The renewed case for currency hedging fixed income exposures
Currency hedging has long been a practical tool for reducing asset return volatility—and with a fair wind, for enhancing returns. But a likely watershed in US dollar strength, and a choppy outlook for Sterling and the euro all support renewed currency focus.
Getting currency calls right has always been a challenge for international asset allocators. The 10% decline in the trade-weighted USD in the first half of 2025 would have comfortably outweighed most asset returns,turning a nominally favourable asset selection bad for non-USD based investors.
State Street foresees ongoing currency challenges for the dollar, euro and sterling, after a period of relatively benign currency trends. We expect a multi-year US dollar bear market, with the currency dropping at least 15% in the face of waning economic exceptionalism and political reliability. We do not discount the dollar falling 25 – 35% over the next decade. This follows a 15-year period where US returns for ex-US investors were amplified by a strengthening dollar. We do not see this continuing, even over the next three to five years. We believe the US dollar free lunch era is over.
We are also modestly negative on the pound over the near term. Sterling rests on a shaky foundation of high debt, persistent current account deficits, and near-stagflation. Fiscal constraints and rising unemployment hamper growth. Relatively high yields are marginally supportive but we see Sterling struggling over the medium term beyond the US dollar and Swiss franc.
And we maintain a negative near-term stance on the euro. European Union fundamentals are lacklustre compared to other G10 economies. The European Central Bank (ECB) is likely near or very nearly done with its rate-cutting cycle, but with the low 2% policy, there are more interesting opportunities to pick up carry.
For more on our currency outlooks visit our currency management page.
What can a fixed income investor do?
Currency hedging is a practical way to mitigate the impact of foreign exchange movements on returns. Through our hedged share classes, we manage base currency risk on a rolling monthly basis—helping investors achieve outcomes more closely aligned with the unhedged index. But viewing a currency hedged share class solely through the lens of currency risk mitigation misses some important potential advantages.
A force for returns
Hedging US dollar risk can be expensive for euro-based investors because the process involves paying US dollar rates and receiving euro rates. The cost of hedging EURUSD forward is around 190 basis points (bp) over the course of a year.1 For investors in higher-rate environments the reverse is true—interest-rate parity can work in their favour. In other words, US dollar-based investors would effectively earn 190 basis points (bp) to hedge out euro risk. This creates a meaningful source of returns on top of the yield generated by the underlying strategy.
For example, the Bloomberg Euro Corp 0-3 Year Index has an annual yield to worst of 2.55%. Adding the additional 1.90% carry from the EURUSD hedge brings the total to 4.45% in USD terms. For USD-based investors this compares favourably to the 4.13% yield available on the Bloomberg US Corporate 0-3 Year Index.2
Hedged share classes are slightly less predictable because currency risks are hedged forward one month at a time, in line with the bond index rebalancing. This may erode the carry from the FX forward if interest rate differentials narrow. But interest rate convergence is usually a gradual process and it is easy to demonstrate the impact on returns of investing in a hedged share class. Figure 1 shows the rolling 12-month returns from the Bloomberg Euro Corp 0-3 Year Index and the identical index hedged into dollar and Sterling. Total returns for both hedged indices were over 200bp above those of the unhedged index for the 12 months to November 2025.3
In addition to minimising the impact of currency fluctuations, currency hedged indices also deliver returns from the underlying strategy along with the carry from the hedge. Of course, currency moves can favour the investor: early 2025 dollar weakness boosted total returns from non-USD denominated assets for USD-based investors.
Figures 2 and 3 illustrates the 12-month rolling returns of the Bloomberg Euro Corp 0-3 Year Index. Each chart plots returns from the hedged version of this index with the unhedged euro-denominated index in the same currency as the hedged equivalent index. This shows how returns would look for USD- or GBP-based investor in their domestic currency. Over the 12-months to October 2025, maintaining a unhedged exposure would have resulted in higher overall returns. The euro’s appreciation in early 2025 provided meaningful returns to both GBP- and USD- based investors. However, as Figure 4 demonstrates, returns have been far less predictable. The index’s annualised 10-year returns in euro was 1.1%, close to returns that an investor would have received in either dollars or pounds on an unhedged basis. In contrast, the hedged strategies produced substantially higher total returns over the same period.
Figure 4: Annualised returns for the Bloomberg Euro Corp 0-3 Year Index in hedged and unhedged exposures.
EUR unhedged | GBP hedged | USD hedged | GBP unhedged | USD unhedged | |
1Y | 3.11% | 5.16% | 5.24% | 8.80% | 13.06% |
3Y | 3.95% | 5.62% | 5.96% | 4.49% | 7.78% |
5Y | 1.66% | 3.04% | 3.40% | 1.23% | 1.09% |
10Y | 1.11% | 2.28% | 3.03% | 0.86% | 1.22% |
Source: State Street Investment Management, Bloomberg Finance, L.P., as at 28 November 2025. The performance data quoted represents past performance. Past performance does not guarantee future results.
This highlights how currency movements can influence short-term returns. Figures 5 and 6 illustrate the excess 12-month return in the investor’s local currency from investing in the Bloomberg Euro Corp 0-3 Year Index on an unhedged basis versus hedged basis. Unsurprisingly these returns closely track the 12-month change in the currency. Significant gains were achieved by remaining unhedged after the 2016 Brexit vote in the UK, and during the recent period of dollar weakness for US investors.
The mean-reverting properties of some currency pairs over a full policy cycle helps limit the impact on long-term total returns. While the hedged share class does not benefit from currency appreciation, it harvests the carry from higher interestrate on one side of the currency pair.
Lower volatility
Holding unhedged positions exposes investors to significant currency volatility (see figure 2). Figure 7 shows annualised index volatilities, highlighting the advantages of hedged exposure — particularlyfor USD-based investors where the annual volatility of unhedged exposure over the past five years has been over five times that of the hedged alternative.
Figure 7: Annualised volatility for the Bloomberg Euro Corp 0-3 Year Index in hedged and unhedged exposures.
| EUR unhedged | GBP hedged | USD hedged | GBP unhedged | USD unhedged |
1Y | 0.41% | 0.45% | 0.44% | 3.44% | 8.87% |
3Y | 1.00% | 0.99% | 0.97% | 3.32% | 7.75% |
5Y | 1.60% | 1.63% | 1.61% | 3.80% | 8.29% |
10Y | 1.44% | 1.46% | 1.43% | 6.02% | 7.53% |
Source: State Street Investment Management, Bloomberg Finance, L.P,. as at 28 November 2025.
Conclusion
Unhedged currency generally increases volatility. This can benefit investors holding high conviction currency views but hedged strategies are often preferable when there is less certainty, or for core portfolio positions held over the long term.
These strategies have significantly reduced volatility, and FX hedge construction can capture carry when exposed to a lower yielding currency. For USD - or GBP-based investors, hedging euro-denominated exposures back to their domestic currency may offer higher yield potential than comparable local market equivalents.
For more on currency hedged ETFs, visit our currency hedged ETF page.