For Some Foreign Investors, US Debt Is Terribly Unattractive Despite Negative Yields At Home

Over the course of the massive rally in US bonds, there’s been no shortage of discussion about the extent to which spillovers from locales where yields are negative are to “blame”.

The global stock of negative-yielding debt has obviously exploded higher of late, amid a deteriorating outlook for global growth, flagging inflation expectations and the assumption that central banks will be forced into perpetual monetary accommodation.

In Europe, the fixed income market is a veritable funhouse mirror, complete with negative-yielding junk bonds.

Read more: The Bubble Isn’t Government Bonds, It’s Corporate Debt

There’s just one problem with the spillover thesis: Compared to the last time the global pile of negative-yielding fixed income surged, FX-hedged foreign investors are better off staying at home.

“Back in 1Q16, there was roughly 50-100bp of yield pick-up for European and Japanese investors who were willing to buy 10y USTs on a (rolling) currency-hedged basis”, Goldman writes, in a note dated Thursday.

(Goldman)

Now, by contrast, hedged-US Treasury yields are “uniformly lower than the negative yields available in many of these regions”, the bank goes on to write.

You might think that the lack of yield pickup for currency-hedged investors would translate into a lack of portfolio flows into USD fixed income, but that hasn’t been the case. Indeed, as Goldman goes on to point out, private foreign investors have stepped up purchases of long-end US debt amid the surge in global negative-yielding fixed income, just as they did in Q1 2016.

(Goldman)

What accounts for this given the punitive cost of hedging the currency exposure? Well, it’s likely attributable to a number of factors, all of which are intuitive.

First, you’ll note that investors in locales with negative-yielding debt can still generate positive carry if they’re financing their positions at rates that are even more negative than the assets they’re buying. Further, given the ferocity of the bond rally, some investors are doubtlessly just buying negative-yielding assets and hoping to sell them to someone else at even crazier prices (i.e., betting that yields will fall even further, generating more capital gains).

But, that calculus doesn’t apply to all investors overseas, and for those folks, owning unhedged USTs might be preferable for a couple of reasons.

“Investors who do not finance their fixed income positions or might have a longer investment horizon are likely to be more averse to holding negative-yielding debt”, Goldman writes, on the way to suggesting that “some such investors (reserve managers, for example) can decide to overweight Dollar assets in their portfolios, and therefore switch to owning Dollar fixed income on an unhedged basis”.

Further, if you’re the type who is simply playing bonds for a rally on the assumption that the fundamental factors which have driven the plunge in yields will continue to inflate the bubble, USTs might make a lot of sense.

“After all, US fixed income has the highest absolute yield levels with the most room to rally in adverse economic scenarios”, Goldman goes on to say.

So, the takeaway is that if you’re looking to explain foreign inflows into USTs despite how unattractive a proposition they are on a currency-hedged basis, there’s your answer. As Goldman says, summing up, “the avoidance of likely capital loss from holding (unfinanced) negative-yielding debt over a longer horizon and/or the fear of recession is the main motivator of recent cross-border flows”.

That stands in stark contrast to the beginning of 2016 when, as you can see from the first visual above, the appeal of USTs for foreign investors was simply that, even when accounting for hedging costs, yield pickup was attractive.