investment viewpoints
Swiss bonds: the benefits vs foreign-currency bonds
Given interest rate levels in the US, Swiss bond investors might be tempted to put their money in ‘risk-free’ US Treasuries instead of hunting for riskier CHF-denominated bonds. This insight offers a comparison of CHF bonds and foreign currency-denominated bonds to gauge which makes more sense for Swiss investors.
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The lure of US government bonds
‘Risk-free’ US Treasuries are currently still yielding more than 4%, while the average yield of CHF bonds have fallen back to well below 1.5%1.
However, Swiss investors should bear in mind that they cannot benefit as much from higher US interest rates when buying US Treasuries because they also have to bear the currency risk. While Treasuries investors only bear the fluctuations in value caused by US rates, Swiss investors in US Treasuries are also facing the fluctuations in value caused by the currency. Currency fluctuations are roughly twice as high as bond price fluctuations caused by interest rates.
If the currency risk is not hedged, an investment in Treasuries by a Swiss investor mainly becomes a bet on the currency. In such cases, the volatility of a Treasuries investment can be comparable to the volatility of an investment in equities.
Looking at currency risk
Currency risks are rarely compensated with an additional risk premium. From the perspective of a franc-based investor in particular, currency risks have rarely been worthwhile due to the long-term, upward pressure on the franc.
Given this lack of an additional risk premium – and the need to maintain the bond character of investments in foreign currency-denominated bonds – the currency risk in bond portfolios is usually hedged completely. The only exception is sometimes in the high-yield segment, where the proportion of price moves caused by the currency component is generally much smaller. In the investment grade space, currency-hedged bonds tend to fluctuate significantly less than non-hedged bonds. In high yield, there are usually no major differences.
If a Swiss investor hedges the currency risk of a foreign-currency bond, the cost of the hedge tends to erode the benefit from the interest rate differential. The foreign-currency yield curve effectively loses the interest rate boost when it becomes a ‘CHF-equivalent’ yield curve, figurately speaking. In practice, currency hedging is often carried out with 1-month FX forwards. This means that the foreign-currency yield curve is effectively shifted into the CHF yield curve at the 1-month point. However, the resulting ‘CHF-equivalent’ yield curve rarely lies exactly on the CHF yield curve because the two generally have a different slope and structure.
A potential yield advantage?
The attentive reader may now raise the point that investing in a currency-hedged 10-year Treasury can still be worthwhile as long as the USD yield curve is steeper than the CHF yield curve. If market conditions remain stable, this point is valid. However, changes in USD and CHF interest rates rarely occur in lockstep. Even if both yield curves move in the same direction, changes in US rates are usually greater. As such, the supposed yield advantage of a currency-hedged 10-year Treasury relative to a 10-year Swiss government bond can therefore quickly be cancelled out by the difference in interest rate sensitivity, especially when rates rise.
It is also important to bear in mind that foreign-currency bonds have both currency risk and foreign-currency interest-rate risk.
With central banks in the US and eurozone being forced to raise interest rates much more than Switzerland has in recent years to combat inflation, interest rate differentials, and therefore hedging costs, have increased. As a result, average CHF-denominated corporate bonds currently show better yields to maturity than currency-hedged foreign-currency credit2 (see figure 1).
FIG 1. Average corporate bond yields for indices in Switzerland, Europe and the US
Source: Bloomberg, as at June 2024. For illustrative purposes only. Yields are subject to change. Past performance is not illustrative of future returns.
As with any rule, there are exceptions. In some ways, foreign-currency bonds can make sense for Swiss investors. First, they provide access to a greater variety of borrowers outside the CHF market. This expands the investment universe, improving diversification. Second, foreign-currency bonds can benefit from slightly better liquidity, on average, relative to CHF bonds.
From a long-term perspective, however, it is clear that CHF-denominated bonds have a better potential risk/return ratio than currency-hedged foreign currency-denominated bonds. Figure 2 illustrates that while CHF bonds have shown the lowest volatility and smallest drawdown over the last 15 years, they have nonetheless achieved almost the same return as currency-hedged foreign-currency bonds.
FIG 2. The relative attractiveness of Swiss bonds
Source: Bloomberg, as at June 2024. Past performance is not an indicator of future results. For illustrative purposes only.
Due to these advantages, we believe it makes sense for Swiss investors in the investment grade segment to favour CHF bonds rather than currency-hedged foreign-currency bonds. The only exception would be in the sub investment grade area because of the required and desired diversification element. Here, the CHF market offers too little choice of issuers to construct a well-diversified portfolio.
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2 Yields are subject to change.
