Amid all the drama in the financial markets over the past two weeks, it has been easy to ignore a ripple effect that could significantly influence global corporate bond flows. That is, the substantial drop in the cost of hedging the exposure to the United States dollar by American credit investments.
This makes US high-yield bonds, in particular, much more attractive to British, European and Japanese investors, which could unleash strong pent-up demand.
The past few years have been a frustrating time for non-US investors seeking income. For much of this period, the high-yield European market offered a return of 2% to 4%, while the American market offered a 5% to 7%. At first glance, you could go to the US market and get double the yield.
In reality, you could only get that if you also assumed the exposure to the US dollar associated with American investments. But currencies can be very volatile. The uncovered approach is normally for the brave or the reckless.
Currency exposure hedging involves selling one currency to buy another. If you are an investor in euros who wants to cover an exposure to the US dollar, you sell enough exposure to the US dollar to cover the value of your investment and buy exposure to the euro with the product.
This has costs. Part of this cost comes from the “cross currency base”, which is essentially the premium you pay to buy a currency in high demand. But most of the cost comes from the difference between the short-term interest rate you receive when you hold one currency and the short-term interest rate you pay when you sell another.
These rates are indirectly linked to the respective key rates of the central currencies of the currencies. The Federal Reserve started raising rates at the end of 2015 and reached 2.5% in the middle of last year. In contrast, the Bank of England has raised rates twice since 2016, but has only reached 0.75% yet – and reversed everything on Wednesday with an emergency cut. The European Central Bank has been frozen below zero for four years.
If you were selling U.S. dollars between 2015 and 2019, then you were paying an increasingly higher interest rate – while the rate you received went nowhere. For investors in euros and pounds holding US assets hedged into foreign currencies, the net cost peaked at 3.6% and 2.1%, with yield erosion, respectively. This is enough to cancel out all the extra yield you got from buying high yield US bonds rather than European ones.
But these costs have fallen steadily in the nine months preceding the Fed’s aggressive 50 basis point drop last week. And after the Fed moved, they fell precipitously. By Wednesday, the cost of hedging the US dollar exposure had fallen below 1% for euro investors and just 12 basis points for sterling investors.
At the same time, US high-yield bonds sold harder during the coronavirus crisis than European high-yield bonds, where issuers tend to be of higher quality and less cyclical. As a result, in their own currency, the high-yield US market still offered some 2.5 percentage points more than the high-yield European market.
Even when you factor in the cost of hedging, you get close to 2 percentage points of return by switching from European bonds to US high-yield bonds. In other words, a euro hedged investor in the US high-yield bond index had a yield of around 2.4% before the coronavirus hit the headlines and the Fed cut rates – but now gets more than 6%.
Is it likely to reverse soon? We doubt it. It’s hard to imagine that the Fed will raise rates by 50 basis points in the coming weeks, or that the short-term minimum rates associated with the euro and pound sterling will drop much lower than dollar rates. In fact, interest rate markets expect the Fed to return to zero. This would likely reduce the cost of hedging the dollar to the euro to around 0.5%, while completely wiping out the cost of hedging the dollar to the pound.
Obviously, the situation is volatile. The relative value of local currency returns may change as markets respond to the spread of the coronavirus. But it’s fair to say that currency hedging costs should no longer be a barrier for investors seeking to allocate to US bonds.
We believe that flows into US assets could accelerate considerably once this reality subsides, and as investors reassess the relative value of supply for bonds in developed markets.
The author is a senior portfolio manager at Neuberger Berman in London
