The soaring cost of buying protection against dollar gyrations is spurring more foreign investors to buy US bonds “unhedged”, raising the risk of painful losses and wider market ructions if the US currency weakens.
With the trade-weighted dollar near its most expensive levels in 20 years and US interest rates high compared to Europe and Japan — despite the Federal Reserve’s dovish turn this year — the cost for foreign investors to insure, or hedge, against fluctuations is near an all-time high.
The effect is to turn US Treasuries, a risk-free staple of investment portfolios the world over, into a negative-yielding investment for many foreign buyers.
Hedged European investors now earn a roughly minus-0.5 per cent yield on a 10-year US Treasury on a three-month rolling basis, according to Bloomberg data, compared to an unhedged yield of 2.58 per cent. Hedged Japanese investors earn minus-0.3 per cent.
Higher US hedging costs are behind the seemingly perverse fact that five-year Greek bond yields are now lower than the equivalent US Treasuries. European investors are opting for euro-denominated debt, pushing up prices and lowering the yield, instead of buying US Treasuries on a hedged basis.
Some analysts fear that a dollar swoon could trigger losses for unhedged investors that quickly wipe out any gains they made from interest payments. That could spur those investors to flee, weakening the dollar further and triggering a feedback loop.
“There is a potential issue here hiding in plain sight,” said Andrew Sheets, the chief cross-asset strategist at Morgan Stanley. “In financial markets, any system that is self-reinforcing is both interesting and potentially concerning.”
Japanese investors continue to buy foreign debt with gusto. For the fourth straight month, they bought $10bn of US bonds in March, according to Japan’s Ministry of Finance. Data on other Asian countries and Europe is patchier, but analysts say flows into the US remain strong.
Most of the capital diverted to US shores was likely unhedged given that the arithmetic remains skewed against buying protection, according to Adam Cole at RBC Capital Markets.
The chief investment officer of Nippon Life, Japan’s largest private insurer, said recently that it had increased its stock of unhedged foreign bonds and plans to add even more in the coming financial year.
Krishna Memani, chief investment officer at OppenheimerFunds, said the dangers were overplayed. “There are always some people that think hedging is for chumps, but overwhelmingly big institutional investors are still hedging,” he said.
Giving the dimming appeal of hedged US bond investments, analysts say some investors are instead electing to buy riskier, higher yielding debt. But the combination of this “reach for yield” in lower-rated corporate bonds and widespread unhedged currency risk is a danger to the broader financial system, according to Daniel Sorid, a strategist at Citi.
He worries that any market disruption — such as a spike in hedging costs, a drop in the value of the dollar or an outbreak of anxiety about rising corporate defaults — could cause investors to ditch their holdings. A fire sale would become particularly problematic given concerns about the health of bond trading conditions, Mr Sorid noted.
“If the dollar funding market were to suffer some kind of negative shock, portfolio managers would be left with the option to roll their hedges at a loss or liquidate their positions,” he said. “While US corporate bonds are more liquid than other instruments, that liquidity is not guaranteed to be there when it’s needed.”