Calling all EUR income investors

Investment Specialist Jake Otto argues that lower hedging costs and a lagging European recovery may warrant a more globalized scope to these investors’ fixed income toolkit.

Views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.

Stubbornly low domestic interest rates have been a challenge for European fixed income investors ever since the global financial crisis (GFC), exacerbated recently by fallout from the COVID-19 pandemic. Central banks’ unprecedented monetary and fiscal responses to the current crisis have likely extended the prevailing low-rate regime well into the future. As a result, Europeans may continue to be hard pressed to earn their desired yields and total returns from their region’s government bonds.

However, high-quality fixed income can still play a key role for these investors. And while steep hedging costs back to the euro currency (EUR) have been a hurdle to earning competitive hedged yields globally in recent years, more extreme central bank policy may go a long way toward easing such pressures, making foreign yield opportunities potentially more attractive to EUR investors.

Against this backdrop, we believe Europeans should restock their fixed income “toolkit” in an effort to benefit from the market dislocations that may arise worldwide during the post-COVID-19 recovery period. For many investors, global credit and macro strategies can be an effective means to that end.

A few words about hedging costs

Hedging costs in the forward-exchange (FX) market are primarily a function of front-end interest-rate differentials and currency-basis (supply/demand) forces. Given the highly liquid nature of developed currency markets, the FX basis is typically low, allowing interest-rate differentials to drive the bulk of forward-market FX pricing in recent years.

Since the end of the GFC, the US Federal Reserve (Fed) has been able to hike the federal funds rate, while the European Central Bank’s (ECB’s) deposit rate has been stuck below zero since 2014. In effect, currency hedging costs have risen meaningfully since 2016 (Figure 1). But as central banks have reacted to the COVID-19 crisis, cutting rates in a swift and systematic fashion, those costs have fallen significantly in recent months.

Notably, the Fed has cut the fed funds rate to the zero lower bound and has implemented emergency swap lines and other facilities to support the front end of the US-dollar (USD) market. The high levels of debt needed to fund government fiscal spending and ensure corporates can stay solvent through the crisis may require global central banks to keep interest rates lower for longer. The net result could be lower or more stable EUR/USD hedging costs going forward.

FIGURE 1

Cost for EUR investors to hedge USD investments

Implications for European investors

But if cheaper FX hedging costs reflect lower interest rates abroad, doesn’t that make the proposition for global fixed income investing less compelling? Yes, but only with regard to the highest-quality front-end rates. Across the yield curve, global yields hedged to EUR have increased overall, but have fallen for USD investors (Figure 2). Thus, the recent downward move in hedging costs has actually improved the current opportunity for European investors to pick up yield globally.

FIGURE 2

Bloomberg Barclays index yields

For EUR investors, our bottom line is this: We think the combination of cheaper hedging costs and lower government-bond yields argues for expanding one’s opportunity set globally to benefit from credit and macro opportunities in the period ahead.

In particular, we believe the crisis has created exploitable opportunities in both investment-grade and high-yield credit market segments, where valuations appear attractive as of this writing and skilled issuer selection may prove fruitful. Consider:

  • The global opportunity set outside of Europe is enormous. For instance, the US high-yield market alone is approximately 3.5x the size of its European high-yield counterpart.
  • While spreads have compressed meaningfully since peaking in March, they remain wide relative to historical averages. In some cases, global opportunities across the credit spectrum may provide superior yields, even after hedging costs.
  • For example, Figure 3 shows that investment-grade and high-yield credit spreads in the US currently offer a yield pickup relative to those in Europe.
  • The US credit markets might also stand to benefit from positive technical support provided by the Fed’s bond-buying program, which now includes corporates and “fallen-angel” high-yield securities.

FIGURE 3

IG and HY credit spreads - US vs Europe

Attractive opportunities to both pick up yield and improve one’s risk-return tradeoff can be found not only in credit, but also elsewhere in global fixed income. Importantly, as world government-bond and currency markets are highly liquid, they lend themselves well to capturing more tactical mispricings in volatile market conditions.

Opportunities amid macro challenges

We believe the potential for an uneven global economic recovery from COVID-19-induced turmoil also supports the case for broadening to a global fixed income opportunity set. The severity and pervasive nature of this crisis may expose fragilities in economies and markets. Fiscal and monetary policy responses have varied around the world. Ultimately, we believe the effectiveness of each response will hinge on its speed and size, as well as the extent to which it helps those hit hardest by the shock.

Multi-decade lows in cyclical data and increased leverage may exacerbate macro challenges, some of which existed even before COVID-19 struck:

  • For the UK, what will the eventual Brexit deal look like? And how and when do negotiations proceed?
  • Will the European Union (EU) fiscal response to COVID-19 be sufficient to keep more peripheral markets calm?
  • How will the deteriorating US/China relationship evolve in the coming months?
  • If central banks are acting more like agents of the government, what does that mean for currency valuations and the US dollar’s reserve currency status?

These highly fluid macro factors can present opportunities for EUR investors across global interest-rate, currency, and credit markets.

Final thoughts

We believe now is a good time to consider whether your fixed income allocation is designed to provide your desired characteristics on a forward-looking basis. For European investors, lower hedging costs and a potentially lagging domestic recovery may warrant a more globalized scope to the fixed income toolkit. With a thoughtful approach to harnessing opportunities globally, ongoing market volatility can be an asset to the investor, rather than a threat.

Please see the important disclosure page for more information.

RECOMMENDED FOR YOU

2021 Investment Outlook
As we head into the new year, thought leaders from across our investment platform share their views on pressing questions.
December 2020
2021 Investment Outlook
,
2021 Fixed Income Outlook
Mercifully for many market participants, 2020 is drawing to a close. Despite persistent risks and challenges in today's extraordinary environment, Fixed Income Portfolio Managers Rob Burn and Campe Goodman see areas of value and opportunity for fixed income investors heading into 2021.
December 2020
2021 Fixed Income Outlook
,
Fighting downgrade drag to reduce pension liability lag
Even robustly constructed liability benchmarks can struggle to keep pace with the liabilities they are meant to represent, and credit-rating downgrades of issuers in the benchmark are a primary culprit. In this paper, members of our LDI Team define the problem and offer ideas to help plan sponsors and LDI managers work together to fight back.
November 2020
Fighting downgrade drag to reduce pension liability lag
,
Bill Cole
 CFA, CAIA
Louis Liu
 PhD, CFA, ASA, MAAA
Clearing the air: Assessing climate transition risks in credit portfolios
As the world transitions to a low-carbon economy, investors need to prepare to manage attendant risks and opportunities in client portfolios. Members of our Fixed Income and Climate Research Teams share their approach to quantifying material climate transition risks and mitigating portfolio-level exposure.
November 2020
Clearing the air: Assessing climate transition risks in credit portfolios
,
The future of alternative investments
Director of Alternatives Danny Sharp explores the future of alts — discussing dispersion in today's markets, the opportunities it presents, and the impact of the COVID-19 pandemic on the alternative investments landscape.
November 2020
The future of alternative investments
,
The path forward for insurers
Multi-Asset Strategist Tim Antonelli offers four major themes and recommendations for insurers that have arisen from his scenario analysis, stress testing, and strategic asset allocation reviews during the past several months.
October 2020
The path forward for insurers
,
Tim Antonelli
 CFA, FRM
Credit market recovery? Take a closer look through an alternative lens
Credit market dispersion remains elevated, and market dysfunction related to liquidity and other factors hasn't gone away. Investment Director Chris Perret explains why and what it means for alternative credit strategies.
October 2020
Credit market recovery? Take a closer look through an alternative lens
,
Expanding the liability-hedging tool kit: A securitized solution?
Concerned about concentration risk, liquidity issues, and other factors that can affect long corporate bond allocations, derisking pension plans are seeking opportunities to diversify their liability-hedging allocations. In this paper, members of our LDI Team share their research on securitized assets as a potential alternative.
September 2020
Expanding the liability-hedging tool kit: A securitized solution?
,

We use cookies to improve your experience on our website. To accept cookies click Accept & Close, or continue browsing as normal. For more information, visit Cookies & Tracking NoticE.