Foreign Bond Funds: To Hedge or Not to Hedge (Unhedged)

Continuing with a theme I started in my last installment, if you are an investor who wants to diversify your investment portfolio outside the US dollar without using the foreign exchange market (forex), consider investing in unhedged foreign (international) bond funds. Foreign bond funds can have two types of returns, from the bond itself and from currency fluctuations. If the bond fund hedges against currency fluctuations the bond fund return will come only from the bond itself. When the bond fund uses foreign currencies hedging, it removes the currency risk from the bond fund and acts as a normal fixed income investment. If the bond fund does not hedge against the foreign currencies, you will also receive the benefit of the currency fluctuation return. It is important for you to know if the bond fund hedges or does not hedge against foreign currency fluctuations.

If the foreign bond fund is unhedged you are investing in the weakness of the US dollar versus the foreign currency of the underlying bonds. When the US dollar strengthens the fund will go down. When the US dollar weakens, the fund will go up. If you don’t want the volatility of the foreign currency market you need to buy foreign bond funds that are hedged in the local currency.

Examples of unhedged and hedged foreign bond funds:  PIMCO has both unhedged and hedged foreign bond funds. 

PIMCO Foreign Bond Fund (Unhedged) - PFUIX: The fund invests in intermediate maturity non-U.S. fixed income securities instruments. The return of the fund has been the following:

1 year              3 Year              5 Year

18.94%            8.82%              9.06%

A comparison of PFUIX versus UUP (tracks the performance of Deutsche Bank long US dollar future index) using charts shows it is the inverse of performance. Since UUP is bullish on the US dollar, when the performance strengthens, PFUIX will show weakness. When UUP show weakness, PFUIX will strengthen.

PIMCO Foreign Bond Fund (U.S. Dollar Hedged) - PFORX: The fund invests in intermediate maturity non-U.S. fixed income securities instruments. The return of the fund has been the following:

1 year              3 Year              5 Year

4.47%              8.39%              6.63%

It is very important that you understand whether the fund is hedged or unhedged before investing in a foreign bond fund. If you are adding the investment to your fixed income portfolio you want the foreign bond fund to be hedged. If you are also interested in diversifying your investment outside of US dollars you want the foreign fund to be unhedged. Investing in unhedged foreign bond funds is only a good investment strategy if the US dollars declines versus the foreign currencies the bond fund is invested in.

Do you think the US dollar will continue to show weakness against foreign currency? Is investing in foreign bond funds that are unhedged a good investment strategy? Please chime in with your comments.

© 2011

Paul Cusick