Much has been written recently about negative interest rates in Europe, Japan, and other markets around the world. Foreign central banks continue to increase the size of their respective balance sheets by buying massive amounts of bonds, and prices continue to increase, driving some interest rates into negative territory. In recent months and years foreign bond investors have significantly increased their purchases of U.S. taxable municipal bonds, corporate bonds, and mortgage backed bonds. In our opinion, bond investors in these countries will continue to seek out relatively attractive risk adjusted returns, and their sights will increasingly focus on U.S. bond markets.
To quantify what these non U.S. investors are analyzing, the 5-year government bonds in Germany, France, and Japan are currently yielding -0.38%, -0.18%, and -0.23% respectively. The U.S. 5-year government bond is currently yielding 1.28%, an average yield advantage of 1.54%. If investors from Germany, France and Japan were to purchase investment grade taxable 5-year AA municipal bonds, a rated corporate bonds, or government agency backed AAA mortgage bonds with a 5-year average life, the yield pickup would be approximately 2.04%, 2.24%, and 2.29% respectively.
If you are a non U.S. bond investor in one of these countries or another similar country, and you are assigned the position of managing bond investments for pension plans, foundations, family offices or other financial institutions, picking up additional investment income of more than 2% in low U.S. credit risk instruments seems like a reasonable investment to consider, even when one considers the additional currency risk, or paying to hedge away this risk.
While the prevailing trends of foreign investor demand are only a portion of the story as it relates to changes in interest rates and credit spreads, and though rates in the U.S. remain near their all-time lows and credit spreads for investment grade issues also remain relatively low, it is still very possible that rates could move even lower in the coming months and years if foreign buyers continue to purchase U.S. bonds.
Jim Bernard, CFA, is the Managing Director, Fixed Income at Ancora Advisors LLC a SEC Registered Investment Advisor. He is also a Registered Representative and Registered Principal of Safeguard Securities, Inc. (Member, FINRA/SIPC)
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