Understanding FX Hedging Costs and Why Japanese Investors Are Moving Money Home

Normally, when yield on debt rises it becomes more attractive. But after the Federal Reserve began raising interest rates in the US in March 2022, investors in Japan sold record amounts of Treasuries and other overseas debt. The reason? Cross-border bond purchases come with exchange-rate risks, and the Fed’s actions have been sending the cost of hedging such risks up even faster than yields. There are also signs European investors may be looking again at their own domestic debt and shifting money home, following the European Central Bank’s key rate turning positive for the first time in a decade last July.

For one thing, a lot of money is involved. Japanese investors are the largest individual group of overseas buyers of Treasuries. The Bank of Japan has set its key rate below zero for the last seven years. That and its firm control of yields through voracious bond-buying programs have led Japanese investors to hunt abroad for higher yields, with returns in their domestic markets squeezed. But with overseas investing comes currency risk: Japanese funds, for instance, have to first convert yen into dollars to buy Treasuries and then exchange their money back into yen when they repatriate the profits. That means that currency swings have the potential to boost or eat into returns.