Foreign Institutional Investors, Monetary Policy, and Reaching for Yield

This paper uses a unique security-level data set to demonstrate that foreign institutional investors shift their U.S. corporate bond portfolios toward bonds with higher credit spreads when U.S. monetary policy tightens, which reflects institutional factors related to nominal return targets and foreign exchange hedging. Foreign institutional investors in low-yielding jurisdictions are unable to meet their return target by only investing in their home bond market. To close this return gap, they increase their exposure to the higher yielding USD-denominated bonds. However, due to regulatory requirements and internal risk management, they hedge against the foreign exchange risk. To take advantage of the yield differential, they invest in long-term USD bonds while hedging the foreign exchange risk through short-term swaps on rolling basis. This makes the shape of the USD yield curve the key factor for the hedged return on their USD-denominated bonds, especially given the persistent premium to access the USD in the swap market since 2008. When U.S. monetary policy tightens, the USD yield curve flattens, erasing all the yield differential once the cost of hedging is applied. As a result, to improve returns on USD-denominated bonds, foreign institutional investors need to take more credit risk. This behavior has meaningful effects on corporate bond prices and issuances