By Tomo Uetake and Saikat Chatterjee
TOKYO/LONDON (Reuters) – A worrying sign of inversion in the U.S. Treasury bond curve is dulling the appeal of the developed world’s highest-yielding bond market for foreign investors.
Overseas investors are reviewing their investments or shunning Treasuries as rates at the short end rise above those at the longer end and make it unprofitable for holders of these bonds to hedge their currency risks.
The difference between short- and long-term bond rates, or the yield curve, has contracted in recent weeks as rising U.S. interest rates meet growing doubts the world’s biggest economy may be slowing down, weighing on longer-dated yields.
And as short-term yields move higher than longer-term yields, the cost of hedging exposure to the U.S. dollar has gone up.
“There is the whole issue of hedging costs. That is the one thing that was inconsequential at the start of the year but now it is sizeable,” said Paul O’Connor, head of multi-asset at Janus Henderson in London, whose firm manages $378.1 billion (297 billion pounds) in assets.
“You are knocking off a substantial part of U.S. yields when you buy from the UK perspective and hedge back that exposure. When we buy government debt, we always hedge it. You don’t want to take the FX risk,” he said.
The U.S. Federal Reserve has raised rates eight times since late 2015 and looks set to hike them again next week even as other global central banks stay shy of normalizing policy, causing a significant gap to open up in short-dated interest rates.
The European Central Bank and the Bank of Japan have both kept interest rates below zero percent, while the Bank of England has raised rates only twice from its record low near zero percent set in 2016 after the shock Brexit vote.
As U.S. short-term rates climb, currency forward markets which are closely linked to the differences in interest rates between currencies have moved to price in the higher cost of holding dollars.
For yen-based investors, they must pay around 3.3 percent of their principal investment to hedge the risk of holding dollars. The picture is similar for euro-based investors.
“We won’t buy U.S. Treasuries with currency hedge. The return would be negative after hedging,” said Kazuyuki Shigemoto, general manager of investment planning at Dai-ichi Life Insurance, which oversees assets of 35.6 trillion yen ($316 billion).
Currency hedge costs: https://tmsnrt.rs/2QNXZtq
Hedging costs erode rate advantage for U.S. debt: https://tmsnrt.rs/2SFGIzQ
Higher hedging costs would not have discouraged investors if longer-term bond yields had risen as much as short-term yields.
The yield on 10-year U.S Treasuries, however, has only risen to 2.8 percent <US10YT=RR> compared with 2.1-2.3 percent before the start of the Fed’s tightening in late 2015. Two-year yields have meanwhile risen 160 basis points, to 2.7 percent.
Last week, a section of the curve inverted when the five-year bond yield dropped below two-year and three-year yields.
Dai-ichi Life’s Shigemoto believes it is only a matter of time before the two- and 10-year yield spread turns negative.
U.S. Yield Curve: http://tmsnrt.rs/2zUqXiW
Japanese and European investors hunting for yield among top-rated government bonds are starting to look elsewhere.
“We have seen a real decline in flows, especially from Japan in particular and a lot of them have been directed to European and even Asian assets,” said Bob Michele, head of global fixed income at JPMorgan Asset Management, whose firm manages $491 billion in asset, in New York.
Even emerging markets are offering some value after a violent sell-off earlier this year on trade war concerns.
A JPMorgan global emerging market bond index denominated in U.S. dollars now offers a yield of over 7 percent versus around 5.5 percent at the start of the year, Refinitiv data shows.
TO HEDGE OR NOT
One option is to give up currency hedging. Still, increasing the holding of dollars just when the Fed may be about to slow its pace of monetary tightening could be risky.
“We want to buy dollars on dips. But an inverted yield curve may portend a future recession and there are many other uncertain factors. So we need to carefully look at economic fundamentals,” said Toshinori Kurisu, deputy general manager of investment planning at Nippon Life, which has total assets of 66.7 trillion yen ($592 billion).
Institutional investors are reluctant to take on too much currency risk for regulatory reasons. The U.S.-China trade war and possible U.S. slowdown are also reasons for investors to lower, rather than raise, their risk exposure.
In that case, the ultimate choice appears to be going back to their home markets.
“The attraction of U.S. Treasuries investment with a full currency hedge has declined. So we have been buying investment grade corporate bonds in the hedged U.S. debt space,” said Ryosuke Fukushima, general manager of investment planning at Japan Post Insurance, or Kampo, which has 76.8 trillion yen ($681.3 billion) of assets under management.
Fukushima said Kampo does not plan to radically change its stance because the firm is on course to meet its internal investment income target for the current financial year ending in March.
“But in the plan for next year, which we have just started contemplating, we will consider whether to flip back to JGBs from hedged foreign bonds, which we see as substitute for JGBs,” he said.
U.S. bond purchases by non-U.S. investors: https://tmsnrt.rs/2SHJrsB
(Reporting by Tomo Uetake and Hideyuki Sano in Tokyo, Saikat Chatterjee in London; Writing by Hideyuki Sano; Editing by Jacqueline Wong)