A strong dollar and eroding quality of debt has investors and money managers reconsidering their allocations to U.S. credit.
Sources at asset owners and investment managers said the widening spread in rates set by U.S. and European central banks, as well as increased hedging costs for euro- and Swiss franc-based investors, also are contributing to a rethink of their exposures.
"There are concerns regarding the hedging costs for euro- and Swiss franc-based investors," said Gregoire Haenni, chief investment officer at the 12.8 billion Swiss franc ($12.79 billion) Caisse de Prevoyance de l'Etat de Geneve, Geneva. "As the interest rate differential increases between the dollar and the Swiss franc, hedging costs eat the yield of your investments."
Mr. Haenni also cited the gradual decline in U.S. investment-grade bond index constituents over the past decade, with more than 50% now rated BBB.
These two elements "are leading us to question the role of U.S. investment-grade bonds in our portfolio," he said.
The U.S. Federal Reserve raised interest rates to a range of 1.5% to 1.75% in March, while the European Central Bank has held interest rates on refinancing at zero and on lending at 0.25% for an extended period of time.
As of May 25, the dollar/euro exchange rate was $1.17 to €1, while the dollar/Swiss franc rate was $1.008 to 1 franc. That compares to $1.05 to €1, and 98 cents to 1 franc at the start of 2017.
A number of money managers said they have noted hedging cost concerns from their clients, particularly given the move in the dollar last year.
"The trade that had been done for some time has been the higher yields on offer in the U.S. and the greater issuance diversity that is available in U.S. credit markets," said Roger Hallam, chief investment officer-currency at J.P. Morgan Asset Management in London. "Non-U.S. investors have been purchasing U.S. credit, longer-term U.S. debt, and hedging back to their base currency."
However, that strategy is "becoming increasingly difficult to justify as the U.S. yield curve has flattened," with 10-year U.S. Treasuries jumping above 3%. "Your hedged yield pickup in those has diminished substantially … and so we have seen non-domestic investor demand for U.S. credit start to diminish because the hedged yield available has declined so much," Mr. Hallam added.
Dollar strength affects asset owners and also money managers, who have made moves in their own portfolios.
"It's something that every fund manager who is managing a global portfolio that includes U.S. assets, and whose base currency is not in U.S. dollars, is facing — increasing hedging costs," said Ryan Myerberg, portfolio manager at Janus Henderson Investors in London. "For managers running funds that are not meant to take FX risk, unhedged exposure can potentially inject unwanted risk and volatility into a portfolio; (it) is a potential capital destroyer if you get an FX call wrong, and especially damaging if it's not in your remit."
The money manager runs strategies with U.S. dollar, euro and sterling base currencies. "Where it is euros or sterling (or another currency) we are having to ask the question of ourselves, what should we do with our allocation to U.S. risk through Treasuries or credit?" Mr. Myerberg said.
Mr. Myerberg said there are places to reallocate in Europe.