Reverse Yankee Bonds and Dornbusch Overshooting

Suppose you are the CFO of a U.S. company that needs to borrow $1 billion over the next 5 years for a planned expansion and you are receiving interest rate quotes near 4.75 percent. Why so high you ask since we are in the era of low interest rates. The banks explain that you have been given a BB credit rating by Standard & Poor’s so they have added 3% to the 1.75% interest rate on U.S. government bonds. This upsets you, however, as you have been hearing stories like this :

Apple announced in an SEC filing that it would issue €2.5 billion in euro bonds, the proceeds of which will be used to fund share buybacks and dividends to be paid in dollars. These bonds will come in two tranches: €1.25 billion of 8-year notes and €1.25 billion of 12-year notes, with coupon payments of 0.875% and 1.375% respectively.

They got to borrow at even longer terms and yet they received such low interest rates? Well part of this story relates to the fact that Apple has a better credit rating but much of it relates to the low interest rates on German government bonds from the expansionary ECB policies. While interest rates on 10-year U.S. government bonds have been near 2.25% lately, interest rates on 10-year German bonds closer to 0.25%. Our story is about “reverse Yankee bonds”, which represent U.S. companies borrowing Euro denominated corporate bonds:

Issuance of these “reverse Yankee” bonds – euro-denominated bonds issued by US companies – has surged because the cost of borrowing in the Eurozone has plunged to ludicrously low levels. Even for the riskiest non-investment-grade corporate debt – called junk bonds, for good reason – the average yield is currently 2.9%. This chart of the BofA Merrill Lynch Euro High Yield Index (data via FRED, St. Louis Fed) shows this Eurozone absurdity

The story also suggests that expected inflation in both the U.S. and Germany is near 2% so the Euro rates are negative in real terms:

they won’t even compensate investors for the loss of purchasing power based on the current rates of inflation: 2.2% in the US and 1.9% in the Eurozone.

Is this an absurdity or an opportunity? If you decide to borrow in Euros, you might negotiate an interest rate near 2.6% even with your BB credit rating as the interest rate on 5-year German bonds is approximately negative 0.5%. Great deal – right? Well Paul Krugman reminds us of the Dornbusch overshooting story:

Rudi asked what would happen if a central bank for some reason suddenly and permanently increased the money supply. In the long run, just about all economists agreed that this would lead to an equal proportional rise in the price level and depreciation of the currency. In the short run, however, prices are clearly sticky, and expansionary monetary policy reduces interest rates. So what happens to the currency? As Rudi pointed out, the fall in the interest rate would induce investors to move their money abroad unless they expected the currency to rise. And the only way that could happen was for the currency to depreciate past its long-run value – to overshoot – so that it could be expected to appreciate back to that value over time.

This describes what the ECB did, which lowered Euro based interest rates and led to a jump devaluation of the Euro. The interest rate differentials we have been describing may very well be the compensation for the expectation appreciation of the Euro with respect to the dollar. If so, the expected cost of borrowing in Euros is not lower than interest rates on bonds denominated in dollars.