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Debt quality, dollar put investors off of U.S. credit

Roger Hallam sees overseas investors starting to steer clear of U.S. debt.

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 (JPM) 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.

A good place to be

"Europe seems like a good place to be — on the Continent there are opportunities for spread compression and curves to flatten, especially peripheral curves like Portugal, if you are constructive on the overall political backdrop in Europe," he said. "We are much less enthused about the prospects for U.S. high yield and investment grade, and believe Europe is in a more benign part of the credit cycle.

"We have taken exposure to pure-play U.S. credit risk to extremely low levels across most of the portfolios," and managers also have reduced U.S. rates exposure "quite significantly" across most portfolios Janus Henderson runs. Instead, managers are taking exposure to the U.S. interest rate market more on the inflation front through Treasury inflation-protected securities.

Currency money management specialists said they are talking to clients about hedging given the dollar's fluctuations in strength in recent months.

"We definitely have seen clients in hedge ratio discussions," said Richard Benson, head of portfolio investments at Millennium Global Investments Ltd. in London. He said euro strength vs. the dollar last year had investors "fretting about having hedges in place previously from the dollar bull market." Now they are worrying whether they need to rethink should the dollar continue to strengthen. "They know the impact of the currency having seen the movements, and (are) aware of two directions the last few years — appreciation and weakness — (which) people found painful having put dollar hedges in place," Mr. Benson added.

And while Record PLC has not seen material changes to dollar asset allocations because of hedging costs, "we have seen a lot of interest in minimizing the cost of hedging and looking at alternatives to incurring that cost," said James Wood-Collins, CEO in Berkshire, England.

He said clients are facing two challenges in managing the implications of hedging currency: liquidity, where hedges generate cash flows that require settlement at typically shorter holding periods than the assets; and "a recently emerged mismatch between what one might expect the cost of hedging to be, and what is materializing. That mismatch is to the detriment of euro and Swiss franc-based dollar asset owners."

Mr. Wood-Collins said by hedging, investors are "immunizing" against volatility in spot rates, and also effectively swapping out the risk-free rate that is embedded in overseas asset returns from the holding.

The dollar return on an asset can be separated into a dollar risk-free rate and a risk premium from the asset on top, he added. By hedging into euros or Swiss francs, investors are replacing that risk-free rate, with the hedge priced by reference to the spot rate. This is also adjusted for the difference in interest rates attached to the dollar and euro, "and your forward contract is long euro, short dollar."

That means a higher dollar interest rate "appears as a negative carry in the hedging contract. With both euro and Swiss franc rates below U.S. rates, there is an apparent negative cost to hedging," Mr. Wood-Collins said.

However, he said FX forward prices have started to drift away from the "mechanical price set by reference to the difference in risk-free rates." That's something that, historically, was not a problem as investment banks would have been able to arbitrage out any differences — something that bank capital reform and solvency regulations have made more difficult. "The gap in risk-free rates needs to be significantly wider before it is worth the banks arbitraging it," he said.

All of this means that, over a one-month horizon, the benchmark interest rates, quoted at 1.9% for the dollar and -0.4% for the euro, should produce a -2.3% cost of hedging. However, using the forward it is more like -2.5%, 20 basis points more expensive than expected before even taking risk-free rates into account.

"For clients with big U.S. fixed-income portfolios, it's bad enough adjusting headline yield for 2.3%, without having to adjust another 20 basis points. At times it has been a lot more than that," Mr. Wood-Collins said.

Ways to deal with the costs

But there are ways to deal with the costs: changing the instruments used to avoid the mismatch or using longer-dated forward contracts to manage cash flows; exploring synthetic hedging by creating a short position in dollars and long euro or base currency; or moving away from a static hedge ratio to an active one.

For U.S. investors though, the strong dollar is creating opportunities. Hedging back from euros to dollars "has a positive carry. We are exploring with (U.S. clients) holding liquidity in other currencies such as euro and Swiss franc, hedging it back into dollars and picking up double-digit basis points," Mr. Wood-Collins said. "There are examples recently where we have been able to enhance yields for dollar investors by 40 basis points to 60 basis points."