FINANCE Bloomberg Businessweek September 16, 201924DATA: COMPILED BY BLOOMBERG○ Currency hedging squeezes some extra return out of negative-yielding Japanese and European debtHow to Make Money
From Money-Losing Bonds
Money managers at BNY Mellon and Pacific
Investment Management Co. have snapped up
Japanese bonds. Both companies have made the
country the second-largest geographic allocation
in some of their biggest international fixed-income
funds. Ordinarily that wouldn’t seem remarkable,
but right now many of Japan’s government bonds
have a negative yield—it actually costs money to
hold them to maturity.
BNY Mellon and Pimco aren’t alone. Investors
from outside Japan more than doubled purchases
of the nation’s debt in July. What’s the logic? It
turns out that buying Japanese bonds can pay
better than holding U.S. Treasuries, as long as you
happen to be a dollar-based investor and hedge
your exposure to currency swings.
The currency effect turns the –0.25% yield
on 10-year Japanese government bonds into the
equivalent of 2.22% in dollars, which is more
than similarly dated Treasuries currently pay.
“The returns are actually pretty good and com-
petitive,” says Brendan Murphy, of BNY Mellon.
About 17% of the $3.2 billion BNY Mellon Global
Fixed Income Fund he co-manages is allocated to
Japan’s bond market.
This bond market alchemy is a product of
foreign exchange rates. When a U.S. fund buys a
yen-denominated bond, it may choose to hedge
the currency risk by entering into a forward con-
tract that allows it to sell yen at a fixed price a
few months later. The key to profitability for the
U.S. fund is that now the yen will buy back more
dollars on the back end of the transaction. The
difference in exchange rates—between the value of
yen now and the agreed price a few months from
now—works out to an annualized return of about
2.5%, more than making up for the negative yield
on the bond.
This might sound like a free lunch, but it makes
economic sense. If one country offers a higher
interest rate than another, and money is constantly
moving around the world to find the best returns,
forward currency markets end up adjusting to
more or less equalize the difference. With U.S.○ Kokusai-sensei, a
mascot created by
Japan’s Ministry of
Finance to promote
government bond salesTreasuries standing out as safe assets that still pay
a positive yield, dollars are in demand around the
world, and U.S. investors are in effect getting paid
a bonus for parting with them to buy other assets.
Thanks to a steady stream of Federal Reserve
rate hikes since 2015, U.S. short-term interest rates
are far higher than in almost every other devel-
oped market, even after the U.S. central bank cut
rates in July to a range of 2% to 2.25%. By contrast,
the Bank of Japan’s key rate stands at –0.1%.
The extra yield that U.S. investors pick up from
currency hedging would erode if the two nations’
interest rates converged. But while traders are
pricing in about 1 percentage point of Fed easing
over the next 12 months, Murphy doesn’t think the
central bank will cut that aggressively.
Pimco money manager Sachin Gupta is of a sim-
ilar mind. Gupta, based in Newport Beach, Calif.,
expects the Fed to lower rates again this year, but
he thinks policymakers may be reluctant to pre-
emptively cut again if the economy stays reason-
ably strong. So he’s comfortable keeping almost
15% of the $12.2 billion U.S. dollar-hedged Pimco
International Bond Fund in Japanese bonds. The
allocation is in line with the fund’s benchmark.
“You’re taking on the risk of the government
of Japan,” says Gupta, who added longer-dated
Japanese bonds earlier this year. “We think for a
Group of Seven country with one of the largest
economies in the world, that kind of risk in your
own currency is de minimis.”
The hedging arbitrage isn’t limited to Japan.
Gupta also owns low-yielding government debt
from nations such as Spain, where hedging from
euros into dollars produces a 2.72% annualized
return. Murphy, of BNY Mellon, holds Spanish and
Belgian debt.
Even bond managers who aren’t especially
bullish on Japanese bonds see the appeal of the
currency play. The $6.6 billion T. Rowe Price
International Bond Fund allocated less to Japan
than its benchmark index does, but it’s been park-
ing money in the nation’s short-maturity govern-
ment bills. “The very short end is an alternativeMake Money
2%10○ Benchmark
interest rates
Bank of Japan policy
balance rate
Fed funds
effective rate9/2009 8/2019 FINANCE Bloomberg Businessweek September 16, 201924
DATA: COMPILED BY BLOOMBERG○ Currency hedging squeezes some extra return out of negative-yielding Japanese and European debtHow to
From Money-Losing Bonds
Money managers at BNY Mellon and Pacific
Investment Management Co. have snapped up
Japanese bonds. Both companies have made the
country the second-largest geographic allocation
in some of their biggest international fixed-income
funds. Ordinarily that wouldn’t seem remarkable,
but right now many of Japan’s government bonds
have a negative yield—it actually costs money to
hold them to maturity.
BNY Mellon and Pimco aren’t alone. Investors
from outside Japan more than doubled purchases
of the nation’s debt in July. What’s the logic? It
turns out that buying Japanese bonds can pay
better than holding U.S. Treasuries, as long as you
happen to be a dollar-based investor and hedge
your exposure to currency swings.
The currency effect turns the –0.25% yield
on 10-year Japanese government bonds into the
equivalent of 2.22% in dollars, which is more
than similarly dated Treasuries currently pay.
“The returns are actually pretty good and com-
petitive,” says Brendan Murphy, of BNY Mellon.
About 17% of the $3.2 billion BNY Mellon Global
Fixed Income Fund he co-manages is allocated to
Japan’s bond market.
This bond market alchemy is a product of
foreign exchange rates. When a U.S. fund buys a
yen-denominated bond, it may choose to hedge
the currency risk by entering into a forward con-
tract that allows it to sell yen at a fixed price a
few months later. The key to profitability for the
U.S. fund is that now the yen will buy back more
dollars on the back end of the transaction. The
difference in exchange rates—between the value of
yen now and the agreed price a few months from
now—works out to an annualized return of about
2.5%, more than making up for the negative yield
on the bond.
This might sound like a free lunch, but it makes
economic sense. If one country offers a higher
interest rate than another, and money is constantly
moving around the world to find the best returns,
forward currency markets end up adjusting to
more or less equalize the difference. With U.S.○ Kokusai-sensei, a
mascot created by
Japan’s Ministry of
Finance to promote
government bond salesTreasuries standing out as safe assets that still pay
a positive yield, dollars are in demand around the
world, and U.S. investors are in effect getting paid
a bonus for parting with them to buy other assets.
Thanks to a steady stream of Federal Reserve
rate hikes since 2015, U.S. short-term interest rates
are far higher than in almost every other devel-
oped market, even after the U.S. central bank cut
rates in July to a range of 2% to 2.25%. By contrast,
the Bank of Japan’s key rate stands at –0.1%.
The extra yield that U.S. investors pick up from
currency hedging would erode if the two nations’
interest rates converged. But while traders are
pricing in about 1 percentage point of Fed easing
over the next 12 months, Murphy doesn’t think the
central bank will cut that aggressively.
Pimco money manager Sachin Gupta is of a sim-
ilar mind. Gupta, based in Newport Beach, Calif.,
expects the Fed to lower rates again this year, but
he thinks policymakers may be reluctant to pre-
emptively cut again if the economy stays reason-
ably strong. So he’s comfortable keeping almost
15% of the $12.2 billion U.S. dollar-hedged Pimco
International Bond Fund in Japanese bonds. The
allocation is in line with the fund’s benchmark.
“You’re taking on the risk of the government
of Japan,” says Gupta, who added longer-dated
Japanese bonds earlier this year. “We think for a
Group of Seven country with one of the largest
economies in the world, that kind of risk in your
own currency is de minimis.”
The hedging arbitrage isn’t limited to Japan.
Gupta also owns low-yielding government debt
from nations such as Spain, where hedging from
euros into dollars produces a 2.72% annualized
return. Murphy, of BNY Mellon, holds Spanish and
Belgian debt.
Even bond managers who aren’t especially
bullish on Japanese bonds see the appeal of the
currency play. The $6.6 billion T. Rowe Price
International Bond Fund allocated less to Japan
than its benchmark index does, but it’s been park-
ing money in the nation’s short-maturity govern-
ment bills. “The very short end is an alternativeMake Money
2%10○ Benchmark
interestrates
BankofJapanpolicy
balancerate
Fed funds
effective rate9/2009 8/2019