U.S. Treasuries need to get a lot cheaper to attract some European investors. Even with yields at multi-year highs, Treasuries are paying less than their pricier German peers when European insurers account for steep hedging costs. A stronger dollar as the Federal Reserve is tightening policy means that currency hedging can slash returns on the 10-year benchmark to just 0.29 percent, a little over half that of Germany.
At the same time, it is punitively expensive to invest on an unhedged basis as well, thanks to European Union’s stringent Solvency II regulations. For Treasuries to regain their attractiveness, yields may need to climb as much as three quarters of a percentage point from around 3 percent currently before European investors return.
AXA SA, the euro zone’s second-biggest insurer, is spurning Treasuries in favor of bonds cheaper to hedge, such as those of Switzerland and Japan. U.S. 10-year yields need to climb at least another 30 basis points relative to German peers to become attractive, according to UBS Group AG. For Achmea Investment Management BV, the increase needs to be more like 50-75 basis points.
“Remaining exposed to FX volatility is more costly under Solvency II,” said Paris-based Nicole Montoya, who helps oversee 746 billion euros ($875 billion) as AXA’s head of fixed income in Asia and the U.K. “So hedged or unhedged, it is less easy or yieldy to go for Treasuries.”
The EU’s Solvency II directive, which came into effect in January 2016, stipulates that European insurers have a capital requirement that protects foreign assets from a 25 percent price swing in the exchange rate. The regulation throws another spanner in the works for the $15 trillion market for Treasuries, widely accepted as the world’s safest and most-liquid sovereign securities, as it struggles to find buyers amid increased issuance on the back of President Donald Trump’s fiscal expansion.
JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon is one of a number of big hitters in the bond market who expect the U.S. 10-year yield to climb to 4 percent, having breached the symbolic 3 percent threshold last month.
Treasuries have tumbled this year on mounting concerns about faster inflation and the pace of Fed rate hikes. While there has been a growing consensus for higher U.S. yields, debate has shifted to the extent of the move, with Dimon and Franklin Templeton’s Chief Investment Officer Michael Hasenstab suggesting 10-year yields are set to climb toward 4 percent.
Treasury 10-year notes yielded 3.01 percent as of 4:16 p.m. in London, having touched 3.13 percent on Friday, the highest level since July 2011. The yield on comparable German bunds was 0.50 percent.
The cost of hedging is a major consideration for funds buying foreign assets, in order to prevent returns being erased by currency price swings. It is possible to buy bonds without protection, but that can often be risky for insurers who have to ensure that returns are sustainable over the long term. Hedging dollar-denominated assets is particularly expensive at the moment as the Fed pushes up U.S. interest rates.
“Europe has the additional hurdle,” Stephen Caprio, a credit strategist at UBS said, referring to Solvency II. “As hedging costs continue to increase, U.S. Treasury yields would need to outpace bund yields by more than 30 basis points to simply be as attractive.”
Only around 20 percent of insurance and pension funds’ 4 trillion euros of bond holdings are securities from outside the euro area, according to data from the European Central Bank.
Even with the yield premium to hold Treasuries over German peers close to the widest since at least 1989, investors are still choosing the latter.
“We’re forced to turn to euro-based liabilities,” said Lucas Bouwhuis, a Netherlands-based senior portfolio manager at Achmea Investment. Bouwhuis added that without regulation and the high cost of hedging, Treasury yields at 3 percent look attractive. “The story has to be very compelling before insurance companies and pension funds in Europe buy Treasuries again,” he said.