Australian superannuation funds that failed to hedge their forex exposure took a hit when the Australian dollar fell against its US counterpart in 2011. Is there a solution in the cross-currency basis swap market?
As Australia increases its ownership of offshore assets across global equities, real estate, infrastructure and other alternative asset classes, foreign exchange has become a major contributor to the investment returns of Australian pension funds.
According to the 2011 Superannuation FX Survey by National Australia Bank (NAB), which polled 49 of the country’s largest super funds with combined AUM of A$523 billion (US$560 billion) representing 79% of the market, unhedged portfolios lost 12.7% in 2010 on adverse currency moves alone, while 100% hedged positions gained 4.5%.
Since mid-2009 the effect is more pronounced, with unhedged positions giving up 30% against gains of 8% for fully hedged positions. The 38% differential represents an opportunity cost to overall portfolio performance of some 3.25% per annum since then, according to NAB.
Against a backdrop of increasing offshore exposure and a focus on relative performance versus their domestic peer group, it should follow that Australian super funds have significant interest in optimising their currency overlay strategies. Outside of the fixed interest sector, however, investment managers say there is little consensus around forex risk management best practice with some funds ignoring it altogether.
Troy Rieck, managing director with the Brisbane-based Queensland Investment Corporation (QIC), an institutional investment manager with AUM of A$60 billion, reports a disparate range of operational approaches. “Some funds use their asset managers to run forex hedging strategies, some rely on their custodians, while others choose not to hedge or don’t really think about it at all,” he says.
Furthermore, the tendency of incumbent providers to rely on traditional hedging tools can act as a drain on liquidity with painful consequences. Between July and October 2008, the Australian dollar dropped by more than 30% versus the US dollar, leaving funds long the Aussie dollar after one-month and three-month AUD/USD forex forward hedges faced a severe, one-off liquidity event. As the deeply out-of-the-money contracts expired, funds faced payouts that far exceeded their strategic cash holdings. Assuming a 30% decline in the AUD versus the US dollar, and net unhedged forex exposure of 17%, the average fund was forced to pay as much as 5.1% (30% x 17%) of its total fund value.
With this experience still fresh in their minds, investment managers are getting excited about a forex overlay approach that has been a favoured tool of international bond issuers and fixed income portfolio managers for some time. The strategy employs longer-dated cross-currency basis swap contracts – plain vanilla derivatives contracts quoted on multiple screens, which advocates argue allow funds to better manage liquidity requirements by smoothing out income gains and losses. Moreover, they argue, it is accretive to the overall risk-adjusted portfolio returns.
“The rollover risk arising from FX overlay programmes based on short-dated contracts can be very large, as the past few years have shown. By using longer-dated cross-currency basis swap contracts, funds can improve the liquidity profile of their FX overlay, and get paid for a risk management activity which they have to do anyway,” says QIC’s Reick.
Funding requirements
The opportunity for better risk-adjusted forex overlay performances is driven by market expectations around the offshore funding requirements of Australian financial institutions. Essentially, the more offshore debt issuance announced by Australian banks, the greater the cost of converting that funding back to the domestic currency using cross-currency basis swaps and vice versa.
At the same time, the relative issuance activities of international borrowers in the kangaroo (domestic Australian) market can have an offsetting effect, with increased issuance and related supply of the domestic currency acting as a cap on basis swap spreads. Since the global financial crisis, broad capital market liquidity and the general availability of funding has amplified the supply/demand dynamic, with the AUD/USD bases turning deeply negative during the Lehman crisis in late 2008 and widening substantially in 2010 on the back of heavy offshore issuance.
Australian banks have recently increased US dollar and euro covered bond issuance as demand for senior bank paper dried up. Issuance of US dollar-denominated asset-backed securities by Australian banks, for example, grew to more than US$1.8 billion in 2011, up from around US$750 million in 2010, while US dollar covered bond issuance grew to US$2.2 billion in 2011 from zero in 2010. Growth of euro covered bond issuance is even more pronounced, with US$17.6 billion-equivalent printed across 18 deals in the first quarter of 2012 alone, according to data provided by Dealogic.
Although the AUD/USD cross-currency basis has tightened in from the 2010 levels across its term structure, increased offshore issuance has kept the basis at elevated levels so far this year.
According to the 2011 Superannuation FX Survey by National Australia Bank (NAB), which polled 49 of the country’s largest super funds with combined AUM of A$523 billion (US$560 billion) representing 79% of the market, unhedged portfolios lost 12.7% in 2010 on adverse currency moves alone, while 100% hedged positions gained 4.5%.
Since mid-2009 the effect is more pronounced, with unhedged positions giving up 30% against gains of 8% for fully hedged positions. The 38% differential represents an opportunity cost to overall portfolio performance of some 3.25% per annum since then, according to NAB.
Against a backdrop of increasing offshore exposure and a focus on relative performance versus their domestic peer group, it should follow that Australian super funds have significant interest in optimising their currency overlay strategies. Outside of the fixed interest sector, however, investment managers say there is little consensus around forex risk management best practice with some funds ignoring it altogether.
Troy Rieck, managing director with the Brisbane-based Queensland Investment Corporation (QIC), an institutional investment manager with AUM of A$60 billion, reports a disparate range of operational approaches. “Some funds use their asset managers to run forex hedging strategies, some rely on their custodians, while others choose not to hedge or don’t really think about it at all,” he says.
Furthermore, the tendency of incumbent providers to rely on traditional hedging tools can act as a drain on liquidity with painful consequences. Between July and October 2008, the Australian dollar dropped by more than 30% versus the US dollar, leaving funds long the Aussie dollar after one-month and three-month AUD/USD forex forward hedges faced a severe, one-off liquidity event. As the deeply out-of-the-money contracts expired, funds faced payouts that far exceeded their strategic cash holdings. Assuming a 30% decline in the AUD versus the US dollar, and net unhedged forex exposure of 17%, the average fund was forced to pay as much as 5.1% (30% x 17%) of its total fund value.
With this experience still fresh in their minds, investment managers are getting excited about a forex overlay approach that has been a favoured tool of international bond issuers and fixed income portfolio managers for some time. The strategy employs longer-dated cross-currency basis swap contracts – plain vanilla derivatives contracts quoted on multiple screens, which advocates argue allow funds to better manage liquidity requirements by smoothing out income gains and losses. Moreover, they argue, it is accretive to the overall risk-adjusted portfolio returns.
“The rollover risk arising from FX overlay programmes based on short-dated contracts can be very large, as the past few years have shown. By using longer-dated cross-currency basis swap contracts, funds can improve the liquidity profile of their FX overlay, and get paid for a risk management activity which they have to do anyway,” says QIC’s Reick.
Funding requirements
The opportunity for better risk-adjusted forex overlay performances is driven by market expectations around the offshore funding requirements of Australian financial institutions. Essentially, the more offshore debt issuance announced by Australian banks, the greater the cost of converting that funding back to the domestic currency using cross-currency basis swaps and vice versa.
At the same time, the relative issuance activities of international borrowers in the kangaroo (domestic Australian) market can have an offsetting effect, with increased issuance and related supply of the domestic currency acting as a cap on basis swap spreads. Since the global financial crisis, broad capital market liquidity and the general availability of funding has amplified the supply/demand dynamic, with the AUD/USD bases turning deeply negative during the Lehman crisis in late 2008 and widening substantially in 2010 on the back of heavy offshore issuance.
Australian banks have recently increased US dollar and euro covered bond issuance as demand for senior bank paper dried up. Issuance of US dollar-denominated asset-backed securities by Australian banks, for example, grew to more than US$1.8 billion in 2011, up from around US$750 million in 2010, while US dollar covered bond issuance grew to US$2.2 billion in 2011 from zero in 2010. Growth of euro covered bond issuance is even more pronounced, with US$17.6 billion-equivalent printed across 18 deals in the first quarter of 2012 alone, according to data provided by Dealogic.
Although the AUD/USD cross-currency basis has tightened in from the 2010 levels across its term structure, increased offshore issuance has kept the basis at elevated levels so far this year.
No comments:
Post a Comment