Since Prime Minister Shinzo Abe brought in his own brand of unconventional monetary easing in 2012, Japan’s investors have had to deal with next to nothing by way of positive yields, with 10 year government bonds opening the first quarter of the 2018 financial year yielding 0.05% and ending the three months at 0.03%, according to Government Pension Investment Fund (GPIF) data. To put that in context, US treasury 10 year yields were at 2.86% in June 2018.
There looked to be hope mid-way through 2018 when the Bank of Japan held a two-day interest rate review. But the central bank said on July 31 that it would keep the key short-term interest rate unchanged at minus 0.1%. The news confirmed that the country would be stuck with negative rates for the foreseeable future and is causing an acceleration of outflows from Japan, says Naoki Kamiyama, chief strategist at Nikko Asset Management in Tokyo.
“There is growing confidence among increasing numbers of financial institutions that negative interest rates will continue through the consumption tax hike, planned for October next year,” he says.
So Japan’s institutional investors are on the move. Some are looking at dollars, after US interest rates were bumped up from 1.5% to 1.75% in March and up again to 2% three months later, while others are expanding their investments beyond developed countries and traditional bond markets. And the pension funds are leading the charge.
“Pension funds, including the big government funds, are much more aggressive than other institutional investors,” says Kamiyama. As a leading example, GPIF is taking more risk, even investing in private equity or structured products, he adds. The giant’s latest portfolio figures show it is shifting further toward offshore investments.
GPIF boosted its foreign equities and bonds allocation to 25.32% and 15.34% in first the quarter of the 2018 financial year, from 23.88% and 14.77% in the previous quarter. The fund had a market value of ¥161tr ($1.4tr), as of June 30.
“My perspective on pension funds, including government ones, is that they are not going into specific areas or specific products, but are looking at a wide range of opportunities,” says Kamiyama. “The emerging and private markets are now on the radar of the major funds.”
Naturally, investors are sensitive to any broader noises in global markets and all have been keeping a close eye on the US-China trade war and US president Donald Trump’s numerous international disputes.
But despite the volatile global environment, an increasing appetite for new and riskier investments has become a trend, not only with Japan’s pension funds but among the country’s other institutional investors as well, with more and more seeking out opportunities in markets often shunned until recently, particularly in Asia.
“Investors are expanding their overseas assets under management and issuer concentration limits, as well as the jurisdictions they want to look at,” says Mizhuo’s Hong Kong-based head of debt syndicate, pan-Asia, Malcolm Mui. “There are some that have specifically indicated to me they want to invest in China, India and Indonesia, which were some of the less focused upon domiciles previously.
“China was a very challenging jurisdiction in the past for accounts to obtain approvals, but it has now become a domicile of which investors are very supportive. There has been very avid support from Japanese institutional investors for some of China’s key SOEs, financial institutions and the sovereign.”
So far, the major choices are Chinese banks issuing renminbi and dollar bonds, but the Chinese bond market is changing and with it Japanese investor appetites, say bankers working in the market.
The buy-side is also looking at India, but with still less exposure than to China. Japanese institutions are focused on state-linked issuers — most desirable are utilities, electric companies and oil firms with government backing.
For Kamiyama, availability is the concern. “Straightforward corporate bonds are not really easy to get in many cases,” he says. “Still, the majority of bond issues for Japanese investors are SOEs or sovereigns.”
Meanwhile, the Australian offshore bond market, long a place sought out by Japanese institutions, particularly life insurance companies, is having an up-and-down year.
“At the end of 2017 we saw traditional life insurance companies looking away from Australian dollar bonds, but that accelerated this year,” says James Holian, head of Asian syndicate and MTN, Daiwa Capital Markets in Singapore.
“The Australian dollar bond market has done well over the past five years because of high interest rates, which have been supportive of long-dated Kangaroo bonds. But over the last nine months the inflow from Japanese life insurance companies has reduced as they look for higher yields after the Australian dollar FX rate was squashed.”
Having hit a high of A$1/$0.81 in mid-January 2018 the rate slid during the first half the year to A$1/$0.72 by early September.
The Australian dollar also offered an attractive arbitrage funding opportunity.
While the Australian dollar has been weakening against the US dollar, it has also fallen versus the yen, similarly down from an early 2018 peak this year of A$1/¥88.92 to A$1/¥79.97 in early September.
“During the first half of the year, we saw some of the large national champions anchoring big Australian bond deals,” says Holian. “They were looking at the arbitrage by hedging from Aussie into yen. They look at the opportunities post-hedge as a spread over [Japanese government bonds].”
The deals included a handful from supranational and agency issuers, such as the European Investment Bank, which came to the Kangaroo bond market twice in January to raise a combined $909m.
The Asian Development Bank tapped the market in January and early February for $312m and $404m, respectively. African Development Bank, Export Development Canada, International Bank for Reconstruction and Development, and Kommunalbanken also issued Kangaroo bonds during the same period.
Public issuance from triple-A rated borrowers dropped off after early February, with little above $200m through to September, according to Dealogic data. However, there could be an uptick in the fourth quarter of 2018 as the Australian dollar/yen exchange rate in August dropped below ¥80 — a trigger for Japanese institutional investors to turn their attention, say bankers covering the Kangaroo bond market.
Ultimately, as Australian yields have started to come down, Japanese investors have not abandoned the currency. But they have begun to loosen their foreign issuer limits, looking down the credit spectrum. “[They are] not just investing in triple-A rated SSAs but also in corporates,” says Holian.
While a strong US dollar caused a drop in demand for Kangaroo issuance, it also presented a problem in rising US hedging concerns for Japan’s investors. Consequently, many increased holdings in Europe.
“It varies from pension fund to pension fund but most have suffered from rising US hedge costs,” says Akira Kunikyo, an investment specialist at JP Morgan Asset Management Japan in Tokyo. “Some are going into European investment grade bonds, where they can enjoy no hedge cost, sometimes a hedge premium from yen to euro.”
Japanese investors have also been pushing into different corners of Europe. A niche market in Denmark has become a particularly hot investment option for Japan, according to bankers and analysts, Japanese investors have been piling money into the country’s mortgage bond market.
“They are so much more attractive compared to anything investors can get in Japan and are quite safe at the same time,” says one analyst. “So we have had big inflows into that product from Japanese institutional investors.”
Data published by Denmark’s central bank in August shows that, as of the end of July, Japanese accounts bought Dkr295bn ($45.9bn) in Danish mortgage bonds, or 29% of the market. The figure represents an almost 10% jump since January 2016, when Dkr154bn was in the hands of Japan’s institutions.
The demand can be chalked up to the Bank of Japan’s purchase of JGBs, according to research by the Danmarks Nationalbank, which has reduced the supply of domestic bonds and put downward pressure on Japanese interest rates.
Danish mortgage bonds come triple A-rated, while offering as much as a 2% return, says Nikko AM’s Kamiyama. The bonds are in portfolios across Japan, from the majors down to regional banks.
However, while the larger investors are given some rope in their investment practices, the country’s smaller, regional financial institutions have less freedom when it comes to buying offshore.
Ever since the banks were caught off guard by US interest rate hikes, the Japanese Financial Services Agency has kept a close watch.
“After Donald Trump became US president and interest rates went up there, investors made huge losses,” says Kazuma Muroi, executive director at Mitsubishi UFJ Morgan Stanley Securities’ DCM team in Tokyo. “The FSA began closely monitoring investors, but particularly regional accounts. This action made investors reduce their amount of non-yen bonds.”
But the regulator threw investors a bone in April when it announced new guidance on the regulatory treatment of Total Loss-Absorbing Capacity (TLAC) holdings. Banks now have to apply a risk weighting of 150% to any TLAC eligible senior bonds they hold above 5% of their core capital, a relief as many had been expecting a 250% risk weighting.
Regional bank participation in TLAC bonds has since jumped: “As a year-on-year comparison, there would have been maybe 10 or 15 regional banks investing in 2017, while now we are seeing around 90 to 100 per transaction,” says Muroi.
Japan’s regional institutions are still buying foreign currency bonds, but at the same time can get the regulator to loosen up a bit by buying onshore. Yen bonds don’t carry any foreign exchange risk, so attract less oversight from the regulator, says Muroi.
“But if regional banks start making more losses then the FSA may step in again,” he adds.