To hedge or not to hedge?

In October the three-largest life insurance companies in Japan announced that they would reduce their holdings of foreign bonds that were “hedged”, or protected, against potentially destabilising currency fluctuations. Instead, two of them — Nippon Life and Meiji Yasuda Life — said they would increase their holdings of unhedged foreign bonds in an attempt to increase their potential returns. Dai-ichi Life Insurance, the second-largest of the trio, said it would consider doing the same given how low bonds yields are at home and across the world more broadly.

It made financial sense as rising US interest rates and a strengthening dollar made it quite expensive for foreign investors to insure against currency movements. In fact, both European and Japanese investors earned, and continue to earn, negative yields if they hedge their US assets.

While US hedging costs remain high despite the Fed tilting dovish, not all Japanese insurers are convinced higher yields are worth the risk of going naked into these trades. In fact, some are doubling down on another tactic to defray higher hedging costs: buying lower-rated, higher-yielding debt, or even diversifying away from US assets altogether.

This week Nippon Life, which has total assets in excess of $600bn, said it will boost its holdings of unhedged foreign bonds in the year through March 2020 and reduce hedged ones. Taiju Life Insurance, a smaller competitor, are also taking this line. On Friday, its head of investment planning announced that the company, which used to be called Mitsui Life, plans to increase its exposure to unhedged foreign bonds by $3.1bn. Another rival, Asahi Life, said it hasn't ruled out the strategy either. It's a bet the global economy will stabilise and the dollar will continue appreciating against the yen.

That is a potentially risky move, warns Shweta Singh of TS Lombard. She pointed out to Alphaville:

If you are investing in dollar-denominated assets unhedged, there is a pressure point when the dollar depreciates, because your asset value decreases.

Other life insurers are cautious of this dynamic, with Dai-ichi warning on Tuesday of a potential US recession and limited upside to the dollar. Rather than going unhedged, many have eschewed US Treasuries for higher-yielding corporate debt and in some cases, European bonds, which can yield more than their US counterparts on a hedged basis.

Executives at Meiji Yasuda, which manages roughly $349bn, said the insurer will continue adding to its stock of non-dollar denominated corporate debt. In the last fiscal year, it bought bonds denominated in Swedish Krona and Canadian dollars. While unhedged foreign bold holdings are not completely off the table, deputy president Masao Aratani mentioned the following at a press conference on Tuesday:

Dollar-denominated instruments will remain our core assets. But we will also explore currency-hedged euro bonds if they offer an attractive alternative to yen bonds.

Europe has also caught the eye of Japanese insurers Taiyo Life Insurance and Fukoku Mutual Life Insurance, the latter of which told Reuters earlier this month that the move comes as part of a “rethink” to its previous investment strategy that centred around buying foreign bonds unhedged. Sumitomo Life Insurance is likewise looking into diversifying away from dollar assets.

For Singh, the move is unsurprising:

The hedged return is negative for many foreign investors, so why would they want to invest in US Treasuries?

While parts of Europe may offer a yield advantage to hedged US bonds, it's worth remembering that growth remains subdued across much of the Continent. The most recent reading of German and French manufacturing data shows that both economies continued to contract in April. In the US, on the other hand, the outlook looks as rosy as it's ever been.

So long as this US exceptionalism persists, it's the cautious investors that will pay the price. Well, for the moment anyway.

Related Links:
Bondholders take on forex risk as hedging costs soar - FT
Weak spots and worries in the global financial system - FT Alphaville
US exceptionalism is not fading just yet - FT Alphaville

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