What a difference a year makes. I have addressed this topic in the past but the picture has very quickly made a 180-degree turn. For a couple of years leading up to 2022, global demand for yield and attractive hedging costs supported a strong overseas bid for U.S. dollar (USD) corporate credit. Today, mounting global inflationary pressures have sustained expectations for the Federal Reserve (Fed) and, more recently, other global central banks to tighten monetary policy rather aggressively. The Fed’s steps toward tightening have broadly outpaced other central banks to this point. As a result, the USD has strengthened and hedging costs have very quickly risen to levels not seen since late 2019 for Europe-based investors.
Today’s Chart of the Week highlights the aggressive move in costs alongside the decline in incremental yield obtained in the USD investment-grade (IG) Bloomberg US Corporate Bond Index versus the Bloomberg Euro-Aggregate: Corporates Index (EUR). Note that the cost to hedge the EUR currency risk is currently 265 basis points (bps), up an incredible 190 bps year-to-date. Despite U.S. IG nominal yields that are still compelling versus EUR yields, the sharp increase in hedging costs has flipped the relative value proposition at the beginning of the year from a net yield advantage to a meaningful yield disadvantage.
At the start of the year, a European investor could find hedged U.S. corporate credit yielding about 100 bps more than local currency opportunities. Today, fully hedged U.S. corporate credit risk yields almost 120 bps less — over a 200 basis-point swing. It does appear that the European Central Bank (ECB) is trying to play catch-up relative to the Fed, with a 75-basis-point increase earlier this month. An acceleration in the pace of rate increases from the ECB could begin to improve the relative value of U.S. credit for European investors but there’s a long way to go.
Meanwhile, credit spreads at the start of the year for the Bloomberg Euro-Aggregate: Corporates Index relative to the Bloomberg US Corporate Bond Index were basically flat. Now, EUR corporate credit is about 60 bps wider than U.S. credit, a basis that is essentially at the wides going back to early 2012. In addition, the U.S. index has a duration almost three years longer than the EUR index. Admittedly, there are fundamental reasons for EUR credit to be trading wider than USD credit — not the least being the Russia-Ukraine conflict and the incredibly high energy prices squeezing margins and closing businesses. The growth outlook in the U.S., while slowing, is certainly more favorable than in Europe.
The velocity and the magnitude of market moves have been quite incredible in 2022, and the fluctuation in currency and hedging costs is no exception. Hedging costs for Asia-based investors have risen even more than they have for Europe-based investors. With elevated hedging costs and higher yields elsewhere, I expect the majority of incremental flows from non-U.S. investors to be directed into local currency markets and not into the U.S. Considering non-U.S. investors are the largest holders of U.S. corporate bonds, with more than 25% of the market, this represents another major demand headwind for U.S. IG corporate credit .
The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
The Bloomberg Euro-Aggregate: Corporates Index is a benchmark that measures the corporate component of the Euro Aggregate Index. It includes investment grade, euro-denominated, fixed-rate securities.
Index performance does not reflect fees, expenses or costs associated with investing. It is not possible to invest into an index directly.
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