UK investors have been warned global bond funds that do not hedge their holdings back into sterling are exposing themselves to potential huge losses in the event sterling bounces back from its current lows, with many investment professionals agreeing the currency is undervalued.
Having fallen around 16% since the EU referendum in 2016, the pound has been hovering around lows of $1.23 to $1.25 over the last couple of months amid Brexit fears.
However, industry experts have warned the currency could rebound sharply if an agreement between the EU and the UK is reached, which could hit foreign fixed income exposures.
Chris Peel, CIO at Tavistock Wealth, said: "Sterling is significantly undervalued against the dollar and should be closer to $1.45, so investors could see potential losses of 18% in FX alone. It is hard to get this loss back."
Peel pointed to the high correlation of returns between the IA Global Bond sector and the dollar rising against a falling pound, saying he was "staggered" to learn that a large proportion of UK funds that invest globally do not offer hedged share classes.
This is a "huge problem" in the global bond market, he said, where investing on an unhedged basis could mean taking on triple the risk.
"There will be huge losses [in global bonds] that could take over a decade to recover," he said.
"It has not come home to roost yet because sterling has fallen from around $1.60 to where we are now, so fund managers have been able to hide behind poor asset allocation decisions and be bailed out by the fall in FX. But they will have to give it all back."
Adrien Pichoud, head of total return strategies at Syz Asset Management, who sees sterling potentially rising to trade at around $1.35 in the near-term, agrees these worries are warranted.
"If sterling were to rise and someone has bonds in dollar or in euro unhedged, the impact will be quite negative; it will be very difficult to see that the yield generated offsets the impact of the FX," he said.
His base case when it comes to overseas bonds is to always hedge: "It would be wrong to buy a bond outside the base currency of a portfolio as then you are expressing an FX view, and bonds may not be the best way to
Anthony Carter, fixed income fund manager at Sarasin & Partners, agrees there is a "case to be made for hedging" assets from low interest rate environments, such as European and Japanese bonds, as "you increase your yield if you hedge back to sterling".
However, in higher interest rate environments, such as the US, where hedging means giving up yield, the question is more "nuanced".
"If you are holding US fixed income you do it to hedge against a negative market outcome, and part of this would be the dollar rallying against sterling, so I would be happier to leave dollar exposure unhedged," he said, but added that further cuts in US interest rates would make hedging more attractive.
Meanwhile, Will Mcintosh-Whyte, fund manager on the Rathbone Multi-Asset Portfolio funds, said some currencies, such as the Australian dollar, tend to be "risk-on currencies", so should always be hedged back to sterling.
"We hold some Australian government bonds to hedge against a risk-off environment, and if the Australian dollar is falling at the same time, this does not give you protection," he said.
When it comes to emerging market exposure, the key question is whether currency or rates are the greatest source of return, said Carter: "If it is rates, then you might hedge; but if it is FX then you leave it unhedged".
Peel added hedging EM bond exposure may not be worthwhile due to the high costs.