For the income hungry, US bonds might currently look like a very attractive proposition, with yields hovering around the 3% mark.
But investors based outside of the US need to approach with caution as the bumper yields on offer can look far less tempting when hedging costs are taken into account. The financial crisis and the years that followed saw interest rates across the developed world stuck in the doldrums. But the US Federal Reserve has begun to deviate from this stance, raising interest rates by 150 basis points (bps) since December 2015, and markets are expecting further increases from the bank in 20181.
At the same time, the European Central Bank and Bank of Japan have reduced key policy rates by 60bps. It is relatively rare to have such large rate differentials and today the difference between US and European rates is the highest it’s been since 1999. This has driven higher hedging costs. As a result, for euro, sterling, Swiss franc or yen based bond investors in US denominated assets, it is unlikely that they would receive the US dollar yield or return.
For example the current yield-to-worst – the lowest possible yield available for a bond without it defaulting – on the ICE US High Yield index is 5.99%. Hedged into euro this becomes 3.21% compared to a yield-to-worst on the ICE Euro High Yield index of 3.09%1. So the pick-up from investing in US relative to European high yield is just 12bps1. But despite these challenges we believe opportunities remain.
For investors buying investment grade, the cheapest AAA rated assets are 10 and 30-year German and Netherland government bonds. Hedged into the dollar they yield more than US Treasuries, hedged into sterling they yield more than gilts and into yen they yield more than long-dated Japanese government bonds. Furthermore sterling has been ignored, but shouldn’t be. Since June last year it has ourperformed all major currencies, hitting $1.44 against the US dollar in April 2018, and when hedged in euros and US dollars, sterling rates, credit and high yield assets provide a potential premium for investors.
For bond investors looking to take on more risk, high yield remains an option. In both US and European markets, yields have risen by 100bps since the lows reached in late 2017 and spreads have widened. With Standard & Poor’s 2017 Annual Global Corporate Default Study presenting global high yield default rates at 2.4% last year, we believe that in a “risk-on” environment, high yield should outperform investment grade credit.
Yields may be low, but ultimately bonds still pay coupons, and in our view short duration high yield and emerging market strategies are most attractive at this stage of the cycle – and could potentially provide investors with the income they are looking for.