(Bloomberg) -- A key patron of U.S. corporate debt markets -- overseas investors -- may turn from friend into foe this year.
The weak dollar has whittled down returns for unhedged money managers, raising the prospect of capital flight if the greenback’s losing streak gathers pace, warn Wells Fargo (NYSE:WFC) & Co. strategists.
"We see a distinct risk that non-U.S. investors could become net sellers as global economic growth converges and central banks transition from a nearly a decade of easing to more normalized polices, resulting in a lower USD," strategists led by George Bory wrote in a report distributed to media this week.
Higher relative yields and the U.S. recovery lured a tide of capital inflows into U.S. credit markets from mid-2014. That eased last year as a dip in the greenback created a "nasty" drag on unhedged portfolios in paper terms.
Overseas flows into the $8.6 trillion U.S. investment grade, high yield and leveraged-loan markets fell by 35 percent in 2017, according to Wells Fargo estimates.
With spreads on U.S. corporate bonds at 2007 lows, Wall Street shares no such fears over waning foreign demand amid buoyant retail demand for fixed income, strong economic data and higher nominal yields relative to Europe. Currency weakness, meanwhile, makes debt cheaper for new buyers outside the U.S., and may reduce the incentive to snap up costly hedges in foreign-exchange markets.
But with non-resident investors amassing 39 percent of the outstanding debt stock after a three-year binge, a ripple of foreign selling could unanchor credit markets from their bullish moorings, Bory and his team conclude.
"A period of sustained foreign selling due to changes in FX valuations could be quite destabilizing for USD (and global) credit markets."