Fed Rate Hike May Cut Foreign Demand for U.S. Company Bonds

  • Tightening will boost currency hedging costs for investors
  • That could squeeze or ‘even turn around’ inflows into credit

The overwhelming foreign demand for U.S. company bonds that’s allowed corporate America to sell more than $1 trillion of cheap debt this year may vanish if the Federal Reserve raises rates.

That’s the warning from Deutsche Bank AG strategists, who say it may become costlier for foreign buyers to own U.S. corporate bonds if the Fed begins tightening just as central banks overseas start to cap their unprecedented stimulus programs.

“Such a combination should result in higher FX hedging costs, making foreign inflows slow, possibly stop, and potentially even turn around,” Deutsche Bank strategists Oleg Melentyev and Daniel Sorid wrote in a Sept. 9 report.

That’s bad news for U.S. companies because foreign buyers purchased $136 billion of their debt in the 12 months through June 2016, according to U.S. Department of the Treasury data. Foreign investors may snap up $400 billion to $500 billion of U.S. notes this year, Bank of America Corp. estimated in July.

That trend could reverse if the cost of currency hedging for investors in Europe and Japan continues to rise, according to Deutsche Bank. In the past three months, strong demand for U.S. corporate debt and increased expectations for a rate hike have lifted hedging costs by 0.4 percentage point

Fed officials appear split on whether a rate hike in September is warranted. Lael Brainard, the last Fed governor to speak before the central bank enters its quiet period ahead of the Sept. 20-21 Federal Open Market Committee meeting, urged prudence in tightening monetary policy in remarks on Monday. The odds for a rate hike next week sank to 22 percent, from 30 percent on Friday.

Hedging Costs

That trend could reverse if the cost of currency hedging for investors in Europe and Japan continues to rise, according to Deutsche Bank. In the past three months, strong demand for U.S. corporate debt and increased expectations for a rate hike have lifted hedging costs by 0.4 percentage point.

Although blue-chip company bonds issued in euros carry an average yield of 0.67 percentage point, compared with 2.9 percentage points for dollar-denominated notes, a rise in hedging costs would mean “little incremental yield pickup” for foreign investors, according to Deutsche Bank. And many of the newest, most liquid bonds “are delivering negative yields already” after hedging.

Foreign investors who buy U.S. bonds typically buy hedges to guard against fluctuations in the dollar.

“Any incremental hikes beyond those priced in are going to widen interest rate differentials,” according to Deutsche Bank. That can make foreign holdings of U.S. corporate bonds “uneconomical.”

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