European Yields on Steroids May Tempt Japanese, U.S. Investors

Updated on
  • Yen-based funds may seek euro-area debt on lower funding costs
  • Funds may extend rotation away from U.S. Treasuries into EGBs

European government bonds yield less than some of their global counterparts, but may actually offer a better return for Japanese and U.S. investors.

The reason: the cost of hedging euro-denominated holdings is negative, meaning a Tokyo-based fund manager will essentially get a pick-up over and above the euro-area yield. That is unlikely to change in the near term, given that the European Central Bank’s first interest-rate increase isn’t priced until March 2019.

The story is pretty much the same for U.S.-based investors. For instance, while the nominal yield on German 10-year bunds is around 57 basis points, a currency-hedged dollar investor is looking at a yield of 3.46 percent.

Dollar Funding

The cost of accessing dollar funds has risen as the market prices in almost three rate increases by the Federal Reserve this year, damping the allure of Treasuries. For instance, 10-year notes offer an 0.21 percent annualized yield on a three-month rolling currency-hedged basis for yen-based investors, a yield pick-up of just 0.17 percent over 10-year Japanese government bonds.

In January, yen-based investors continued to rotate out of Treasuries into euro-area securities, with this flow dynamic likely to continue given dollar funding costs. It isn’t hard to see why: French and German securities, long favored by Japanese investors for their liquidity, offer 1.08 percent and 0.84 percent respectively on hedged 10-year tenors.

While Italy and Spain offer greater yield pick-ups, peripheral bonds make up a small fraction of Japanese foreign-debt purchases given they view them as less safe. S&P Global Ratings is scheduled to review Spain’s credit ranking on March 23, with an update from Moody’s Investors Service due April 13. Should one or both upgrade the nation’s debt, that may open the door to some increased allocation into Spanish bonds, given they have the second-largest yield pick-up among U.S., U.K., euro-area government bonds and Australian securities.

A solid euro-area economic recovery and persistently low rates volatility has underpinned peripheral bonds. Euro-based investors have much better yields domestically rather than buying abroad and that helps support the buy-the-dip theme.

For dollar-based investors, EGBs also look very attractive, with Italian 10-year bonds offering a 4.86 percent annualized yield on a three-month rolling currency-hedged basis.

  • The increased shift from USD to EUR assets and higher-yield assets such as corporate bonds may bode well for receiving EUR/JPY XCCY basis given the diminished UST yield pickup
  • Political turmoil or sharp fall in equity and credit markets remain risks to peripheral bonds which can be hedged via rates volatility (trading near all-time lows) and Schatz swap-spread wideners
  • Overall, Japanese foreign bond purchases may show further signs of moderating as some of the flow slowly shifts back into domestic bonds and extends on the JGB curve as USD funding costs rise
  • NOTE: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice
(Adds outlook on Japanese foreign-bond flows in final bullet.)
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