The power of currency hedging: Three key benefits for investors

With some foreign bonds offering lower local yields and others providing higher local yields but carrying greater currency volatility risk, it is unsurprising that many U.S. investors exhibit a “home bias” and allocate heavily to U.S. bonds. However, many of the perceived drawbacks of investing in foreign bonds can be overcome through currency hedging. In this article, we explore how currency hedging works and outline three key benefits for investors.

How currency hedging works

Currency hedging is a well‑established method for reducing the foreign exchange risk associated with investing in overseas assets. When investors hedge foreign bonds, they typically enter into a currency forward—a binding contract between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a specific future date. This allows both parties to effectively “lock in” the exchange rate on a future transaction.

For example, a U.S. investor buying a 10‑year French government bond might enter into a 12‑month forward contract to sell euros (going short) and buy U.S. dollars (going long) equivalent to their exposure. As the contract approaches expiry, the investor will evaluate the prevailing market conditions and proceed to close out the contract, settling the difference between the con-tract’s agreed price and the spot rate. The investor will then typically enter into another 12‑month forward con-tract. This “rolling” process is generally repeated throughout the bond’s holding period.¹

Overall, an investor’s total return is equal to the bond’s coupon (distinct from yield), any capital appreciation or depreciation in the bond’s price, and the net return from a currency forward contract. An important feature of the latter is the “carry” component. This is the profit, or the cost, associated with the interest rate differential between the two currencies being swapped. When the interest rate of the currency being bought (long) is higher than that of the currency being sold (short), an investor can earn a positive carry, which can help enhance returns. By contrast, when the differential is negative, it results in a cost.

Three key benefits of currency hedging

1. Potential to boost yield

Hedging lower‑yielding developed market bonds back to the U.S. dollar can increase yields, allowing investors to earn more income. In the current environment, U.S. deposit rates are higher than most other developed market countries, which means the interest rate differential is positive. This offers investors the potential to earn a positive carry from currency hedging, which can enhance yields and boost returns.

For example, consider a hypothetical U.S. investor buying and hedging a 10‑year French government bond. On June 30, 2025, French 10‑year bonds yielded 3.28% at a price of 99.39. To purchase 100,000 par value, an investor would have required EUR 99,392 at the spot rate of 1.17873, or USD 117,156. To hedge the currency risk, the investor will enter into a 12‑month forward contract to sell the foreign currency (EUR) and buy U.S. dollars. Because deposit rates in Europe were lower than U.S. rates, the investor sells the foreign currency at a lower rate and receives a higher yield on the U.S. rate through the 12‑month forward contract, resulting in “positive carry” from the currency hedge. This is roughly equal to the USD Secured Overnight Financing Rate (SOFR) of 3.88% less the implied euro forward yield of 1.82%, which is equal to 2.06%. This is added to the 3.28% yield of the French bond for a total yield of 5.34%, which is more than 1% higher than the 10‑year U.S. Treasury yield of 4.23%.²

2. Helps to reduce volatility

Currency hedging can also be used to reduce the volatility from foreign currency in higher‑yielding emerging market bonds. For example, consider an investor looking at an emerging market local currency bond with a much higher yield—and greater volatility—than U.S. Treasuries. In this case, to hedge the volatility from currency risk would reduce the yield rather than boosting it as in the previous example of the French bond. Thus, a hypothetical investor seeking to buy 100,000 South African bonds maturing on March 31, 2033, yielding 9.36% at a price of 103.46, would need ZAR 103,460 or USD 5,841.

"Currency hedging can also be used to reduce the volatility from foreign currency in higher‑yielding emerging market bonds."
Andrew Keirle, Portfolio Manager

Assuming the investor wants to hedge all the bond’s currency exposure back to U.S. dollars, they would sell the South African rand forward 12 months at an implied yield of 6.84% and effectively receive USD SOFR of 3.88% for a net cost of hedging of 2.96%. Given that the yield the investor receives from owning the bond is 9.36%, the effective hedged yield is 6.4% (9.36% less 2.96%). Equivalent U.S. Treasury bonds were yielding 4.05% on June 30, 2025. In this case, the hedged South African bond yields less than the unhedged bond, but with much less volatility, and still outyields the U.S. Treasury bond.³

3. Diversification benefits

From a portfolio construction perspective, we believe having exposure to hedged foreign currency bonds offers significant diversification benefits. To provide an indication of the global opportunity set, Figure 3 shows the yields of 10‑year bonds from various countries when hedged back into U.S. dollars on June 30, 2025. As the chart shows, the yields available to U.S. investors from hedged foreign bonds are substantially different from the unhedged yields (illustrated by the teal diamonds). Typically, hedged yields are higher than unhedged yields for developed market bonds, while the reverse is the case for emerging market bonds.

“From a portfolio construction perspective, we believe having exposure to hedged foreign currency bonds offers significant diversification benefits.”
Jeanny Silva, Associate Portfolio Manager

Correlations also tell an interesting story as they vary across sovereign bond markets. Figure 4 shows that developed markets—excluding Japan and Italy—have the highest correlations with the U.S. bond market. By contrast, emerging markets have much lower correlations, suggesting they may provide potential diversification benefits. However, it should be emphasized that lower correlation or an attractive yield does not by itself provide a reason to purchase a bond—rather, it provides a signal that a bond is worth examining more closely. As yields move and prices fluctuate, we believe fundamental research, combined with active portfolio and risk management, will be necessary to outperform market benchmarks.

Conclusion

Most U.S. investors have the majority, if not all, of their fixed income allocations in U.S. bonds, which means concentrated exposure to U.S. interest rate risk and the U.S. credit cycle. Many investors hear the words “global bonds,” and they think of low yields or excessive currency volatility. But astute investors understand the benefits of using currency hedging to cast a wider net and invest in a larger opportunity set, finding higher yields, greater potential returns, and a reduction in portfolio risk.

 

Appendix

For Figure 1 and Figure 2 the results do not reflect actual trading or the effect of material economic and market factors on the decision‑making processes. The estimated results shown are hypothetical, do not reflect actual investment results, are not a guarantee of future results and are subject to numerous limitations. The results do not reflect actual market conditions including the ability/inability to purchase and sell on the dates indicated in the illustrative example. Certain assumptions have been made for modeling purposes that may not be realized. Management fees, transaction costs, taxes, potential expenses, and the effects of inflation have not been considered and would reduce returns. Actual results experienced by clients may vary significantly from the results shown. Data is subject to change. For Figures 1–3, the bond yield referred to is yield-to-maturity.

Forward contracts are usually over‑the‑counter (OTC) instruments, exposing them to higher risks than exchange‑traded derivatives. OTC instruments are subject to higher counterparty risk, market risk and liquidity risk. These instruments are typically only available to institutional investors because of default risk and the requirements for customization and capital. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. The risks of international investing are heightened for investments in emerging market and frontier market countries. Emerging and frontier market countries tend to have economic structures that are less diverse and mature, and political systems that are less stable, than those of developed market countries. Fixed‑income securities are subject to credit risk, liquidity risk, call risk, and interest‑rate risk. As interest rates rise, bond prices generally fall.