`Major' Capital Shift Puts U.S. Credit in $2.7 Trillion Quandary

(Bloomberg) -- In credit markets, it’s America first no longer.

A wave of foreign selling of U.S. corporate bonds threatens to unhinge global debt markets from their bullish moorings, according to HSBC Holdings Plc.

After a multi-year binge, the largest owners of America Inc.’s debt -- overseas investors -- are paring their exposures as higher short-term U.S. rates drive up hedging costs, especially for Europeans. The accompanying pressure on the biggest corporate bond market risks hobbling credit bulls around the world.

“Our analysis of foreign investors in U.S. dollar and euro suggests major changes in global capital flows are underway,” strategists led by Jamie Stuttard wrote in a report this week. While European issuers will benefit from repatriation flows, a “disorderly” retrenchment from dollar debts would ensure no developed credit market escapes the “bearish correlations.”

Higher relative yields and the U.S. economic recovery lured a tide of capital inflows in recent years. Now short-term dollar rates are at crisis-era levels, increasing the cost for foreigners to hedge their exposures, and dimming the market’s allure even as yields on U.S. investment-grade notes rise to seven-year highs.

Europeans have pulled money from the U.S. for two consecutive months in the last three -- the longest stretch in four years -- and Asians slowed purchases, according to HSBC, citing Treasury data. For good reason. The British bank calculates investors in the euro area now pay about 280 basis points to currency-hedge dollar credit.

The pain is far-reaching. Overseas buyers own the largest chunk of the U.S. market, at 28 percent. They snapped up $469 billion last year alone. Foreign private institutions hold a whopping $2.7 trillion of the domestic credit stock in total.

Last year’s dip in the greenback exerted a heavy drag on unhedged portfolios in paper terms. The dollar’s rebound over the past month, meanwhile, underscores the allure of protecting against currency swings.

HSBC joins UBS Group AG to Wells Fargo & Co. in warning that the U.S. market has become exposed to new risks from overseas investors often more-fickle than those at home. The allocation conundrum is heating up, with investors including Pacific Investment Management Co. and M&G Ltd. offering different takes on the relative appeal of American securities for euro-based clients.

Regardless, diminished foreign appetite for U.S. securities comes as domestic inflows to fixed-income funds in 2018 struggle to match last year’s frenetic pace -- another headwind for a market reeling from rising interest-rate risk.

“Annualized FX volatility is far larger than the outright USD IG corporate yield, for all non-USD and non-pegged investors other than Taiwan, which means unhedged positions are primarily currency plays, not credit investments,” the HSBC strategists wrote.

©2018 Bloomberg L.P.

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