International Bond Currency Risk: Hedged vs Unhedged Funds Explained

When you invest in international bonds, you're not just betting on interest rates-you're also betting on exchange rates. That’s a problem most people don’t realize until their portfolio drops not because the bond market crashed, but because the dollar got stronger. This isn’t speculation. It’s a measurable, documented risk. And the solution isn’t complicated: hedged international bond funds eliminate this risk. Unhedged ones don’t. The question isn’t whether currency matters-it’s whether you want it driving your bond returns.

Why Currency Risk Matters More in Bonds Than Stocks

People often assume that if currency risk is okay for international stocks, it’s fine for bonds too. But bonds don’t behave like stocks. Stocks can grow, adapt, and earn more over time. Bonds pay fixed interest. Their value is tied to interest rates and credit risk-not earnings growth. When you add currency swings to that, you turn a stability tool into a gambling chip.

Take a U.S. investor who buys a Japanese government bond yielding 1%. If the yen falls 5% against the dollar over the year, your total return isn’t 1%. It’s -4%. Even if the bond itself didn’t lose value, you still lost money. That’s not investing. That’s currency speculation.

Vanguard’s research shows that in unhedged international bond funds, currency movements account for 20.75% of total risk. Interest rates drive the rest. But here’s the kicker: in hedged funds, currency risk drops to near zero. That means your portfolio moves with bond markets, not exchange rates.

The Numbers Don’t Lie: Hedged vs Unhedged Performance

From 2002 to 2007, the U.S. dollar weakened. Unhedged international bond funds surged-returning 61.5%. Hedged funds? Just 36.8%. That’s a 24.7-point gap. It looked like unhedged was the clear winner.

But then the dollar turned around. Between 2008 and 2023, the dollar strengthened. Unhedged funds lost ground. Hedged funds held steady. Over a 20-year period, the average annual return for unhedged funds was 2.9%. For hedged? 3.0%. Same return. Different ride.

The difference isn’t in returns. It’s in volatility. Unhedged international bond funds had annualized volatility of 6.5%. Hedged? Just 1.3%. That’s five times less risk. For a bond fund, that’s not a small difference-it’s the difference between a safety net and a rollercoaster.

During the March 2020 market crash, unhedged international bonds fell 12.3%. Hedged ones? Down only 4.7%. That’s not a coincidence. That’s the result of removing currency risk.

How Currency Hedging Actually Works

Hedging isn’t magic. It’s math. When you buy a euro-denominated bond, your fund doesn’t just hold it. It also enters a forward contract to sell euros and buy dollars at a fixed rate in the future. That locks in the exchange rate. If the euro falls, you’re protected. If it rises, you miss out on the gain-but you also avoid the loss.

Vanguard uses one-month forward contracts, rebalanced every month. That keeps the hedge tight. The cost? Around 0.15% per year. That’s less than the average expense ratio on many actively managed bond funds. And you’re not paying for speculation-you’re paying for stability.

Some funds use swaps or futures. The method varies. The outcome doesn’t: currency risk is neutralized. You get the bond yield. Not the currency swing.

Why Most Advisors Recommend Hedged Funds

A 2025 survey by Cognizant Wealth found that 82% of financial advisors recommend hedged international bond funds for core portfolio allocations. Why? Because clients don’t want their bond holdings to act like currency trades.

Bonds are supposed to reduce risk. They’re the cushion when stocks crash. Unhedged international bonds failed that test in 2008 and 2020. Hedged ones passed. They moved less. They recovered faster. They behaved like bonds should.

Nobel laureate William Sharpe’s research supports this. He says currency risk in bonds is uncompensated. That means you’re taking on extra risk without expecting extra return. In stocks, you might get paid for currency exposure over decades. In bonds? Not really.

Vanguard’s July 2023 whitepaper says it plainly: “Bond funds benefit the most from currency hedging.” That’s not marketing. That’s data.

The Downside: When Hedging Loses Out

There’s no free lunch. When the dollar weakens, unhedged funds outperform. That’s why some investors cling to them. They remember 2002-2007. They think, “I’ll time it.”

But timing currency movements is harder than timing the stock market. No one predicted the dollar’s 10-year slump after 2002. No one predicted its 2022 rally. If you’re trying to guess which way the euro or yen will go, you’re not investing-you’re gambling.

And even if you’re right for a few years, the long-term data shows it doesn’t matter. Over 35 years, currency moves didn’t add meaningful returns to international bond portfolios. Any gain from a weak dollar was eventually erased by a stronger one.

Hedging doesn’t guarantee higher returns. It guarantees more predictable ones.

What the Market Is Doing

The market is voting. Vanguard’s hedged international bond ETF (BNDW) grew from $500 million at launch in 2013 to $28.7 billion by mid-2024. The unhedged version? Just $12.3 billion.

Target-date funds-the go-to choice for retirement savers-now use hedged bonds in 78% of cases. That’s up from 35% in 2016. Major providers like iShares and Schwab have followed suit. iShares even launched a hedged emerging markets bond ETF in March 2025.

Even funds that once offered unhedged options are closing them. One popular unhedged international bond fund was shut down in mid-2025 and replaced with a hedged version. That’s not an accident. That’s industry evolution.

Morningstar predicts that by 2027, 90% of new international bond allocations will be hedged. The shift isn’t coming. It’s already here.

Should You Hedge? The Simple Rule

Ask yourself this: Why are you holding international bonds?

If your goal is to reduce portfolio volatility, get exposure to global economies, and keep things stable during stock crashes-then you need a hedged fund.

If you think you can predict currency movements, want to bet on the euro rising, or believe foreign exchange will boost your returns-then you’re not investing in bonds. You’re investing in forex. And that’s a different game.

For 95% of investors, the answer is clear: hedged. The cost is low. The risk reduction is proven. The long-term results are better.

Unhedged funds have a place-for speculative portfolios, currency plays, or tactical bets. But not for core bond allocations.

What to Look For in a Hedged Bond Fund

Not all hedged funds are equal. Check these three things:

• Expense ratio: Look for funds under 0.25%. Vanguard’s BNDW is 0.07%. iShares’ BWXH is 0.18%. Anything over 0.35% is too high.
• Hedging method: Funds using forward contracts are standard. Avoid those using options or complex derivatives unless you understand the risks.
• Track record: Look at performance over 10+ years, not just the last 3. Hedged funds should show lower volatility and similar returns to unhedged over long periods.

Avoid funds that hide hedging costs in the expense ratio. SEC rules require them to be disclosed separately. Check the prospectus.

Final Thought: Bonds Are for Stability

You don’t buy bonds to chase returns. You buy them to avoid losing money when everything else crashes. If your bond fund is swinging with the euro, the yen, or the pound, it’s not doing its job.

Hedged international bond funds fix that. They let you own global debt without owning global currency risk. That’s not a trick. It’s basic portfolio design.

The data, the advisors, the market leaders-they all agree. For bonds, hedge. Always.