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Fixed Income

U.S. bonds become less obvious choice for Japanese institutions

Hedging costs are rising for Japanese investors who've been scooping up U.S. paper in lieu of domestic government bonds yielding nothing. That could benefit European credit as well as emerging markets debt and private debt, market veterans say.

The policy divergence between a Bank of Japan still squarely on the path of quantitative easing and a U.S. central bank well into a tightening cycle is denting a carry trade that's seen local asset owners shift hundreds of billions of dollars into U.S. Treasuries and credit, including investment-grade, high-yield and municipal bonds, as well as bank loans.

Japanese investors hedging U.S. exposures back to yen now are facing costs roughly three times the 60 to 70 basis points that prevailed a few years back, said Vijay Rajguru, global co-chief investment officer with Alcentra, a London-based alternative fixed-income manager.

With Europe's central bank tapering gently but still not tightening, those same investors can enjoy gains of roughly 40 basis points hedging euro exposures back to yen, he said.

Dollar-yen hedging costs are approaching 250 basis points, which — combined with management fees — is effectively raising the return hurdle asset owners must clear to pick up yield on U.S. investments to roughly 3%, said Naoki Shimizu, Tokyo-based representative director, Ashmore Japan.

Concerns about hedging have grown as Japanese investors added global exposure in recent years to deal with yields of zero or less for Japanese government bonds, said Taeko Sumiyoshi, Tokyo-based managing director and business development strategist with Greenwich Associates Japan K.K.

Greenwich's latest survey of more than 380 institutional investors, conducted during the second quarter of 2017, found 29% of respondents citing hedging risks as a challenge, up from 19% the year before and a mere 9% in 2015, said Ms. Sumiyoshi, in an email. It wouldn't be surprising to see that number rise further this year, she said.

Even so, institutional sales veterans say they have yet to see a material pickup in Japanese allocations to European paper, and the U.S. market's relative depth and scale should ensure it remains the principal magnet for allocations going forward.

But the fraction of Japanese investment flows heading to Europe is likely to get bigger, they predict. That would partly serve to diversify Japanese investor exposures at a moment when the U.S. head start in tightening monetary policy could leave investors facing losses on the bulk of their overseas bond holdings, exacerbated by rising hedging costs.

Ken Yoshida, a Tokyo-based partner with BlueBay Asset Management and head of Asian sales, said relatively attractive euro-yen hedging costs now are prompting more flows to Europe but the bigger issue is that most asset owners in Japan already park 80% or more of their overseas bond allocations in U.S. paper. Moving some of their holdings into European bonds and credit could buy them some time as U.S. rates push higher, he said.

Japanese asset owners preparing for the fiscal year starting April 1 are focusing more on opportunities in Europe as a flattening of the U.S. yield curve and a tightening of credit spreads force them to contend with the prospect that the clear-cut opportunities they saw from U.S. credit in recent years "are not going to be there tomorrow," said Adam McCabe, Singapore-based head of Asian fixed income with Aberdeen Standard Investments.

Within the broader credit universe, market veterans say European high-yield bonds might not attract much Japanese money because aggressive purchases by Europe's central bank has pushed yields well below those offered by their U.S. counterparts. However, bank loans — a relatively deep and fast-growing market segment in Europe — could see a pickup in inflows.

"You're seeing Japanese investors looking actively at deploying more capital" to European loans​ — both for the pickup from the hedging cost differential and because there's a better pipeline coming out of Europe now vs. the U.S., said Alcentra's Mr. Rajguru.

Some market veterans aren't convinced the case for a shift to European credit from U.S. credit now is strong. Catherine Matthews, a London-based global fixed-income product specialist with Western Asset Management Co., said in a Feb. 23 presentation to clients in Singapore that rising hedging costs have largely been offset by the rise in U.S. yields, so the value proposition for Japanese investors considering U.S. credit today "is not that different from where it was a year or so ago."

Others see the math differently. With the U.S. short-term rates that determine the costs of one- to three-month hedging contracts rising more than longer-term market yields, the increase in hedging costs has effectively reduced the net yield Japanese investors can enjoy on their allocations to U.S. assets, said Timothy A. Palmer, managing director, portfolio manager and head of the global interest rates and governments, and emerging markets sector teams at Nuveen Asset Management.

And that pressure could continue to build. Tjalling Halbertsma, London-based managing director and head of global business development with Eaton Vance (EV) Management (EV) (International) Ltd., said his team expects only two-thirds of the 75 basis points of Fed rate hikes anticipated for 2018 to feed through to the long end of the yield curve, which could lift hedging costs further.

In contrast to the consensus view that Fed policy risks lean toward a pickup in the pace of tightening, Western Asset Management anticipates less near-term pressure on the U.S. central bank to raise short-term rates.

Instead, said Ms. Matthews, investors looking to weight allocations more toward Europe now could be walking on the wild side. With the U.S. central bank already well into its tightening cycle, there's far greater likelihood that the next "taper tantrum" will emanate from Europe, she said.

Western Asset simply sees "better value and opportunities in the U.S. credit markets," and demand from Japanese investors for U.S. bonds remains "very high," said Ms. Matthews.

Even money managers who believe hedging costs will have some impact on allocations agree interest in U.S. paper should remain healthy.

Conversations with clients become tougher as hedging costs tick up but even at recent elevated levels Japanese clients remain interested in U.S. credit strategies such as bank loans and municipal bonds, said Robert White, Singapore-based president of Eaton Vance Management International (Asia) Ltd.

"At the margin, the Fed rate increases have made U.S. assets less attractive to Japanese buyers but the yield pickup available in the U.S. continues to provide a much-needed opportunity for Japanese investors, agreed Nuveen's Mr. Palmer.

Continuing or on track

Recent signs suggest the country's biggest institutional investors are either continuing to allocate more to U.S. credit, or on track to do so. On Feb. 20, Japan's 162.7 trillion ($1.5 trillion) Government Pension Investment Fund asked active managers of overseas high-yield bond strategies to register with the fund's manager-entry system — pledging to review potential candidates beginning March 19.

The latest information on GPIF's high-yield allocations as of March 31, 2017, showed strategies with a U.S. high-yield bond benchmark accounting for roughly 85% of a total allocation of 298.4 billion. The remaining 15% used a European high-yield benchmark. A GPIF spokeswoman declined to comment.

Konosuke Kita, Russell Investments' head of investment consulting for Japan, said European credit is becoming more interesting for local clients but many are choosing to award global mandates to managers, leaving the decision on balancing U.S. and European exposures to them.

In addition, however, they stand ready to issue dedicated mandates for segments such as bank loans or private debt, depending on where they spy investment opportunities, he said.

Nobuo Ohtsuka, a Tokyo-based partner at Mercer Japan Ltd. and director of the firm's Japanese business, said the rise in dollar-yen hedging costs — together with the wake-up call from the spike in volatility at the start of February — could leave more clients receptive to Mercer's recommendations over the past two years to consider higher allocations to credit, either through middle-risk, middle-return unconstrained absolute return strategies or higher-risk, higher-return multiasset credit strategies.