I understand that the concept of hedging is there to "Reduce currency risk", but what does that mean in practice for the market price of the shares of that two ETF?

(Thanks for your patience with the long post. I did some googling but failed to find a single resource which would coherently cover all of the above-covered scenarios)

To elaborate, if I understand correctly, if I buy a share of each of those today, then, over time, the price of those already purchased shares can be influenced by the following events:

- the actual change in the exchange rate of USD/EUR:

a) rate stays the same,

b) increases (USD becomes stronger)

c) decreases (USD becomes weaker)

- what the market begins to expect will happen to the exchange rate in the future, For example, the exchange rate so far did not change, but some news suddenly broke out and now the market has strong reasons to suspect that in the coming months:

d) the dollar will long term become stronger

e) the dollar will long term become weaker

Let's break it down, let me know if my following understanding is correct:

• In the case of (a), USD/EUR exchange rate doesn't change, the shares of both ETFs will perform exactly the same over time. That is to say: my existing shares of both ETFs will increase, or decrease, in value over time in exactly the same way (i.e. depending on other market events, e.g. if interest rates suddenly rise, both will decrease in value by the same amount (because newly purchased Bond of the same type will be generating higher yield than the already issues ones, due to higher interest rates)).
• in the case of (b), dollar becomes stronger:
  • my existing shares of "Bond USD" will increase in value. This is because the bond yields USD, which will be able to purchase more EUR. On top of that, the ETF yield of existing shares will increase (it yields in USD which can now purchase more EUR).
  • my existing shares of "Bond EUR hedged" will decrease in value (rather than stay the same). To hedge, the ETF is investing in financial instruments which appreciate in value if USD grows weaker, but depreciate in value if USD grows stronger. Because the dollar is growing stronger, the ETF is therefor loosing money, therefore it's worth less. On top of that, the yield of my ETF will decrease for the same reasons.
• in the case (c), weaker dollar, pretty much the reverse of the above happens (i.e. my "Bond EUR Hedged") would perform better over time than "Bond USD". This is because hedging actually paid off i.e. the EUR value of the yield did not decrease).
• in the case of (d), news broke out that dollar will become stronger - this is similar to what would happen in scenario (b) - the value of "Bond USD" shares will increase even before the exchange rate actually changes (people/market will start expecting higher future effective yields (same amount of USD will buy more EUR), so they will be willing to pay more for the ETF already now). But for the yields to actually increase on my already purchased shares of those ETFs I will actually have to wait for the exchange rates to actually change (which might or might not happen).
• in the case of (e), news broke out that dollar will become weaker - this is similar to what would happen in scenarios (c) - and similar to the above (d) -- the market value of ETF shares will change in anticipation of the change of exchanges rates, but the yields on already purchased shares will actually change only once the exchange rates have actually changed (at which point the "Bond USD" will be yielding fewer EURs each year compared to "Bond EUR hedged")

Is the above correct? Or am I completely not understanding how the bond markets, and hedging, works?

 

[cadenawright]

@lemandas Bonds should always be hedged to your local currency (which does cost $$), stocks should never be hedged.

If you don't hedge bonds, you don't really have a position in bonds anymore, but a position in that foreign currency including all risks that come with bonds.

 

[nicky_uk]

@cadenawright What if you are in a euro country that doesn't use the EUR currency? Is there any I can still hedge? There are obviously no funds that hedge for RON

 

[alexandervrc]

@nicky_uk I'm not an expert but I suppose the best bet would be the currency which is the most stable relative to RON - which I suppose is still EUR?

 

[evietheturtle]

@nicky_uk You probably won't find a good, cheap product... I have CHF as currency, and still barely managed to find 1-2 products.

I looked at charts and saw that in the longterm the RON is slowly devaluating compared to other currencies... So I guess you won't have big problems by just hedging to EUR or USD.

 

[alexandervrc]

@lemandas Let's say the underlying index goes up 20%, and EUR gets 20% stronger against USD. The unhedged ETF will have gained 0%, while the hedged one will have 20%, as if you bought it in USD (minus the cost of the hedging).

If you look on justETF, you can see that the EUR hedged charts look the same in EUR as the unhedged charts in USD.

 

[mini999]

@lemandas Yes, you're right and it's good idea to do it.

 

[evietheturtle]

@lemandas Currency Hedging can be done in the fund by having shortterm (e.g. 3 months) contracts about currency trades.

E.g. "In 3 months we will trade USD for EUR at a fixed rate". That protects you from unexpected currency fluctuations. The problem is that that fixed rate, is influenced by the differences in safe bond yields... And you more or less lose the yield difference by that.

So at the end, by hedging you roughly get the same yield as bonds in your home currency, but with the risk of the actual bonds.

So it might make sense to hedge global bonds (to spread the risk, for the same yield). But it doesn't make sense to buy bonds from another country beceause of high yields, and hedge them.