TOKYO (Reuters) - Japanese investors sold a record amount of U.S. dollar bonds in February as the soaring cost of currency-hedging undercut yields while they extended their purchases of euro-denominated bonds, government data showed on Monday.
Investors sold 3.924 trillion yen ($36.68 billion) of U.S. dollar bonds in February but scooped up 1.059 trillion yen (8.06 billion euros) of euro-denominated bonds - which offer higher yields after currency hedging.
It was their fifth consecutive month of euro-denominated debt purchases.
Since October, investors offloaded 7.675 trillion yen ($71.72 billion) of dollar bonds and bought 4.079 trillion yen (31.06 billion euros) of euro bonds.
Japanese investors have expanded foreign bond investments in recent years as domestic bond yields continue to hover at low levels due to the Bank of Japan’s aggressive monetary easing.
But most Japanese institutional investors do not want exposure to fluctuations in the currency market and typically have currency hedging on a large part of their foreign bond portfolio.
The cost for dollar hedging, which is closely tied to dollar interest rates, has been steadily rising since 2014. But its rise accelerated last year as investors priced in faster rate increases by the U.S. Federal Reserve.
The cost of three-month hedging stands at 0.67 yen per dollar JPY3M=, or about an annualized 2.5 percent. That means buying 10-year U.S. Treasuries yielding 2.80 percent US10YT=RR with currency hedging leaves Japanese investors a meager return of 0.3 percent.
And the cost of hedging looks set to rise further as the Federal Reserve is expected to raise rates a few more times later this year.
“For many Japanese investors, U.S. Treasuries are no longer an option,” said Tomoaki Shishido, market economist at Nomura Securities.
Shishido said investors were likely to buy higher-yielding mortgage bonds and could buy a small amount of Treasuries without currency hedging.
“But it will be impossible to see a return to the boom we saw before the Brexit,” he said.
In 2015, they bought 16 trillion yen of dollar bonds, including 13.8 trillion yen in U.S. Treasuries, data from Japan’s finance ministry showed.
Investors are likely to continue buying euro zone debt, given that the European Central Bank is expected to wind down its huge stimulus program at a much slower pace, meaning any rise in euro hedge costs will be much milder.
In February, Japanese investors bought 625 billion yen of French bonds and 291 billion yen of German bonds. In January, their purchase of euro bonds hit the second highest on record.
Editing by Sam Holmes and Jacqueline Wong