It’s no secret that foreign inflows into US fixed income markets have been an important source of demand for mortgages, investment grade credit and high yield securities over the past several years. The Bank of Japan’s (BoJ) zero interest rate policy and the European Central Bank’s (ECB) negative interest rate policy have helped increase the relative attractiveness of US fixed income for non-US investors.
What’s perhaps less apparent is that, for non-US investors, evaluating US fixed income is not as simple as comparing US yields to domestic yields. In our experience, most evaluate US fixed income on a currency-hedged basis and then implement a currency hedge when they invest. That currency hedge can result in significant changes in the economics of foreign bond investing.
As our colleague Vivek Bommi noted two weeks ago on the spread differential between euro-denominated and US dollar-denominated high yield bonds, this is a particularly important subject right now.
Currency-hedged credit yields at multi-year lows
Its impact is felt well beyond the high yield markets. Relatively low US yields, tight credit spreads, expectations for additional Federal Reserve hikes in 2018 and the potential fallout from the Fed’s recently announced balance sheet reduction plan are combining to reduce the currency-hedged yields available in US fixed income.
Let’s take a look at the yield-to-worst for the Bloomberg Barclays US Credit Index, for example. At the end of September, a US dollar-based investor could expect 3.1 per cent. By contrast, a Japanese yen-based investor was looking at just 1.0%. The 200 basis points of difference was the cost of hedging dollars back to yen. Today, by this measure, currency-hedged credit yields are at five-year lows.
They may be heading even lower.
In practice, we find (and often favour) that investors hedge their currency risks for shorter periods than one year, such as three months. When we look at forward markets in three-month currency hedges, the pricing suggests that the cost non-U. S. investors face to hedge the currency risks associated with their US fixed income allocations is likely to head higher as we move into 2018.
For example, we estimate that a euro-based investor buying US fixed income and using a three-month hedge currently incurs an annualised cost of some 2.09 per cent. Nine months from now, market pricing suggests that a new three-month hedge would cost 2.30 per cent, approximately 21 basis points higher. The cost of a three-month hedge for a Japanese yen-based investor is forecast to rise by 41 basis points.
Why are currency-hedging costs priced to increase? Because these costs are determined by money market interest rate differentials and an additional, supply-and-demand-driven “cross-currency basis,” we believe that two factors are at work. First, an expectation of interest rate hikes from the Fed compared with more static monetary policy from the BoJ and ECB is leading to a forecast for wider interest rate differentials between US dollar money markets and those denominated in euros or yen. Second, the Fed’s balance sheet reduction may trigger higher demand for US dollars, which would widen the cross-currency basis.
Investors should remain vigilant on hedging costs
Some potential implications follow for investment strategy.
First and foremost, it’s important to recognise that market-based forecasts for higher hedging costs are just that: forecasts. Exact hedging costs over time will vary, and in fact, over the past several weeks, we have even seen a modest decline in expected hedging costs.
We believe this topic of hedging costs and hedge-adjusted yields will be an important topic, and is something we are monitoring closely, but it’s also important to recognise the uncertainty around how hedging costs develop.
Second, if hedging costs do end up increasing in 2018, we would expect investors to respond by looking at additional, attractive income sectors for new allocations, such as European credit or emerging markets. In our opinion, fundamentals behind US credit remain relatively robust and attractive.
In conclusion, we believe this topic of hedging costs and hedged yields will likely rise in importance over the next 12 months; but right now, it’s something investors should have on their radar rather than providing a rationale for specific portfolio action.
— Brad Tank is a Managing Director, Chief Investment Officer, and Global Head of Fixed Income at Neuberger Berman.
