The unprecedented surge in the value of Treasurys means that U.S. investors can now get the best risk-free yields from a most unlikely source: Japan.
Concerns about the coronavirus and a sharp drop in the price of oil have led markets to expect even more interest-rate cuts from the Federal Reserve. Treasury yields have fallen to record lows as a result. Even after Tuesday’s rebound, returns on 10-year paper are around 0.7%.
A pedestrian looks at a quotation board displaying foreign exchange rates in Tokyo.
Photo: kazuhiro nogi/Agence France-Presse/Getty ImagesAt first glance, it might seem like there is nowhere to run. Yields are plunging everywhere: Negative yielding debt now makes up 25% of the global investment-grade bond market, compared with 19% in mid-January, data by JPMorgan shows. 10-year German bunds, the risk-free benchmark in the eurozone, are edging close to minus 0.7%. In Japan—a country famous among traders for decades of almost-zero yields—government bonds trade for around minus 0.05%.
Yet perhaps there is an answer hiding in plain sight.
For U.S. investors, a crucial metric is how much an asset bought abroad returns after hedging out the currency risk. Fund managers often do that by rolling over three-month currency derivatives contracts, which tend to be more liquid than longer tenors. On that metric, Japanese government bonds yielded around 1.4% at Monday’s close, almost a full percentage point more than Treasurys. This excess yield or “pickup” has been increasing in recent months, to the point where the return available from hedged Japanese debt has even outpaced that from hedged German bunds.
A reason for this is that Fed rates were previously higher than their equivalents in Europe and Japan, which are already negative and can’t go much lower. As a result, U.S. bond yields have much more space to fall relative to Japanese ones.
When using full-maturity hedges, 10-year Japanese bonds have consistently earned a pickup over Treasurys since at least 2008. But the latest market turmoil sent the yield premium to its highest level since 2013 on Monday. It narrowed on Tuesday, but the return available is still sizable.
In theory, this shouldn’t happen, because arbitrageurs usually make sure that no extra money can be made without risk. Since the global financial crisis, though, regulatory constraints placed on banks have restrained lending in global markets, forcing investors to pay a premium for borrowing U.S. dollars in exchange for foreign currencies. This is especially true in times of stress.
Since the plumbing of financial markets has remained broadly resilient during the recent coronavirus selloffs, the anomaly presents an opportunity for U.S. investors who can suddenly find no yield. Ironically, the place where they can now get returns is infamous for offering none.
Write to Jon Sindreu at jon.sindreu@wsj.com
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