Managers running European pension funds' liability driven-investing programs could have a challenge on their hands: The pool of euro-denominated, highly rated U.S. corporate bonds they've been buying over the past year might be about to dry up.
U.S. corporations issued more than $16.6 billion in euro-denominated AA and above-rated corporate debt in 2016, according to Thomson Reuters data, prompted by a strong dollar and a demand caused by the European Central Bank's asset purchase program, which is vacuuming up about €350 million ($368 million) per day.
U.S. corporate bonds tend to have longer maturities than do European equivalents, making them a good choice for LDI managers seeking to better match the duration and cash flow patterns of pension fund liabilities. By comparison, European corporate bonds usually on average rate in the BBB region and have shorter durations than higher quality U.S. corporate bonds.
These U.S. corporate bonds also have been higher yielding than European government bonds — something German and Dutch pension funds benefited from in particular, as their longer government bond yields languished in negative territory last year. Yields since have gradually risen and 10-year bunds traded at 0.42%, while 10-year Dutch bonds traded at 0.53% last week.
“Corporate bonds are used in our LDI strategies. Moreover, corporate bonds denominated in euros from U.S. issuers are significantly allocated in matching portfolios,” said Rene Penzler, co-head of multistrategy and pension solutions at Deutsche Asset Management in Frankfurt.
“Given the reduced liquidity in corporate bonds markets and the ECB asset purchase program, new issuance is an important source to add exposure in matching portfolios,” Mr. Penzler added.
BNP Paribas Investment Partners incorporated euro-denominated U.S. corporate bonds into client LDI portfolios last year, said Anton Wouters, head of customized and fiduciary solutions in Amsterdam.
However, analysts warn that euro-denominated U.S. corporate bond issuance is expected to decline this year, in part due to the ECB's plan to reduce the rate at which it will purchase assets after April.
In December, ECB President Mario Draghi announced the bank would trim the target monthly purchases — a decision interpreted by market participants as the beginning of the end of quantitative easing. In December, the ECB purchased only e4 billion, 39% less compared with average monthly purchases.
“At the moment, it is still interesting for U.S. corporations to issue in euros because of the low rates,'' said Mr. Wouters.
“The moment the rates will rise, this may change depending on where the rates are going to be in the U.S. and other regions, but I am not sure it is going to happen soon,” he said. “It depends on when the ECB will start the "real' tapering.”
Contend with increased costs
In addition to concerns that fewer U.S. corporate euro-denominated bonds will be available, managers would also be forced to contend with increased costs associated with the trades if they have to buy non-euro-denominated debt for LDI portfolios. “Currency hedging is increasingly costly to do at reasonable spreads,” said Markus Allenspach, head fixed income research at Julius Baer in Zurich.
This has left LDI managers and their pension fund clients searching for ways to plug the gap they anticipate should U.S. corporate eurobond issuance drop, as analysts expect. Some managers have been preparing portfolios by incorporating other debt into their strategies — including such esoteric options for LDI portfolios as mortgages.
“Dutch mortgages still have a nice spread compared to other LDI instruments and they are perceived as "safe' because in the Dutch mortgage pools, a relatively large portion has an indirect government guarantee,” said Mr. Wouters.
Another option could be to use reverse convertibles — yield-enhanced bonds with an above-market coupon — that perform well “in this highly volatile environment,” according to Mr. Allenspach.
Nevertheless, some money managers that specialize in LDI have not completely given up on euro-denominated U.S. corporate bonds because these so-called “reverse Yankees” were used even before Europe's central bank enticed global companies with cheap financing.
Mr. Wouters said things could change if “an increase in rates or tapering could tempt U.S. corporations to choose to issue in another cheap currency.”
But Mr. Penzler said, “as long as yields in Europe stay low, I expect continuous demand from LDI investors for corporate bonds, and U.S. firms issuing bonds in euros remain an important player in sourcing these bonds.
“As long as cross-currency metrics in connection to diverging interest rate policies in the U.S. and eurozone remain favorable, U.S. corporate issuers will continue to diversify their investor base by issuing in euros,” he added.
Not completely new
The trend toward using global credit for LDI is not a completely new concept, but it has seen an uptick since March 2016, according to Legal & General Investment Management.
The interest in euro-denominated corporate bonds had to do with yield enhancement quality in addition to the liability hedging purposes and practicality for financial accounting, which these bonds offered, sources said.
Marcus Mollan, head of investment strategy at LGIM in London, said using corporate bonds for LDI is particularly popular with finance directors of companies as it helps them reduce the risk of volatility associated with what they have to disclose.
Mr. Penzler added: “Apart from providing a yield pickup against government bonds, (corporate bonds) are particularly important to align a matching portfolio's exposure to the discounted liabilities under IAS19 ..., which uses a discount curve of high quality corporate bonds.” International Accounting Standard 19 requires companies to disclose a pension fund's funding position on the corporate balance sheet.
This article originally appeared in the January 23, 2017 print issue as, "European funds could face scarcity of U.S. bonds for LDI".