By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) - The coronavirus pandemic has slashed costs for foreign investors seeking to neutralize the currency exposure of owning dollar-denominated assets, making U.S. securities more attractive and providing additional boost for the nation's fixed income market.
Dollar hedging costs since the virus outbreak have declined by as much as 100 basis points for European and Japanese investors, two of the biggest overseas buyers of U.S. assets. A significant factor in the reduction was the Federal Reseve cutting U.S. interest rates to zero last month to mitigate the economic impact of the pandemic.
Additionally, the Fed is now actively backstopping every corner of the bond and credit sector, except distressed debt, and the U.S. economy looks primed for what could be a slew of inflows from offshore investors in the coming weeks and months, analysts said.
For foreign investors, this is one big incentive for investing in the United States, even amid a global health crisis.
"It's a global competition for capital. What matters here is the relative performance of each country in confronting the crisis," said Robert Brauns, portfolio manager for multi-strategy fixed income at BNP Paribas Asset Management in New York.
"Even though the U.S. administration was probably late to the party, they came together, and monetary as well as fiscal support measures that were put in place were quite effective and quite strong," he added.
Hedges are typically done through currency forwards that specify the rate at which a currency may be exchanged at the end of a contract period -- usually three to six months. The forward rate is determined by the interest rate differentials between the two currencies. The forward contract effectively protects a fund if the foreign currency weakens against its home currency.
For example, a European investor who buys $100 million worth of U.S. corporate bonds would enter into a three-month or six- month forward contract to sell dollars and buy euros at specified rate as the FX hedge.
Prohibitive hedging costs had deterred some foreign investors in Europe and Japan from buying U.S. assets because they eroded returns when investors convert dollars into their home currencies.
For European investors, hedging costs have now declined to 1% per annum from about 2.2% before the coronavirus outbreak, while for Japanese investors, the cost has fallen to 1% as well from 2.0% beforehand, according to Adrian Ng, director of Chatham Financial, a financial management risk advisory firm.
A year earlier, these costs were much higher: 3.1% for euro investors and 2.9% for Japanese buyers, analysts said.
There are already indications that the favorable hedging environment for foreign investors may have partly prompted an increase in overseas allocations.
Japan's Government Pension Investment Fund (GPIF) announced on its website last month that it plans to raise the proportion of foreign bonds in its portfolio to 25 pct from the current 15 pct and cut its domestic debt allocation to 25% from 35% as Japanese bond yields languished in negative territory.
"To the effect that rates have come down in Asia is an aggressive push factor for investors overseas," said Ed Al-Hussainy, senior interest rate and currency analyst, at asset manager Columbia Threadneedle Investments in New York.
"What GPIF did was a reflection that rates in Japan have collapsed," he added.
BENEFICIARIES OF FOREIGN INFLOWS
The U.S. investment grade sector is widely viewed by investors as the biggest beneficiary of foreign inflows during this pandemic, largely thanks to the Fed's corporate credit facility.
"We think asset classes or sectors that are benefiting from direct policy support are attractive," said BNP's Brauns.
BNP Paribas and Columbia Threadneedle are both looking at the U.S. investment grade sector.
Investment grade spreads over U.S. Treasuries have been steady at 283 points as of Wednesday, suggesting a more positive outlook for the sector, compared with their lower yield counterparts.
Aside from corporate bonds, U.S. Treasuries are attractive as well, some investors said, not only because of its safe-haven appeal, but also because of the Fed's heavy purchases. Over the last three weeks, the Fed has bought more than $1 trillion in Treasuries.
"Our policy is don't fight the Fed and its balance sheet and that is a great backstop," said Columbia Threadneedle's Al-Hussainy.
(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Alistair Bell)