(Wall Street Journal) — Foreign investors have plenty of reasons to be wary of U.S. government debt at the moment. Now there is another: They can often receive better returns buying bonds in their own countries.

The risk of a weaker U.S. dollar and the cost of protecting against that risk, are making American assets less attractive around the world. That comes at a bad time for the U.S. Treasury market, which is already contending with a darkening U.S. budget picture and the trade war.

Foreign investors likely don’t fear a U.S. default or anything close. But the premium many once received for buying U.S. debt, thanks to higher long-term rates here, has disappeared.

That circumstance has resulted from the rising cost of protecting against, or hedging, currency moves.

This is happening because short-term rates have stayed high in the U.S. relative to those in the rest of the world, and the Federal Reserve looks less likely to cut them anytime soon.

It isn’t clear how much overseas investors contributed to the recent bond-market rout. Official data show foreign Treasury holdings still rose in March. Similar government-bond selloffs have also occurred in Germany, Britain, and Japan.

Still, the market’s negative response to President Trump’s tariffs, and Republicans’ tax-and-spending package, has often coincided with a falling dollar. This could signal capital flight. Foreigners hold about one-quarter of the Treasury market and lend significantly to U.S. corporations.

Will key financiers of American growth withdraw? Perhaps not, but they will likely demand to be compensated for the currency risk associated with the recent fall in the dollar, which comes with higher costs.

When institutional investors buy foreign-currency assets, they must hedge this risk or face potential losses from exchange-rate moves. This is why, for major U.S. debt buyers in the eurozone and Japan, 10-year Treasury yields of around 4.5% aren’t necessarily attractive, even if their own government bonds offer just 2.5% and 1.5%, respectively. What matters is the return after hedging dollar fluctuations. Since 2008, this pickup has often justified the trade.

That is no longer true. British investors switching from U.K. government bonds to Treasurys receive no premium after hedging. Eurozone buyers experience a post-hedged yield difference of minus 0.6 percentage point compared with Germany’s 10-year government bonds and even worse versus other European bonds.

Japanese investors face an even less appealing trade-off. Though they remain the top foreign holders of Treasurys, they now receive a hedged 10-year yield 1.3 percentage points below domestic alternatives.

This is still a smaller drag than seen in 2022 and 2023, when the Federal Reserve raised rates to combat inflation while the Bank of Japan held firm on stimulus. While Japanese banks, pension funds and insurers could have theoretically bought more U.S. debt and clipped the bigger coupons, the rise in hedging costs, driven by the Fed’s pushing up short-term rates, was much steeper. This led them to dump $331 billion of it instead, according to International Monetary Fund data.

Yet it was only a matter of time until the Fed paused. As hedging costs eased, banks resumed buying

The problem is that Trump’s tariffs have turned the tables again. If they stoke inflation, the Fed might cut rates at a slower pace. Anticipation of this has led to a flatter yield curve in the U.S., just as it steepens in the eurozone, Britain and Japan.

This matters for currency-hedged returns: Investors hedge long-term bonds using short-term derivatives — typically three-month foreign-exchange swaps, which are highly liquid — making it an implicit bet on the relative shape of yield curves.

There are full-maturity hedges, too, but they currently offer no significant pickup.

So the only path left to profit from higher U.S. yields is to buy bonds unhedged.

Banks are unlikely to do that, as they must be careful about risk exposures. Pension funds and insurers might, as that has often been their approach over the past decade. Japan’s Government Pension Investment Fund, for example, has typically held almost all foreign bonds unhedged. Similarly, the Bank of Japan reported last October that the country’s insurers reduced their hedge ratios from 60% in 2021 to closer to 40% in 2023. European pension funds often didn’t hedge either.

But they did this while riding dollar gains of 31%, 17% and 12% against the yen, euro and pound, respectively, between early 2021 and mid-2022. Now, the greenback is on a downward trend.

To be sure, the yen didn’t shoot up in May as Japanese bond yields rose — unlike the Taiwanese dollar, which pointed to insurers in that country repatriating their money. This suggests that Japanese firms do have some remaining willingness to buy unhedged bonds.

Nevertheless, such appetite is probably limited until investors see a sustained rebound in the dollar. For one, regulators in Taiwan and Japan have introduced rules that discourage such exposures. In fact, Japanese insurers are now apprehensive about buying any long-term assets: The new rules pushed them to load up on them, only for the likes of Sumitomo Life, Nippon Life, and Dai-ichi Life to report big paper losses during the first quarter as rates rose.

When these firms return to the market, they will likely look home first: A Japanese 30-year bond now yields 2.9%.

The good news is that quantitatively minded investors — unlike those who fear the U.S. is uninvestable — can be lured back. The bad news is that, without a Fed turn that makes hedging cheaper again, they might demand significantly higher yields.

Write to Jon Sindreu at jon.sindreu@wsj.com