Debt funds — what is the impact of currency movements on fund performance?
Many debt funds in Europe provide loans to borrowers in other countries. This decision is motivated by several factors such as geographical diversification to reduce portfolio risk, demand of major investors seeking exposure to certain countries, or the search for yield. These loans are often in currencies other than the one in which the funds report or are denominated. As a result, the funds are inherently exposed to currency risk – that is, any depreciation of the currency in which the loan is made decreases the value of the principal and interest in terms of the reporting currency.
Example: a EUR €2 billion fund plans to provide GBP £510 million of loans to borrowers in the United Kingdom across various corporate sectors, which is about 30% of capital commitments. The manager has a minimum target of 6% IRR from EUR-denominated loans and expects the GBP-denominated loans to return 8% IRR on average — higher yield on one hand, currency risk on the other. While the loans differ in contractual maturity based on the needs of the borrowers, the manager projects the effective tenors to be four years on average.
Chatham builds custom models for fund managers to quantify the currency risk to their fund performance. The currency risk can be positive (i.e., the foreign currency strengthens against the reporting currency) or negative (i.e., the foreign currency weakens against the reporting currency), and fund managers want to see the range of potential IRR. Table 1 reports the simulated IRR in different paths of future EUR-GBP spot rate (a sample output of our models). For debt funds with lower target returns than other private equity strategies, the extent of potential erosion may be unacceptable.
Many fund managers facing such currency risks will formulate and implement a currency risk management programme. Our models incorporate two–three common risk management strategies, along with realistic hedging costs, so that the managers can see their impact and compare the relative pros and cons. Table 2 reports the simulated IRR in the same scenarios assuming that the GBP loan principals are being hedged with four-year Sell GBP Buy EUR forward contracts. If the future EUR-GBP spot is the same as the current level — i.e., no currency risk transpires — then the hedged IRR of GBP loans is 1.1% point lower than the un-hedged IRR. That is the cost of hedging. The benefit is that the hedged IRR is much healthier in GBP weakness. Currency risk management offers investors less variance in potential IRR, notwithstanding the wide range of currency scenarios.
Constructing a currency risk management programme is seldom viewed by debt fund managers as one of their core competencies, but the task unavoidably becomes their responsibility as they and their investors seek to preserve the investment performance. The process can be complex: a manager must consider several clusters of factors that in turn may interact with one another. For example, a manager may find a cross-currency swap to be ideal on paper. It mirrors the GBP loan principal and interest and synthetically converts the loan into EUR. However, since the fund is domiciled in the EU and is classified as a Small Financial Counterparty under the European Market Infrastructure Regulation (“EMIR”), a cross-currency swap falls under variation margin — whereas a forward contract does not. While EMIR may not apply in full when an EU-domiciled Non-Financial Counterparty trades with non-EU financial institutions, regulations in other jurisdictions may come into play. Table 3 lists the key considerations in constructing a currency risk management programme.
Diversifying geographically and earning higher yield may be financially and strategically important to debt fund managers. In so doing, currency risk becomes inherent to their investment thesis. As demonstrated above, the risk can be substantial. Quantifying the risk and evaluating mitigation approaches is fundamental to an informed dialogue with investors and internally within the risk committee. Constructing a risk management programme is not simple as there are several clusters of factors to consider, including how they interact with one another. We at Chatham are uniquely positioned to partner with debt fund managers in crafting a risk management programme, communication with investors, and sustaining the programme.
Want to learn more about how currency movements can affect your fund's performance?
Connect with an expert
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.22-0006
Our featured insights
Semiannual Market and Economic Update
Join Chatham for our latest webinar update on global economic conditions and events. Jackie Bowie and Amol Dhargalkar will share insights and discuss opportunities to manage risk and enhance decision making in the capital markets.
CAD/USD volatility continues as Canadian and U.S. monetary policy diverges
CAD and USD have been among the most volatile global currency pairs in recent weeks.
Pricing a foreign currency loan spread competitively
A EUR-denominated fund has an opportunity to make a mezzanine loan to a UK borrower. The prospective borrower can accept a five-year mezzanine loan in British pounds (GBP) at three-month Sterling Overnight Index Average (SONIA) plus 600 basis points. The fund has a minimum return target of 6% IRR...
Monitoring an FX hedging programme with dashboards
Once a currency risk hedging programme has been established, a manager’s risk management focus shifts to ensuring that the programme achieves its objectives in both risk reduction and maintenance cost, and that they deliver hedged performance profiles that investors expect. Tools and dashboards...
Establishing and operating hedged sleeves
Diversifying the asset base geographically and earning higher yield from investing in different jurisdictions may be financially and strategically important to debt fund managers. In so doing, general partners (GPs) are exposed to currency risk on the asset side of the fund’s balance sheet.
Chatham Financial announces CEO transition effective January 2022
Matt Henry named the next Chatham CEO
Chatham Financial wins Hedging Adviser of the Year at the Risk Awards
On November 26, Chatham Financial accepted the inaugural Hedging Adviser of the Year award at the 2020 Risk Awards. This new award recognizes excellence in providing independent advice to derivatives users.