It is all relative in the global capital markets. Over the last year or so, the high currency-hedging cost has made US dollar corporate bonds less attractive for international investors despite the relatively high level of US yields. This is now about to change.
Small differences matter
US dollar-denominated investment grade corporate bonds currently yield 3.2%, much higher than the 0.3% available on euro-denominated equivalents. Superficially, US bonds look much more attractive for European investors than their domestic market. But are they really? Not necessarily.
This is because of the way that currency hedging impacts returns. Currency volatility can materially impact the risk of investing in overseas bonds, doubling it in some cases.
As a result, international investors normally invest in overseas bonds on a currency hedged basis. This can dramatically alter the attraction of various investments.
The key drivers of hedging cost are short term interest rate differentials (see below summary of the mechanics of currency hedging below figure 1).
The fact that US rates are much higher than European yields means that it costs European investors a lot to hedge US dollar exposure. So much so, that it wipes out the entire yield uplift. On a currency hedged basis, US dollar bonds yield less than euro bonds!
This has been the case since late 2018 (see chart below). Sterling-based investors have faced a similar choice with the local corporate bonds yielding more than their hedged US dollar counterparts.
The mechanics of currency hedging
The theory of currency forward pricing is based on covered interest parity, which states that forward prices should be driven by short-term interest rate differentials.
If not, there would be the potential to earn a risk-free profit. Mathematically, the relationship between the spot exchange rate and forward exchange is:
Forward rate = Spot rate * 1 + foreign interest rate / 1 + domestic interest rate
When the domestic interest rate is lower than the foreign interest rate, currency forward markets should therefore price the domestic currency to appreciate in value relative to the foreign one (and depreciate when the domestic interest rate is higher than the overseas one).
This will reduce the return or yield on an overseas investment below its local currency equivalent. The greater the interest rate differential, the greater the drag on yields/returns from currency hedging.
Influencing investor behaviour
While these yield differences may seem small, they can be sufficient to influence investor behaviour. Net foreign purchases of US corporate bonds fell sharply during 2018 (see chart below, right side) in response.
In 2014, the euro area quantitative easing programme (QE) induced a large rotation from Europe to the US, supported by the relatively high hedged yields of US bonds. Over the last year, these flows have dried up.
Japanese investors have also been rejecting US bonds in favour of European bonds because they offer a higher yield on a currency-hedged basis.
For Japanese investors, the domestic bond market offers limited opportunities both in terms of yield and selection of securities.
Since the beginning of 2017, Japanese investors have bought ¥2 trillion worth of dollar-denominated bonds, but this pales in comparison to the ¥11 trillion of euro-denominated bonds they have purchased over the same period (see chart below, left).
The coming change
The higher interest rates in the US which have made hedging US bonds so expensive relative to other markets look set to ease. The Federal Reserve (Fed) has made a spectacular U-turn since January.
Weakening domestic growth, persistently low inflation and global uncertainties have prompted the Federal Open Market Committee (FOMC) members to favour easier monetary policy.
The FOMC cut short-term interest rates by 0.25% at its July meeting. The market is currently expecting three more rate cuts by the end of 2020.
Granted, the European Central Bank (ECB) is also considering lowering euro interest rates further into negative territory, but the magnitude of possible cuts is likely to be much smaller.
These rate cut expectations are now transforming into lower interest rate differentials and lower US dollar hedging costs, improving the attractiveness of US dollar corporate bonds.
Two-year currency forwards, priced based on the expected path of interest rates over the next two years, quantify these expectations.
The dollar to euro hedging cost, implied by the two-year EURUSD FX forward is currently 2.3%. Given that the yield of the US investment grade index is 3.2%, euro investors can earn a 0.9% hedged yield.
This is three times the yield on the euro investment grade corporate index, assuming that interest rates follow the expected path.
In sum, as long as the Fed follows through with interest rate cuts, falling hedging cost should make US dollar bonds more attractive for non-USD investors and lead to a pick up in demand for these bonds.
 Buying assets in a foreign currency implicitly involves taking exposure to the movements in the exchange rate between the foreign and domestic currencies. If the foreign currency rises in value against the investor’s domestic currency, the investor will realise a gain when they convert the currency back, or will take a loss if the foreign currency weakens. Currency hedging effectively aims to remove this risk.