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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.
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.
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.
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.
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.