Friday, April 17th, 2020

Income in Dollars, Please

This note is intended for our European clients. It would never really occur to US investors to take their income in any other currency. The yield on their government bonds is still higher than most other developed markets and they have many other domestic fixed income options. Even when they lend to foreign issuers in order to get a better spread, they have no need to step away from their own currency,

Eurozone investors are not so lucky. The yield on most of their host government bonds is miniscule, if not actually negative. The spread over Bunds is often unstable, and while this may throw up trading opportunities, it is not helpful when it comes to planning an income. Unlike the US, corporate investment grade issuance is too concentrated in the Financials sector. The main reason for ultra-low yields on government bonds has been the balance sheet weakness of the Eurozone banks, and these low yields also explain the banks’ poor earnings power. If investors try to stay in euros and diversify away from core-Eurozone government bonds, they end up exposed to over-indebted governments or thinly-capitalised financial institutions – or both. There are simply not enough non-financial, investment grade credits.

Many euro-denominated investors are reluctant to buy dollar-denominated debt without hedging the currency exposure, which frequently removes almost all of the yield pick-up. We have always argued against this strategy, believing that there is enough liquidity to allow investors to move in and out of US dollar fixed income based its total return in euros, but we accept that this is still regarded as unorthodox. Even with a hedge, we believe it makes sense to increase exposure to dollar-denominated credit. Our two preferred options are US Treasuries – at the medium to long end of the curve – and EM sovereign bonds, provided they are bought as part of a portfolio in order reduce the country specific risk.

Nobody knows what solution the governments of the eurozone will agree in order to restore financial stability to Italy and the rest of the periphery, However, uncertainty during negotiations may give rise to some nasty tail-risks, which a prudent investor should avoid, if at all possible. If those negotiations go badly wrong, there may be significant dislocation in European credit markets and an extended period of currency weakness. Owning dollar-denominated bonds in these circumstances would be a crucial risk reduction strategy.

Investors who have already done this trade should also look at their equity portfolio and consider the source currency of their dividend yield. Healthcare is the obvious sector with high dollar earnings and some pharma companies already pay their dividend in dollars. Energy is the other industry where this practice is commonplace. We have been very negative on the sector for most of the last two years, but it is hard to believe that crude oil prices can fall much lower. If the oil majors maintain their dividend this year, they will do it in future. Unlike banks, there is no regulator with the power to prevent them from paying one. There is always a trade-off between the security of the yield and the currency in which it is earned or paid.  This year, it may be better to own a riskier dividend, paid in a safer currency,

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