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Japanese SSAs prepare for a more international future

25 Sep 2012

With such a large and liquid domestic market, Japan’s public sector borrowers could, if they wanted to, rely wholly on local investors. But more and more issuers are turning their attention overseas, planning ahead for the time when domestic demand diminishes as the population ages and appetite for yield recovers.

Selling famously low-yielding Japanese government bonds (JGBs) to international investors has never been a simple task. But they are probably an easier sell today than they have been for several decades. As Goldman Sachs put it in a recent update: "We think JGBs have finally hit foreign investors’ radar screen."

That JGBs are becoming more than a luxury in global investors’ government bond portfolios is clear from the data on ownership of the market. According to Goldman Sachs, at the end of March 2012, foreign investors accounted for 8.3% of the market, compared with 5.7% at the end of March 2010. Japan’s Ministry of Finance (MoF) puts foreigners’ share at a rather lower 6.2%, because it excludes volatile short-term bills from its calculations.

Whichever number is used, to put this share in perspective, it remains very low relative to the size of the JGB market, given that Japan accounted for 32.4% of the Barclays Global Treasury Index, dwarfing even the US (25.6%).

It is also low compared with international holdings of other advanced government bond markets. In the US, according to data published by the MoF, foreigners held 44% of the Treasury market as of March 2012. In the UK, according to the most recently available data, they hold 32%, and in
Germany they own 56%. In Australia, meanwhile, their share is well over 70%.

The outright ownership figures for JGBs, however, disguise two important trends in foreign participation in the market. The first is that overseas investors are becoming more active at the longer end of the curve. According to Goldman Sachs, "in FY2010, foreign investment was focused on short-dated JGBs, but in FY2011, net purchases of long-dated exceeded that of short-dated".

The second is that having declined for several years during the last decade, foreign investors’ market share of turnover has been rising appreciably in recent years in both the cash and futures markets. As the MoF observed in its most recent investor presentation, "while foreign ownership of JGBs has been relatively low, foreigners’ presence in the JGB market has been substantial due to higher

Conventional wisdom is that increased foreign ownership of JGBs over the last few years has been driven principally by safe haven flows. Chikahisa Sumi, deputy director general at the financial bureau of the Ministry of Finance, spends much of his time meeting foreign investors, and he says that a large part of the buying from overseas is inevitably attributable to the so-called cleanest shirt principle.

Sumi also says, however, that there are more constructive ways of interpreting rising foreign participation in the JGB market. "Anecdotal evidence is that we continue to receive positive interest from overseas central banks," he says. "Some of the motive is that in the context of an international beauty contest central banks have to choose the currency in which they hold their foreign reserves. Additionally, the CDS premium on JGBs has come down reputedly because of the tri-party agreement that has been reached on the increase in consumption tax, which demonstrates Japan’s commitment to addressing its fiscal problems."

Given the recent turbulence in European government bond markets in which foreign investment is (or was) high, some may question how desirable increased foreign participation in the JGB market is. After all, one of the commonest (and soundest) reasons cited for low yields and stability in the JGB market, despite a mountainous public debt that makes Italy’s debt-to-GDP ratio look modest, is the strength of domestic demand.

This domestic demand shows no sign of weakening; nor is it likely do so in the next few years. "Japan has abundant savings and continues to be a net saver," says Sumi. "Realistically, this and Japanese people’s long life expectancy will therefore continue to generate very strong demand for long-dated yen securities. So although foreign inflows are welcome, they are not likely to be the principal driver of the market’s behaviour. In a sense, foreign investors will be additions to the market which is already crowded with strong demand."

Savings crisis

That may be. But the ageing and shrinking of the Japanese population is such that in the view of some local economists, it is only a matter of time before Japan’s savings surplus turns into a savings crisis. External analysts share the view that from a longer term perspective, increasing the international ownership of Japanese government debt should be a priority. As an IMF report published last year observed, "the market’s capacity to absorb new debt is... likely to diminish gradually as the population ages and risk appetite recovers.

"Japan’s large pool of domestic savings, a stable investor base, low share of foreign ownership of JGBs, and current account surpluses have helped maintain stability in the JGB market," the IMF report added. "But these favourable factors are likely to diminish over time as population ageing reduces household savings and a rise in risk appetite lowers demand for safe assets. Without a significant policy adjustment, the stock of outstanding JGBs could exceed the level of household financial assets (currently at 300% of GDP) within five to 10 years, suggesting that the government may need to turn more to other sources, such as the corporate sector or to foreign investors, to help finance its deficits."

Another — possibly more pressing — reason why Japan wants to encourage more overseas participation in its government bond market is to minimise its vulnerability to herding among the largest Japanese institutions, which has been a weakness in the past. "Attracting investors with strategies that are little or inversely correlated with domestic institutions is an important way of counterbalancing against the risk of herding," says Sumi.

That risk will also be counterbalanced by the availability of a broad range of products allowing investors to express their views across the curve. That product range will be further widened with the planned reintroduction in the later part of this fiscal year of inflation-linked bonds.

Sumi is mindful, however, of risks associated with over-expansion of the product range. "I think there is always a trade-off between liquidity and the number of products available," he says. "At the longer end, we have the 40 year bond which has only been traded for five years, so that still needs more time to becomes established."

Chocolate or vanilla?

As Sumi says, the breadth of products available in the JGB market, twinned with its unrivalled liquidity, will mean that government bonds are likely to remain the first port of call for investors wanting exposure to Japanese risk free assets. But he also recognises that with yields so low, overseas investors may well look to other public sectors issuers to add some yield to the risk-free component of their Japanese exposure. "When you’ve eaten plenty of vanilla, it’s understandable if you want to taste some chocolate," he says.

The most internationally-focused of the public sector borrowers, by virtue of its mandate, is the so-called new Japan Bank for International Cooperation (JBIC), the former international wing of the Japan Finance Corporation (JFC), which was officially spun off from JFC at the start of April 2012. Because its lending is in overseas currency, so too is the bulk of JBIC’s funding, which also means that its investor base has an unusually large skew towards investors outside Japan.

"Wherever possible we try to expand our overseas investor base beyond Japanese investors, which probably account for less than 10% of our total investor base," says Tetsuya Oura, director of the capital markets and funding division in the treasury department at JBIC’s headquarters in Tokyo. "That makes us very different to other Japanese public sector borrowers."

JBIC’s most recent international transaction, which was a five year $2bn global led in July by Bank of America Merrill Lynch and HSBC, bore witness to the issuer’s safe haven appeal and scarcity value in two ways. The first was that JBIC was able to print a transaction
for a volume that was almost identical to the size of the book, which points to the high quality of the demand the issue generated. Final allocations were very well balanced between Asia (37%), Europe and the Middle East (35%) and the Americas (28%). By investor type, banks took 47%, with central banks and official institutions accounting for 31% and asset managers for 22%.

The second way in which the JBIC issue was symptomatic of the safe haven properties of the Japanese public sector was in the pricing relative to other SSAs. The bonds were priced in line with revised guidance at 34bp over swaps (versus original guidance of 35bp), which represented a limited new issue premium. But as Reiko Hayashi, head of corporate and public finance debt capital markets at Bank of America Merrill Lynch in Tokyo points out, this was 6bp through where EIB had priced its five year dollar benchmark before the JBIC deal.

July’s transaction followed a $1.25bn seven year global, JBIC’s longest ever, led at the end of January by Deutsche, JP Morgan and Nomura. Priced inside guidance at 68bp over Treasuries, this generated total orders of $1.8bn. "Because our maturities on the asset side
are generally longer than our liabilities, we have had some internal discussions about lengthening the average maturity of our funding, but this depends on pricing," says Oura.

DBJ looks to non-GGBs

Among the other leading agency borrowers in Japan, the focus is on decreasing their reliance on government-guaranteed issuance. This is especially apparent in the case of Development Bank of Japan (DBJ), which saw its movement towards privatisation slowed — but not stopped — by the earthquake and tsunami of March 2011.

"We are aiming to increase our self-funding — or non-guaranteed funding — to about ¥400bn this fiscal year," says Yasuhiro Matsui, director in the division of financing of the treasury department at DBJ’s headquarters in Tokyo. "The majority of this will be in the domestic market, although we also expect
to continue to make use of our
MTN programme to issue in the dollar market."

DBJ’s funding plan for this fiscal year calls for this to be complemented by ¥200bn in the domestic government-guaranteed market and ¥150bn from the international market in guaranteed format. Matsui says that DBJ aims to maintain a presence in the international market for its guaranteed bonds by issuing several times a year.

In FY2011, DBJ rounded off its funding programme for the year with a well-executed $500m five year Reg S trade led by Barclays, BNP Paribas and Nomura. At guidance of 40bp-42bp over mid-swaps, this generated orders of $1bn, allowing for the deal to be priced at the tight end of the range. Asian investors accounted for 74% of final allocations, with central banks and other official institutions taking just over half of the bonds.

Asian investors are also accounting for a growing share of DBJ’s non-guaranteed issuance, according to Tomoki Matsuda, director general of DBJ’s treasury department. "We are seeing more interest in our non-guaranteed issuance from overseas investors, but as they are sold in Asian time these are only sold to Asian investors at the moment," he says.

"In the long run, we recognise that we will need to issue more non-guaranteed bonds. But the speed of our increase in non-guaranteed issuance depends on how fast we move towards privatisation. This will be decided at the end of FY2014, so until then the structure of our funding will remain unchanged. But we know that we need to prepare for the change, and from that perspective we will aim to further expand our investor base."

For the time being, the mix of guaranteed and non-guaranteed funding in the domestic market underpins a well diversified issuance programme in terms of diversification of maturities. As Matsui explains, DBJ issues guaranteed bonds in six, 10 and 20 year maturities, while unguaranteed bonds are regularly issued in three and five year maturities, with two and seven years bonds issued less frequently on a spot basis. The six year guaranteed bond, he says, is especially popular among investors looking for diversification away from JGBs, given that the government does not issue at the six year point on the curve.

Extending maturities is not an immediate priority for DBJ. "On the asset side our average duration is between five and six years, so we have no need to issue super-long bonds," says Matsui. "But from the perspective of diversification we may look to offer some alternative maturities."

JFM: standard bearer

Another borrower that is seeing a change in the balance of its guaranteed versus unguaranteed issuance is Japan Finance Organization for Municipalities (JFM), which is the largest issuer in Japan other than the government. This year, JFM plans to raise close to $30bn (equivalent), of which 95% will be in the domestic market.

Although it is therefore overwhelmingly a domestically-oriented borrower, JFM has been issuing successfully in the international market for many years, and has often acted as a standard bearer for Japanese borrowers overseas. Its $1bn 10 year global in 2011, for example, which was led by Bank of America Merrill Lynch, JP Morgan and Nomura, was the first Japanese government-guaranteed global since the Lehman crisis.

JFM has also been very active in the MTN market, setting up its ¥500bn programme at the start of 2012. This year, JFM plans to almost double its issuance under this programme, from ¥68bn in FY2011 to ¥130bn.

JFM also passed an important landmark in September, with the issuance of its first internationally-targeted benchmark in unguaranteed format. This is in line with the progressive move towards unguaranteed issuance following a change in the law governing JFM in 2008.

The JFM $1bn five year benchmark, led by Bank of America Merrill Lynch, Barclays and Nomura, was a spectacular success. Priced 2bp below revised guidance, at 73bp over mid-swaps, the transaction generated demand of $2.5bn, with a relatively low 54.2% of the bonds placed in Asia. Some 45.6% was distributed in Europe and the
Middle East.

Bankers say that although their MTN programmes are providing them with outstanding arbitrage funding opportunities, they are perhaps not doing as much as some borrowers had hoped to diversify their investor bases. "Borrowers like JFM and DBJ have been doing very successful dollar deals through their MTN programmes, but the largest buyers have been the Japanese regional banks," says Yasuro Ken Koizumi, managing director and co-head of the financing group at Goldman Sachs in Tokyo. "The regional banks have excess dollar deposits and they are looking to invest those dollars in the credits they know best."

Another group of borrowers with substantial aggregate funding requirements are Japan’s local governments, which have been facing revenue shortfalls stemming from a decline in tax revenues.

These funding requirements continue, for the most part, to be met almost entirely from the domestic market. "As always, Japanese muni-cipal borrowers have continued to be very big issuers in the domestic market," says Hayashi at Bank of America Merrill Lynch. "Demand has continued to be strong, especially at the longer end of the curve. Tokyo Metropolitan Government (TMG), for example, has seen the spread on its 20 year bonds come in from 7bp over JGBs to 6bp over the last year."

The most dramatic recent indication of how spreads have narrowed at the long end of the curve, however, came in July, when TMG priced a new 30 year bond at 1.93%. This ¥30bn issue was the first non-JGB issued at a coupon below 2%.

At the shorter end, meanwhile, spreads over the government curve are at razor-thin levels for all best-regarded municipal borrowers. Although these spiked out briefly after last year’s earthquake, they are now back to no more than 2bp or 3bp over JGBs, which is effectively a modest liquidity premium.

Against that backdrop, it is easy enough to see why local government borrowers in Japan are not racing into international markets. "Because domestic funding opportunities are so cost-effective and quick, involving virtually no execution risk, many of the municipal borrowers still think it is too early to start looking at international markets," says Hayashi.

TMG: the exception

The one notable exception has been TMG, long-regarded as the most internationally-minded and progressive of the Japanese municipal borrowers. By most yardsticks, it is also the strongest credit in the Japanese local government sector — so much so, that it believes it warrants a higher credit rating than the Japanese government itself, according to Yoshiko Aida, director of the bond section in the Bureau of Finance at TMG.

That is unlikely to be an argument that will cut much ice with S&P, nor with many investors — although at a domestic level their confidence in TMG’s credit was strikingly illustrated by the response to its 30 year deal in July.

When TMG made its long-awaited return to the international capital market at the start of 2012, however, it was the magic of the basis swap, rather than a superior credit quality to the sovereign, that allowed it to access super-competitive funding costs. Bankers say that on an after-swap basis, TMG has funded in the dollar market at between 10bp and 15bp through where it would borrow in yen, which would suggest double-digits below JGBs.

Little wonder, then, that TMG had been eyeing up opportunities in the international market for a while, roadshowing in Asia in October 2011. It was not until January 2012, however, that it felt comfortable enough to pull the trigger on its first international bond since January 2008 and its first ever US dollar issue without a government guarantee.

This was a $650m five year Reg S issue led by Bank of America Merrill Lynch and Deutsche Bank, for which price guidance was originally set at 80bp over mid-swaps. A well diversified book that eventually reached $800m allowed for the transaction to be priced at the tight end of revised guidance of between 78bp and 80bp over swaps, which equated to 110.8bp over US

Demand was led by Asia, which accounted for 70% of final allocation, followed by Europe (20%), Middle East (5%) and offshore US accounts (5%). By investor type, banks accounted for 60%, with asset managers taking 20%, insurance companies 10%, and central banks and other official institutions 5%.

TMG followed its January benchmark with a larger $880m five year deal in May, led by Bank of America Merrill Lynch, Citi and Daiwa, which achieved tighter pricing in spite of — or perhaps because of — heightened concerns over the European debt crisis. With total demand exceeding $2bn, pricing was at 75bp over mid-swaps, or US Treasuries plus 108.21bp, which was at the tight end of a revised guidance range of 75bp-80bp over swaps.

Again, Asia was the principal driver of demand, accounting for 74% of distribution, with Europe taking 19%, 6% placed in the Middle East and 1% going to offshore US accounts. As they did in January, banks provided anchor demand, absorbing two-thirds of May’s benchmark, with 15% bought by central banks and public institutions, 12% by asset managers and 5% by insurance companies.
25 Sep 2012