US corporate borrowers have an overseas investor problem
US companies are finding that the flow from the foreign-money spigot is slowing.
Foreigners showed signs of being net sellers of US investment-grade corporate debt this week, according to Bank of America data. Any selling pressure comes after international investors bought just US$38bil of US investment-grade corporate debt in the fourth quarter, according to UBS Group AG, the least since the beginning of 2016, when the corporate bond market was in a freefall.
Overseas money managers are a key pillar for the market, having bought more than US$1.4 trillion of the securities since 2013, UBS says. With the dollar extending losses after plunging last year and hedging costs near decade-highs by one measure, overseas investors have fewer reasons to buy fewer US company notes. The securities are on track for their worst first quarter since 1994. The weakness could translate to even higher borrowing costs for companies than they’ve already experienced in the last three months.
“This problem is here to stay for the remainder of the year,” says Nathaniel Rosenbaum, credit strategist at Wells Fargo, in reference to a falling dollar, rising hedging costs and declining foreign demand.
Bigger problem
Overseas demand is a key question for US fixed-income markets broadly. The Treasury, for example, is ramping up debt sales in response to a swelling federal deficit, just as foreign central banks’ appetite may be fading.
A host of other factors have hurt US corporate bonds, which according to Bloomberg Barclays index data have lost 3.3% this year through Wednesday, a bigger loss than the 2.1% decline in US Treasuries. The Federal Reserve hiked interest rates on Wednesday and said it was planning steeper increases in 2019 and 2020. Rising rates make fixed-income investments less attractive to money managers and lift corporate borrowing costs.
New tax laws are giving cashrich US companies less reason to buy corporate bonds. And a growing risk of trade wars could trans- late to weaker company profits.
“The negative returns are a signal to investors that maybe this is not such a great place to be,” says Kathleen Gaffney, money manager at Eaton Vance, which managed US$432.2bil as of Dec 31.
Painful math
For many foreign investors, rising hedging costs are eating into or erasing the extra yield to be earned from a US corporate bond. European investors must sacrifice around 2.7 percentage points in annual yield to hedge using rolling three-month forwards for a year when buying in US dollars and hedging back to euros, data compiled by Bloomberg show. The Japanese have to forfeit about 2.4 percentage points when hedging back to yen, around the highest level since 2008.
For a European investor, buying US investment-grade corporate debt and hedging it back to euros results in yields that are around 0.2 percentage point lower than 30-year German bunds on average now, according to UBS. That’s a big shift from a year ago, when hedged US company notes yielded around 0.44 percentage point more than bunds. As the Fed keeps hiking rates, hedging is likely to get even more expensive.
“The math just doesn’t work anymore,” says Josh Lohmeier, head of US investment-grade credit at Aviva Investors, which manages about US$300bil in fixed-income assets. “It’s driving away foreign investors that hedge.”
Biggest driver
Gordon Shannon, a money manager at TwentyFour Asset Management in London, is one of them. He has reduced his holdings
in dollar debt because the hedging costs are so high. With the Federal Reserve hiking rates now, the cost of hedging will only rise, he says. US dollar-denominated corporate bonds only make up 7% of Shannon’s £1.1bil (US$1.6bil) TwentyFour Absolute Return Credit Fund, down from 15% at the start of 2017.
“The currency cost is the biggest driver,” Shannon says.
Many investors are more inclined to hedge when the dollar is weakening, says Wells Fargo’s Rosenbaum. The US dollar fell the most in two months on Wednesday, and has plunged more than 10% against a basket of currencies since the start of 2017. Factors including tariffs and changing European monetary policy could weaken the currency further. When hedging was expensive last year, some investors could choose not to protect themselves against currency risk, Rosenbaum says. That’s less of an option now.
Debt in Europe looks increasingly attractive to at least some investors. Japanese money managers have been selling US government bonds and buying European sovereign securities for months, according to balance of payments data from Japan’s Ministry of Finance. They are likely looking to take advantage of yields that have been rising on the Continent since mid2016.
Forecasting changes in demand is difficult, and not every foreign investor will act the same way. Nippon Life Insurance Co, for example, is focusing more of its US holdings on corporate bonds as hedging costs rise, to earn higher yields, said Kiyokazu Kimura, deputy general manager at the international investment department, in an interview last month.
But for many Japanese investors, rising US interest rates and the weaker dollar are good reasons to be cautious when buying American corporate bonds, says Katsuyuki Tokushima, chief investment analyst at NLI Research Institute.
“Investors probably feel that they should stay on the sidelines for now,” Tokushima says. “They’ll feel uncomfortable if the dollar weakens further.”