Up For Debate: Currency-Hedging Costs - The Threat To Bond Markets

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by: Neuberger Berman

By Neuberger Berman Asset Allocation Committee

Currencies have moved to the center of the global risk web. That's unusual, so what does it mean?

Neuberger Berman's Quantitative Investment Group maintains "spanning tree" maps of the correlations across financial assets as part of its analysis, which enable us to keep track of how risk is manifesting in the system, to see when particular markets take on a greater importance, moving to the center of the web of risk.

Usually, if any market sits at the center of the web, it's a major equity market. Right now, however, the space is filled with currencies. That's understandable after nine months in which the currency of the world's biggest economy has lost a tenth of its value. What might be surprising is how big a risk some members of the AAC think currency markets pose to fixed income.

The decision about which bond markets to invest in may seem like an easy one. Which market is yielding the most per unit of credit risk? But it's not as simple as that. Buying bonds overseas creates a foreign currency exposure that most investors will hedge using the forwards market, and this incurs a cost, equal to the difference between the interest rates for the bond's and the investor's currencies at the point on the forward curve at which the contract expires.

When credit spreads are tight and interest rate differentials are wide, that cost can erode a very large part of any yield advantage from going overseas. At the end of August 2017, a hedged euro-based investor in U.S. dollar assets was paying away 2.1% annualized on currency-forward contracts, while a U.S. dollar investor in euro assets was gaining 2.1% from its hedge.

These currency-hedging costs have grown rapidly over the past two years. Moreover, some Committee members are concerned that the Federal Reserve's program of balance-sheet reduction could compound these costs. Mopping up liquidity from the system leaves investment banks with fewer reserves, which they use to collateralize the currency forward contracts they write: as cash collateral dries up, banks may put up the cost of hedges.

U.S. Dollar Hedging Costs Have Reached Extreme Levels

Source: Bloomberg

In investment grade, where currency-hedging costs can erode all of the yield differential from investing in U.S. dollar assets, the considerable, yield-seeking investor flows we have seen into U.S. bonds could reverse very suddenly, creating volatility.

Some Committee members cautioned against assuming that this scenario would play out while others noted that the extreme interest rate differentials already in place appear to be dislocating the behavior of bond yields from that of currencies: U.S. yields have continued to climb relative to those in Europe, at the short end of the curve, even as the dollar has weakened and the euro has strengthened. The flow reversal may already be underway.

About the Asset Allocation Committee

Neuberger Berman's Asset Allocation Committee meets every quarter to poll its members on their outlook for the next 12 months on each of the asset classes noted and, through debate and discussion, to refine our market outlook. The panel covers the gamut of investments and markets, bringing together diverse industry knowledge, with an average of 25 years of experience.

Committee Members

Joseph V. Amato
President and Chief Investment Officer

Erik L. Knutzen, CFA, CAIA
Chief Investment Officer-
Multi-Asset Class

Thanos Bardas, PhD
Portfolio Manager, Head of Global Rates

Alan H. Dorsey, CFA
Chief Risk Officer

Ajay Singh Jain, CFA
Head of Multi-Asset Class Portfolio Management

Andrew Johnson
Head of Global Investment Grade Fixed Income

David G. Kupperman, PhD
Co-Head, NB Alternative Investment Management

Ugo Lancioni
Head of Global Currency

Wai Lee, PhD
Head of the Quantitative Investment Group
Director of Research

Brad Tank
Chief Investment Officer-Fixed Income

Anthony D. Tutrone
Global Head of Alternatives

Ashok Bhatia
Senior Portfolio Manager-Fixed Income

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