Fixed Income: How to Make the Depressed Dollar Work for You

Investments in non-dollar denominated assets are a nice hedge now.

Where is the U.S. economy heading? One telltale sign is the dollar, which has been sinking for the past year against major currencies and, in May, recorded a four-year low against the euro. The reasons are many — including the lingering economic slowdown, miniscule interest rates, a swelling current-account deficit and the prospect of massive federal budget deficits.

It would be inadvisable for your retail clients to start trading currency futures to profit from the swings in the dollar. On the other hand, it may be highly desirable for clients to get some foreign-currency exposure in their portfolios as a diversification strategy.

Sophisticated reps should consider allocating, say, five to 10 percent of a client's portfolio to highly-rated foreign issues. It can be accomplished easily — merely by taking a position in a foreign stock or bond. On the fixed-income side, there is an immediate payoff: In many parts of the world, yields on highly rated debt are considerably higher than in the U.S. For example, six-month, AAA-rated New Zealand government notes are paying 5.33 percent; U.S. government paper yields just 1.17 percent. (For more examples, see table, page 70).

Shorting the Dollar

But there's another benefit for investors in both stocks and bonds: When they repatriate the money from overseas investments, clients can get an extra boost from currency translations if the dollar continues to lose ground. In essence, your client is shorting the dollar and gaining a nice hedge against the U.S. economy. Even if these foreign economies weaken, central bank interest rate cuts would boost the value of most already issued fixed-income investments.

Clients can also short the dollar, in effect, by purchasing ADRs — of Nokia or DaimlerChrysler, for example. They are denominated in dollars, but they also represent a bet on the euro.

The Trend Is Your Friend

Now might be a good time to seek non-dollar denominated assets. Over the past year, the dollar has lost a significant hunk of its value against a number of leading currencies: 15.1 percent against the Australian dollar, 23.2 percent against the euro and 24.2 percent against the Swedish krona.

However, the key question is whether the dollar's current weakness is a blip or a secular change in its fortunes. The latter, some experts say. The current account deficit is near all-time highs, and with yields low and equities in the dumper, investors are exiting the U.S. Indeed, foreign direct investment has virtually collapsed, says Jay Bryson, global economist at Wachovia. It peaked at around $325 billion annually in the late 1990s, but has fallen to less than $50 billion. And net foreign money “will likely not bounce back anytime soon,” Bryson says.

Marc Chandler, chief currency strategist of HSBC in New York, is another dollar bear. He points to the volatile combination of loose monetary and fiscal policies, aggravated by the soaring budget and current account deficits. “The dollar is still trading on the strong side of its moving average, and under these conditions, the dollar isn't likely to sustain its value,” posits Chandler. By the end of 2003, he projects high single-digit gains against the U.S. dollar by the Australian and Canadian dollars, and double-digit-gains by the euro, New Zealand dollar, Swedish krona and Norwegian krone.

Stephen Jen, Morgan Stanley's chief currency economist in London, points to the current account deficit. “A major currency usually gets into trouble when budgetary and current account deficits total 7 percent of GDP,” says Jen. “The U.S. breached that threshold during the first quarter and the sum may approach ten percent by the end of the year.”

Short Dollar Vehicles

Your first inclination might be to put investors into global bond funds. Some have been doing well. But they are generally expensive to buy and hold, which cuts into the yield spread. Worse, they are far from transparent, mixing higher credit and currency risks, along with U.S. Treasury exposure. Further, some hedge their FX risk, eliminating the potential gain from a weakening dollar.

“If you are investing less than $50,000, the minimum for a currency contract,” says HSBC's Chandler, “unhedged foreign bonds are an ideal means of gaining FX exposure while capturing the interest rate spread. The yield curve in many of these countries is either flat or inverted, meaning you can capture the maximum return with relatively short maturities.”

From the perspective of yield-to-maturity, New Zealand government bonds offer the highest returns, even after a recent 25 basis point rate cut. A sovereign bond due in April 2004 has a yield to maturity of 5.24 percent. A February 2005 issue has a yield to maturity of 5.25 percent.

The next highest yields are offered by Norway. A November 2004 bond has a yield to maturity of 4.85 percent. Given the country's slow growth, HSBC thinks the central bank will likely cut rates by 100 basis points over the coming year, which helps explain why January 2007 bonds pay only 8 basis points more on an annualized basis than the 2004 issue.

Australia is perhaps the only developed high-yield market that's not likely to see rates fall this year, thanks to its strong economy. Accordingly, the country's yield curve ascends modestly. September 2004 government bonds offer a yield to maturity of 4.69 percent and a February 2006 issue is yielding 4.80 percent.

Swedish sovereigns are generally yielding 100 basis points less than the above-mentioned bonds. But if the krona registers another year of double-digit gains against the dollar, as a number of analysts predict, then this could prove to be the best play of all.

Investors would probably be well served by holding a series of these shorter-term sovereigns until maturity. However, to maximize returns, brokers need to regularly track interest and exchange rates. A sudden spike in currency due to an unexpected event might offer a good selling opportunity, or, in the event of temporary weakness, a chance to add to an existing position.

At the same time, falling interest rates could portend subsequent currency weakness, which could whittle down the value of the investment. Ultimately, an advisor who follows this strategy needs to think a bit like a foreign-exchange trader. That might not be for everyone. But clients will appreciate the returns.

Losing Strength

Given the predictions of more robust economic growth and higher interest rates, experts expect the U.S. dollar's slide will continue.

Country Est. Growth in '03 GDP Overnight Rate Est. YE '03 Yield Exchange Rate [U.S. dollar per unit of local currency] 12 Month FX Forecast 12 Month Currency Appreciation [vs. U.S. dollar]
New Zealand 3.20% 5.50% 5.50% $0.55 $0.58 5.50%
Norway 1.0 5.5 4.5 0.138 0.145 5.1
Australia 2.7 4.75 4.75 0.61 0.67 9.8
U.K. 1.7 3.75 3.5 1.57 1.67 6.4
Sweden 1.4 3.5 3.0 0.118 0.134 13.6
Canada 3.1 3.25 3.75 0.699 0.719 2.6
Eurozone 0.6 2.5 2.0 1.08 1.18 9.3
U.S. 2.0 1.25 0.75
Sources: Merrill Lynch, HSBC, Morgan Stanley, Citigroup as of April 16, 2003.
* Also trades OTC

A Good Bet

Sovereign yields are attractively compensating investors who anticipated the underlying currencies strengthening against the U.S. dollar.

Yield to Maturities
Country 3-6 Month 1 Year + 2 Years +/- 3 Years +/- 5 Years +/-
New Zealand 5.33 5.24 5.25 5.38 5.55
Norway 5.10 4.85 4.72 4.93 5.10
Australia 4.68 4.69 4.71 4.80 5.00
U.K. 3.50 3.38 3.41 3.65 4.01
Sweden 3.40 3.55 3.65 3.81 4.17
Canada 3.31 3.48 3.66 4.00 4.41
U.S. 1.17 1.18 1.51 2.06 2.81
All Bonds are AAA-rated and are actively traded.
Source: Bloomberg and the Financial Times as of 24 April 2003.
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