Photographer: Daniel Acker/Bloomberg

Corporate Bonds Have Become a Deal-Seeker's Nightmare

Rising currency hedging costs mean investors are facing unpalatable choices leading to "the definition of reach-for-yield behavior," according to Deutsche Bank analysts.

There are no bargains left in U.S. corporate credit, according to Deutsche Bank AG.

Ultra-low interest rates in Europe, Japan and the U.K. have spurred investors to seek returns by buying the debt sold by U.S. companies with investment-grade ratings, leading some analysts to label the market as "the only game in town." But the rush into the asset class and the rising cost of protecting against currency-risk on dollar-denominated securities means foreign investors are facing an increasingly unpalatable menu of options when it comes to generating higher returns by buying U.S. corporate debt.

"The U.S. investment-grade market has earned a reputation as the source of global yield for overseas portfolio managers," wrote Deutsche Bank credit strategists Oleg Melentyev and Daniel Sorid in a note published late last week. "But a combination of rising FX hedging costs, low U.S. yields and tight credit spreads is challenging that reputation."

The toxic mix means that "the best days of the global reallocation to U.S. credit may be behind us," they added.

Low interest rates and continued monetary stimulus have encouraged bond investors to seek higher yields outside of their local markets, spurring a wave of currency hedging as portfolio managers attempt to offset added foreign-exchange risk. The surge of interest in dollar-denominated assets has helped lift currency-hedging costs to the point that they now eat into the additional returns generated by buying U.S. corporate bonds to a potentially untenable degree, the Deutsche Bank analysts write.

According to their estimates, for instance, a one-year currency hedge shaves an extra 40 to 90 basis points of yield off U.S. corporate bonds purchased by portfolio managers in Taiwan, Japan, South Korea or the euro zone. A Japanese investor buying a five-year corporate bond rated single-A would likely generate a yield of -0.24 percent after hedging for currency risk — or less than the -0.21 yield on five-year Japanese government bonds.

These rising currency hedging costs mean non-U.S. investors must assume more risk to generate yield — by buying lower-quality debt or opting not to fully hedge their foreign-exchange risk. In some cases, investors must be willing to assume multiple risks to generate a significant pick-up over local government debt, Deutsche Bank said.

DB
Source: Deutsche Bank

"To achieve anywhere close to a reasonable spread level over local sovereigns, a portfolio manager must be willing to layer multiple portfolio risks upon each other," the analysts concluded. "This trade-off between target yield and incremental risk is the definition of reach-for-yield behavior, which often results in mispricing of risk, if pursued by large enough group of investors."

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