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FX hedging for private debt funds

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In this short whitepaper: FX hedging for private debt funds, originally published in Private Equity International's book Private Debt Investor - The Global Guide to Private Debt, James Stretton discusses the source of FX exposure for debt funds, the methods of mitigating such exposure, and some of the challenges and choices around that process of mitigation.

Download the FX hedging for private debt funds whitepaper here.

Foreign Exchange (FX) exposure

This chapter is an introduction to FX hedging for private debt funds. It briefly discusses the source of FX exposure for debt funds, the methods of mitigating such exposure, and some of the challenges and choices around that process of mitigation.

Many debt funds make loans in currencies other than the one in which they report. As a result, they encounter FX risk, in that a depreciation of the currency in which the asset is held versus the reporting currency will lead to a diminution in the asset’s value (and related coupons) as measured in the reporting currency.

For example, a EUR denominated fund that, pre-Brexit referendum, made a £10 million loan at 1.3000 (EUR13 million) would now have an asset of only EUR11.75 million (£10 million at 1.1750), following sterling’s depreciation.

Most debt funds seek to mitigate this risk through FX hedging. Unfortunately, there is always a cost to hedging either in terms of credit consumption or cash. Given debt funds’ lower IRR than equity funds, the relative cost of hedging tends to be higher for a debt fund. Nonetheless, in the vast majority of cases, the desire to ‘lock down’ as much risk as possible means debt funds are more likely to hedge than equity funds. 

Methods of mitigating FX risk

The FX hedging technique most commonly used by debt funds is a simple, vanilla sale of foreign currency for the reporting currency or, if credit allows, a cross currency swap. 

Cross currency swap

In the case of a EUR-denominated fund invested in a GBP asset, the fund would notionally exchange EUR for GBP value spot and commit to physically exchange GBP back for EUR at the end of the loan period in, say, three years’ time at the same exchange rate. In the meantime, the fund would pay floating three-month Libor plus whatever margin it charges on its asset (to exactly match GBP payables and receivables) and receive the equivalent three-month floating EUR interest.

Forward contracts

With a forward contract, the fund simply sells GBP forward to a certain date. Unlike a cross currency swap, where the GBP/EUR interest rate differential manifests itself over the life of the swap through GBP payables and EUR receivables, with a forward the interest rate differential manifests itself at maturity in the form of a forward rate that is different from the spot rate (see Figure 16.1).

Figure 16.1: Forward rate explanation

Forward rate explanation
In an ideal world, synthetic foreign currency liabilities, created by cross currency swaps or forward contracts, should be matched as closely as possible to foreign currency assets. However, typical tenors for loans are between three and five years, and long-term FX hedging lines are very consumptive of credit and therefore expensive from a credit perspective. Apart from lower expected IRRs, another difference between private debt and private equity funds is that debt funds tend to be smaller. Often, this has the effect of making credit a scarcer resource for debt funds. Thus, having made, for example, a three-year loan, a debt fund may find it can only secure a three-month FX line and is therefore restricted to three-month forwards. In this circumstance, after three months, the hedge contract will have to be rolled over.

Rollover

A perceived disadvantage of rolled over, short-term forwards is that, upon rollover, the fund may experience a negative cash event. 

This has been a particular issue for GBP-denominated funds on account of the sharp depreciation in the GBP since the Brexit referendum in June 2016. A GBPdenominated fund may have chosen to make a EUR-denominated loan and then sold EUR forward against GBP for three months as a hedge. In three months’ time, the fund needs to roll over its hedge by executing an FX swap where the fund buys back EUR value spot and simultaneously sells EUR forward for another three months. However, if the GBP/EUR exchange rate on the old, maturing forward trade was, for example, 1.3000 and the current spot rate is 1.1750, the fund will have made a loss on the hedge of 12.5 cents or approximately £82,000 per EUR1 million hedged. This loss – a so-called negative cash event – will be crystallized on a rollover of the hedge and the loss will need to be funded.

It is important to note that the realisation of a loss on rollover does not have any impact on the overall return of the investment. In our example, as it rolls over its hedge, the fund loses 12.5 cents on the spot leg of the FX swap but gains 12.5 cents on the forward leg, since the three-month forward rate will also have moved lower in parallel with the spot rate. However, this will be no consolation if the loss on the spot leg cannot be funded until it is offset, in three months’ time, by the profit on the forward leg. 

Dealing with/avoiding negative cash events

Where credit constraints preclude the implementation of long-term hedging to cover the full tenor of a loan and shorter term hedging is therefore effected, it is essential to maintain sufficient liquidity to cover the risk of negative cash events. 

Liquidity

If a short-term FX forward contract has a negative mark to market at maturity and the contract is rolled over, the negative mark will still be realised. This can present a liquidity challenge. There are three commonly used methods of ensuring that a fund has sufficient liquidity to allow the crystallization of losses on rollover: 

  1. Rely on quarterly coupon payments from assets
    Clearly, if this method is relied on solely, much will depend on the proportion of the fund invested in foreign currency. With only 20 percent of the fund invested in foreign currency, and assuming an average annual yield on the fund of eight percent (two percent per quarter), a forward contract would need to expire with a 10 percent negative mark to market to absorb all the coupon income in a given quarter. This would reduce to only a four percent negative mark to market were 50 percent of the fund invested in foreign currency assets. 
     
  2. Limit loss forwards
    In order to limit the extent to which a forward contract can crystallize a loss on rollover, some funds use limit loss forwards. For example, a EUR-denominated fund with GBP assets may have decided to hedge the risk of GBP depreciation by selling GBP against EUR three-months forward at a GBP/EUR exchange rate of 1.1720. From a liquidity perspective, the fund is now at risk of an appreciation in the GBP, leading to the crystallization of a loss on rollover of the forward contract. The fund anticipates coupon payments on its loan portfolio of two percent per quarter and its GBP-denominated assets represent 30 percent of the portfolio. 

    If at the end of the quarter, the GBP has appreciated by more than 6.67 percent against the EUR, the fund will find itself in the unenviable position of having to use all its income in that quarter to make good the crystallized loss on rollover of the forward contract. The fund’s managers decide that restricting the maximum loss on a forward to five percent of the hedged amount makes sense in order to leave a prudent amount of headroom ahead of the 6.67 percent absolute limit. 

    Rather than hedge with a vanilla forward, the fund therefore elects to use a limit loss forward instead. This is achieved by selling GBP three-months forward and simultaneously buying a 5 percent out-of-the-money GBP call/EUR put option. The premium for the option is embedded into the forward contract, meaning no upfront premium is payable. The embedded GBP call effectively cancels out the forward contract once the spot rate has moved five percent above the rate on the forward contract. The fund can now be confident that, unless there are unpaid coupons, it will have liquidity to spare, even if the exchange rate moves significantly more than five percent higher. A perceived disadvantage to this strategy is cost. A five percent out-of-the-money forward GBP call/EUR put option currently costs in the region of 0.7 percent of the notional hedged amount. Using this strategy every quarter would thus act as a roughly 2.8 percent per annum drag on the performance of the fund’s GBPdenominated assets – or in our example, around 0.85 percent of the fund’s overall annual performance. This is clearly very expensive. Then again, as we have seen of late, GBP/EUR is a very volatile currency pair. A similar strategy for a USD fund investing in EUR-denominated assets would cost only around 0.3 percent, rather than 0.7 percent. 

    The above example shows how a limit-loss forward can protect a fund’s natural liquidity provided by its income. Limit loss forwards may also be used where a fund has not secured a ‘clean’ line for its FX hedging but is subject to a credit threshold, above which margin must be paid, an arrangement often formalised in a credit support agreement (CSA). The principle remains the same and the strike rate of the embedded GBP call/EUR put option would be set such that the option cancelled out the forward at the rate at which margin became payable under the CSA. The same technique can be used to control potential negative marks to market on cross currency swaps.

    Overall, a limit loss forward strategy tends to be used by smaller funds with a limited track record. 
     

  3. Revolving credit facility (RCF)
    Some funds use RCFs against which they draw when a maturing forward hedge contract crystallizes a loss that is too great for the fund’s natural liquidity position. This can be an excellent method of covering the liquidity risk of hedging with short-term forwards. Multi-currency RCFs allow more widely diversified funds to cover the liquidity risk against a variety of foreign currencies. 
     

Longer term hedging

More established, larger funds may have access to longer term FX hedging lines, which allow them to put in place longer dated forward contracts and avoid the potential frequent liquidity issues of hedging with short-term contracts.

The forward curve

Unless there is no interest rate differential at all between two currencies, there will always be some shape to the forward curve. Currencies with lower interest rates trade at a premium in the forward market to those with lower interest rates, and vice versa. This creates an additional cost for a EUR-denominated fund with GBP assets, since the fund needs to sell GBP forward to hedge back into EUR and the GBP, on account of its higher interest rates, trades at a discount to the EUR in the forward market. This can be seen in Table 16.1 below.
 

Table 16.1: The GBP/EUR forward curve

GBP-EUR-forward-curve


Figure 16.2: Spot GBP/EUR (daily close), January 1999 to December 2016 

Spot-GBP-EUR-daily-close-1999-2016

Source: Bloomberg

However, for a GBP-denominated fund investing in the EUR, the situation is beneficially reversed. Such a fund will need to sell EUR forward against GBP to hedge and the EUR trades at a premium to the GBP in the forward market. In this situation, the fund is effectively paid by the market to hedge. Given that only a small amount of positive interest rate differential is required to offset dealing costs, many funds find themselves in this happy position. This includes not just GBP funds investing in the EUR, but USD funds investing anywhere where interest rates are lower than in the US – into both EUR and GBP, for example.

Forward rates and the cost or benefit of hedging must always be taken in the context of potential moves in the spot rate and it is easy to forget just how historically volatile currencies can be. Figure 16.2 shows the spot GBP/EUR rate since the euro’s inception on 1 January 1999. 

Breakage costs in the event of early repayment 

If a GBP fund has made a EUR loan, which the fund has hedged by selling EUR forward against GBP, and the loan gets repaid early, the fund is protected from a spot perspective. However, the fund took points in its favour when it entered the hedge (since EUR trades at a premium to GBP in the forward market on account of the EUR’s lower interest rates compared to GBP’s).

When the fund comes to break the hedge following early repayment of the loan, if EUR rates have moved even lower relative to GBP rates, the fund could find itself taking more forward points against it on breakage than it took in its favour on the way in.

It should be noted that these breakage costs would also apply in the case of a  fixed/fixed cross currency swap (which effectively replicates a forward contract), although not in the case of a floating/floating cross currency swap, which would be more suitable for hedging a floating interest rate asset. 

Figure 16.3: Three-month and three-year forward adjustments, January 1999 - October 2016

Three-month-three-year-forward-adjustments
 

Figure 16.3 shows the extent to which the GBP/EUR interest rate differential has moved over the years, expressed as the number of GBP/EUR pips applied to the spot rate to derive the forward rate, where -400 means that the GBP trades at a discount of 4 cents in the forward market. While the movements in the three-month adjustment (the yellow line) are relatively mooted on account of the short tenor, those planning on longer term hedging should take note of the gyrations in the three-year forward adjustment (the purple line).

Fortunately, most debt funds discourage borrowers from repaying early with substantial penalties. Nevertheless, it is particularly important that debt funds contemplating FX hedging have sufficiently rigorous penalties in place to cover potential breakage costs relating to FX hedging, as the standard penalty agreements may be insufficient to cover breakage costs on FX hedging in the event of large changes in interest rate differentials. 

FX Options

Some debt funds (although they are the exception) prefer to hedge FX risk with FX options. These confer on the holder the right – but not the obligation – to exchange one currency for another at a pre-agreed rate (the ‘strike rate’), on a pre-agreed date.

Advantages:

    • Maximum negative cash flow is known in advance in the form of the premium payable.
    • No credit line is required beyond the small line to cover the two-day period between the purchase of the option
      and the payment of the premium. 
    • Allows the fund to benefit from advantageous movements in the underlying currency pair. 

Disadvantages:

    • Premiums are usually payable in advance.
    • Premiums are priced on the basis of the ability to benefit from advantageous movements and this is a feature
      that debt funds may not require and for which they would therefore rather not pay. 

Hedging coupons, capital or both 

Some funds focus more, or even exclusively, on hedging coupon payments rather than capital. This may seem counterintuitive, as it may be perceived that the bulk of the FX risk will relate to the larger principal amount rather than the relatively small coupons. However, in the case of evergreen funds, whereas one foreign currency loan is repaid, another tends to be made in the same currency, the capital is often regarded as a ‘sunk asset’ and FX hedging focuses only on the income stream. Note that future income may be hedged either on a quarterly basis as far forward as the credit line allows (cross currency swaps, if correctly structured, have the particular advantage of hedging coupons and principal simultaneously), or the NPV of future income may be hedged as one ‘slug’ on a short-term basis with a forward contract and rolled over in the same manner as an FX hedge for principal. 

Feeder funds and sub-classes 

Some debt funds may declare that they will not hedge against FX risk, and leave that risk for investors to manage. For certain investors, this may be acceptable but others require the security of knowing that FX risk is being dealt with. In such a situation, hedging may take place at feeder fund or sub-class level, but the principle is the same.

If a EUR-denominated debt fund makes a loan in GBP but does not hedge the consequent FX risk, a significant investor may insist on investing via a feeder fund structure in order to effect FX hedging. Here, the investor would invest EUR into the feeder fund. The feeder fund would sell EUR for GBP to make the investment and simultaneously sell GBP forward against EUR to hedge the investment.

A feeder fund may be set up for one investor only, or for more than one investor, in which case it represents a ‘EUR-hedged sub-class’ and subsequent EUR-reporting investors can choose whether to hedge in the EUR-hedged sub-class or the unhedged GBP sub-class. 

In this case, any FX hedging pertains to the feeder fund/sub-class only. It is, therefore, paramount that contamination of the main fund is avoided by keeping the feeder/sub-class FX hedging discrete. In the case of a feeder fund, a providing bank will make a credit decision based on the creditworthiness of the feeder rather than the main fund, which will inevitably have an impact on the credit line available for hedging. 

Overlay strategies 

‘Overlay strategies’ is a phrase that has many different meanings. For the purposes of this chapter, it refers to the use of models to decide whether or not a particular currency pair should be hedged or not.

Some models are programmed to consider a combination of previous price action in the spot market; the shape of the forward curve and the level of implied volatility in the options market, in order to come to a conclusion as to whether to hedge or not. Others analyse momentum indicators in order to identify trends.

One of the advantages of such overlay strategies is that they typically restrict themselves to hedging in the spot market, meaning that credit lines for forward trades are not required. For start-up funds of smaller size and with little or no track record, such overlay strategies can appear to offer the best of both worlds: protection against adverse currency movements, without the difficulties around credit and liquidity that so often come when using forward contracts to hedge.

However, there is no such thing as a free lunch. Overlay strategies tend to underperform a normal forward hedging strategy when the underlying currency pair moves against the fund. This is on account of the fact that whatever method is chosen by the overlay strategy to hedge – whether human judgement or momentum-seeking algorithms – the overlay strategy will inevitably lag a permanently-in-place forward when it comes to protecting against an adverse market movement.

In fairness, the opposite is also true. In the case of a beneficial underlying movement, an overlay strategy at least stands a chance of outperforming the traditionally hedged position, since it has the opportunity to be fully or partially unhedged, thus benefiting, at least to some extent, from the beneficial underlying move.

Whether an overlay strategy will beat a strategy based on vanilla forwards over a given timeframe depends on the extent to which the overlay strategy beats the forward strategy during favorable underlying moves, compared with the extent to which the for- ward strategy beats the overlay strategy during adverse moves. Given FX markets’ tendency to trend, the choice of an overlay strategy rather than a forward strategy could therefore look brilliant or awful, depending on whether the next big move was positive or negative on the underlying position. 

Summary

  1. The lower levels of return on debt funds makes FX hedging an important consideration.
  2. Availability of credit will define the FX hedging strategy and this can present a significant challenge for smaller start-up funds with no track record.
  3. As with all FX hedging, liquidity risk has to be managed.
  4. Unforeseen cash calls are more deadly than unrealised FX losses. 


Download the FX hedging for private debt funds whitepaper here.


About this white paper

This white paper originally appeared in Private Equity International’s book: Private Debt Investor - The Global Guide to Private Debt. It is the most comprehensive and detailed publication on the private debt market available today. It brings together the latest views and opinions of 19 of the world’s leading practitioners. To find out more about this comprehensive guide go to: www.privatedebtinvestor.com 

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