European-Based Investors May Benefit from Lower USD Hedging Costs | Lord Abbett
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Economic Insights

As long as U.S. dollar (USD) hedging costs remain low, we anticipate strong interest by European-based investors in U.S. investment-grade corporate bonds. 

 

In Brief:

  • Interest-rate differentials between the United States and Europe have declined significantly since the beginning of 2020.
  • For European-based investors, this has resulted in a sharp reduction in the cost of hedging U.S. dollar-denominated securities back into their local currencies.  
  • As long as hedging costs remain low, and the search for yield continues, we anticipate strong interest by European-based investors in U.S investment-grade corporate bonds.

March was an unprecedented and extraordinary time for both the global economy and for markets. But one silver lining for European-based investors has been the sharp reduction in the cost of hedging U.S. dollar (USD)-denominated securities back into their local currencies.  

 

Figure 1.  The Cost of Hedging USD-Based Securities Back Into European Currencies Has Declined Significantly
Hedging costs based on 3-month FX Forwards* (January 2008-April 2020)

Source: Bloomberg and Lord Abbett.  *An FX Forward is a contractual agreement between the client and the bank, or a non-bank provider, to exchange a pair of currencies at a set rate on a future date.

 

Focusing on the euro (EUR), pound sterling (GBP), and the Swiss franc (CHF), Figure 1 reveals that, in all three currencies, the cost to hedge USD-denominated securities has fallen by much more than half year-to-date (April 27, 2020). This reduction was primarily the result of reducing the short-term interest-rate differential between the U.S. Federal Reserve (Fed) and European central banks.

During the month of March, the Fed cut its interest rate by 1.5% to a range of 0 – 0.25%. Over the same period, the Bank of England reduced its base rate by 0.65% to 0.1%, while the European Central Bank and the Swiss National Bank held their rates flat at -0.5% and -0.75%, respectively.  Those moves left short-term rates in the United States roughly equivalent to those in the United Kingdom and closer to those of the euro-area and Switzerland.

Short-term interest rate differentials represent a lower bound for where we can expect hedging costs to go.  Currently, hedging costs remain higher than these lower bounds, but we believe the support facilities recently put in place by the major central banks, will help decrease the gap. To understand the measure and intent of those facilities, its helps to review the early sign of turbulence, as it was manifested in the foreign exchange markets.

An Early Sign of Turbulence
While news circulated in February 2020 that COVID-19 was threatening to become a global pandemic, it was not until early March that global financial markets started reacting. One of the earliest signs of turbulence could be seen in the foreign exchange (FX) market. The FX market is one of the most liquid markets in the world, with an average of over $6 trillion traded daily, according to the 2019 BIS Triennial Survey.  Roughly 88% of those transactions involve the U.S. dollar, and 65% of those are in contracts with maturities of less than seven days. Because the FX markets depend heavily on short-term funding rates in the U.S. economy, they reflected, almost immediately, any excess pressure in these rates as well as any increased demand for dollars. 

Sudden, Large Demand for Dollars
When equity, commodity, and credit markets all started falling and volatility increased, investors globally sought to de-lever and transfer as much as they could into the most reliable asset – cash, usually in the form of USD. This sudden, large demand for dollars caused funding markets to seize up. In addition, companies rapidly drew down their credit lines, helping to push LIBOR (London Interbank Offered Rate, which is an unsecured inter-bank lending rate) much higher, even though the Fed quickly cut its overnight rate to effectively zero. A large gap was created between LIBOR and the so-called “risk-free” rate in the United States which has only partially closed at the time of writing.

Alleviating the Pressure
The Fed responded to these developments with special facilities to alleviate pressure on short-term funding rates and excess demand for dollars.  As these facilities were announced and activated and de-leveraging ran its course, hedging costs were able to start moving lower.

Our View on the Likely Trajectory of Hedging Costs
As LIBOR rates continue to compress towards so-called “risk-free” government rates and swap lines remain active, we expect hedging costs to continue to fall.  The cost for the GPB could stabilize close to zero.  However, costs are likely to remain positive for the EUR and CHF, given our belief that the United States will continue to have higher short-term interest rates.  We do not expect the Fed to cut its rate any further, relying instead on the rapid expansion of its balance sheet to provide further stimulus.

Implications for Investment in U.S. High Quality Corporate Bonds
Over the past couple of years, as U.S. monetary policy diverged from that in Europe, the relatively high cost to hedge USD-denominated bonds into local currencies has been a headwind for European investors’ participation in U.S. investment grade (IG) corporate bonds. With hedging costs now lower, it may make more sense for these investors to access the potential diversification benefits that this asset class may bring to their portfolios.

The Fed is supporting this market directly through primary and secondary purchases for the first time ever. In our opinion, nominal yields are likely to remain higher than EUR-denominated IG corporate bonds, even as spreads over risk-free government bonds tighten, given, as we believe, that the Fed is unlikely to cut short-term rates to negative levels. For all these reasons, we think the interest in U.S. IG corporate bonds will continue to grow, in Europe and globally.

For readers wishing a more granular description of dollar hedging costs and the Fed’s response to the market’s stresses, we offer the following: 

Appendix

Hedging Costs and the Fed’s Response

The cost to hedge the dollar into a foreign currency (or vice versa) is determined by two market-dependent rates: the interest rate differential between the currencies and the cross currency basis.

The interest rate differential between the currencies. The interest rate used for this calculation is LIBOR, rather than government rates (i.e., the so-called “risk-free” rates of U.S. Treasury bills and the like). Therefore any divergence between unsecured lending rates and the risk-free rates in a given economy will be reflected in the FX hedge. As you can see in Figures 2 and 3, the three-month LIBOR rate differential with the Euro Interbank Offer Rate (EURIBOR) has come down from the peak at the end of 2018 of over 3% to around 1% in January 2020.

 

Figure 2.  Interest Rate Differentials Based on LIBOR
Three-month LIBOR-based interest rate differentials versus EURIBOR* (2008-April 2020)

Source. Bloomberg and Lord Abbett. *The Euro Interbank Offer Rate (EURIBOR) is a reference rate that is constructed from the average interest rate at which eurozone banks offer unsecured short-term lending on the inter-bank market. The maturities on loans used to calculate EURIBOR often range from one week to one year.

 

Figure 3. Interest Rate Differentials Based on Government Bills
Three-month U.S. Treasury bill rate versus German, British, and Swiss government rates (2008-April 2020)

Source. Bloomberg and Lord Abbett.

 

However the three-month Treasury bill differential between the United States and Germany is down to around 0.7%. In the GBP market, the difference is even greater, as the U.S. three-month bill is now below the UK bill rate but USD three-month LIBOR rate is still 0.4% higher than the GBP inter-bank rate.

The Fed Response. The Fed designed some of its new facilities to try to bring LIBOR closer to the risk-free rates. In particular, the Commercial Paper Funding Facility and Money Market Mutual Fund Lending Facility are targeted towards providing short-term funding to corporate issuers and banks, respectively, and should continue to alleviate pressure on short-term rates.

The cross-currency basis. The second determinant of the cost of hedging is the premium (or discount) foreign companies and banks need to pay (or receive) in order to access USD in exchange for their local currencies. When the basis is negative, this means that dollars are more expensive and vice versa. When European investors swap EUR into USD, they receive EURIBOR (Euro Inter-bank Offer Rate) + the basis as interest in exchange for having to pay the LIBOR rate. When the basis is negative, these investors are receiving less than they would if they lent their euros to another European investor. In times of stress, such as occurred in the middle of March, this basis gets very negative.

The Fed Response.  In response, the Fed expanded its swap lines and repo facilities with other central banks. What these facilities do is make dollars readily and more cheaply available to other central banks that can either lend to their local banks or use the dollars directly to intervene in their local markets. As you can see in Figure 4, the basis in all three currencies has snapped back to positive or zero, reflecting a normalization in the demand for dollars in the FX market.

 

Figure 4. Cross Currency Basis Swaps Reflect a Normalization of the Demand for USD in the FX Market
Cross-currency basis swaps: Negative=Premium paid for USD (January 2018-April 2020)

Source. Bloomberg and Lord Abbett.

 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. U.S. Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Income from Treasury securities is exempt from state and local taxes. Although Treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk.

Past performance is not a reliable indicator of future results.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

Glossary of Terms

A Commercial Paper Funding Facility (CPFF) was established by the Fed on March 17, 2020, to support the flow of credit to households and businesses. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle that will purchase unsecured and asset-backed commercial paper rated A1/P1 (as of March 17, 2020) directly from eligible companies.

currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency. At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.

Hedging costs can be decomposed into two parts: Short-term rate differential: This is the difference between short-term rates in the domestic and foreign currency. FX/currency basis: This is the additional cost investors pay to buy and sell currencies forward, on top of the rate differential.

An interest rate differential is a difference in the interest rate between two currencies in a pair. If one currency has an interest rate of 3% and the other has an interest rate of 1%, it has a 2% interest rate differential.

LIBOR is the average London interbank interest rate at which a selection of banks on the London money market are prepared to lend to one another. LIBOR comes in 7 maturities (from overnight to 12 months) and in 5 different currencies.

A lower bound is an element less than or equal to all the elements in a given set: The numbers 0 and 1 are lower bounds of the set consisting of 1, 2, and 3.

A Money Market Mutual Fund Lending Facility was established by the Fed on March 19, 2020, to help ease the flow of credit and meet demand for money market redemptions by households and businesses.

The nominal yield is the coupon rate on a bond. Essentially, it is the interest rate that the bond issuer promises to pay bond purchasers. This rate is fixed and it applies to the life of the bond. 

The risk-free interest rate is the rate of return of a hypothetical investment with no risk of financial loss, over a given period of time. Since the risk-free rate can be obtained with no risk, any other investment having some risk will have to have a higher rate of return in order to induce any investors to hold it. 

A FIMA Repo Facility was created by the Fed on March 31, 2020, as a temporary repurchase agreement facility for foreign and international monetary authorities () on March 31, 2020. The FIMA Repo Facility will allow FIMA account holders, which consist of central banks and other international monetary authorities with accounts at the Federal Reserve Bank of New York, to enter into repurchase agreements with the Federal Reserve. In these transactions, FIMA account holders temporarily exchange their U.S. Treasury securities held with the Federal Reserve for U.S. dollars, which can then be made available to institutions in their jurisdictions. This facility should help support the smooth functioning of the U.S. Treasury market by providing an alternative temporary source of U.S. dollars other than sales of securities in the open market. It should also serve, along with the U.S. dollar liquidity swap lines the Federal Reserve has established with other central banks, to help ease strains in global U.S. dollar funding markets.

swap line is another term for a temporary reciprocal currency arrangement between central banks. That means they agree to keep a supply of their country's currency available to trade to another central bank at the going exchange rate. Banks use it for overnight and short-term lending only.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

The information provided is for general informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education.  None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.   If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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