Trimming The 'Hedges'

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Summary

It's that time again.

Time to revisit the ongoing fallout from the global USD shortage.

This go around, let's have a look at the prospects for US corporate credit.

It's funny how some topics sit well and others just don't.

There doesn't seem to be any rhyme or reason to what grates an audience's nerves, although I suppose if I knew everyone's particular circumstances, I could surmise why some subjects are taboo and others aren't.

Of course, it's always the contentious topics that create the best discussions and that's precisely because, whether a reader realizes it or not, the only way to become more confident in your convictions is to subject them to scrutiny. And if scrutiny is what you need, I've got a surplus of it stored away in my head.

In any event, one subject that everyone seems to find agreeable is the global dollar shortage. I cannot, for the life of me, figure out why everyone is so enthusiastic about a topic that necessitates a discussion of LIBOR and things like cross-currency basis swaps (maybe it's a sense of nostalgia for the Heisenberg gimlet threshold, FRYBOR, and the Albanian girls), but I certainly like writing about it and if you like reading about it then we've got ourselves a win-win.

When last I broached the subject, I talked a bit about why foreign investors might be more inclined to run higher FX exposures. More specifically, I highlighted a Morgan Stanley note that quantified the yield pickup a Japanese investor could expect from running an unhedged position in US credit. Basically, you just subtract the cross currency basis from the yield on the instrument you're buying. Here's a visual aid using US 10s:

(Chart: Morgan Stanley)

So let's think about what that means for IG (NYSEARCA:LQD) credit. Needless to say, corporate credit has benefited from rock bottom rates on DM government debt. Indeed, ZIRP and NIRP have forced investors to reach for yield and that means climbing down the quality ladder, taking more duration risk, or both. As discussed previously, that leads to more IG and HY supply, which in turn means more EPS-inflating buybacks.

The fact that rates are even lower in Europe and Japan than they are in the US means foreign money has contributed to the demand for US corporate paper.

But now, with the policy divergence between the US and Europe/Japan fueling wider cross-currency bases and thus higher hedging costs, it's entirely possible that foreign demand for US IG paper will begin to dry up, removing one of the market's embedded cushions against a bond sell-off.

Here are some bullet points and graphs from Deutsche Bank that illustrate how much lower the (hedged) yield pickup is now in US IG than it was at the start of 2016 (my highlights):

Foreign demand for US credit has turned into a strong factor propelling valuations this year as central bank policies in some domiciles turned their domestic investors into refugees, seeking shelter from negative rate repression. It has not been a frictionless journey for many of them: With US yields rising over the past few months, anyone who purchased US IG since April is now underwater in total return terms. On top of that, FX hedges have become more expensive with yield differentials widening. Not only has it become more expensive to hedge, but those hedges keep working against their holders, as the US dollar has strengthened, delivering further disappointing contribution to FX-hedged foreign money in US credit.

  • For JPY-benchmarked portfolios, the 1yr FX-hedged yield on US IG has dropped from 225bp a year ago to 140bp today
  • For EUR investors, the same math works out to 200bp last December, 110bp today

Deutsche Bank goes on to note that rising UST yields have helped to mitigate the hunt for yield, but the stronger USD and commensurate rise in hedging costs makes it a zero-sum game.

Here's where it gets disturbing. Consider the list of measures foreign investors are taking to increase the yield on their investments (emphasis in original):

Our conversations with overseas investors indicate a degree of discomfort with the yield enhancement options they are layering one upon the other, to meet business obligations. Moving down in quality, out in duration, down in liquidity via off-the-run and locally listed bonds, lower in the capital structure via subordination, selling options via callable bonds, underhedging foreign exchange risk, and shortening FX hedge terms. Asian investors in particular are not just selecting from one of the following strategies, but checking the box that reads 'all of the above'.

In other words, foreign money is taking on more and more risk in order to tack on a few extra basis points wherever possible. Needless to say, that money will be glad to adopt a more conservative investment strategy once rates on risk-free DM government debt finally rise.

Deutsche Bank also provides a very interesting real-world example of how important the foreign bid is when it comes to mitigating a quick move higher in domestic rates (just like what many observers think we're about to see in the US). To wit (my highlights):

We can demonstrate this point by comparing a monthly time series of Taiwanese life insurance companies' USD equivalent flows into foreign bonds against monthly mutual fund flows beginning in the period around the Taper Tantrum of 2013. Foreign investors in the earlier stages of their foreign portfolio accumulation stepped in as U.S. retail investors tried to flee interest rate risk by selling their bond fund shares. Between May and September 2013, U.S. IG funds saw $17.5 bn of outflows. Taiwanese life insurers were initially sellers in June 2013, but then began to take advantage of higher yields by adding $17.6 bn of foreign bonds over the same period.

In other words, the foreign bid is very useful in a pinch, but the high cost of hedging could discourage inflows.

So the moral of the story: The global USD shortage in conjunction with a growing policy divergence between the Fed and other DM central banks threatens to wipe out the foreign bid for US corporate credit in a market that's already nearing the end of the cycle. US credit investors (both IG and HY) should be aware of this dynamic.

As for the equity (NYSEARCA:SPY) investors out there, I'll leave you with one chart:

(Chart: Morgan Stanley)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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