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Emerging Markets

Where now for JGBs?

Yields on Japanese Government Bonds have surged following intense volatility, leaving investors confused. However, bankers advise the buyside to keep their nerve and look for opportunities. They also believe the Bank of Japan could help with clearer communication.

Since the momentous Bank of Japan policy meeting on April 3-4, David Bradbury, SMBC Nikko’s executive director and head of rates trading in London, has received a string of enquiries from perplexed fixed income investors. The question has been simple enough: why has volatility in Japanese government bonds surged to unprecedented levels, leading commentators to describe the sector as the most volatile government bond market in the world?

The heightened volatility has led to a near-trebling of the yield on 10 year JGBs since early April, with the yield briefly touching the psychologically important 1% on an intra-day basis in late May, on the day when the Nikkei-225 index suffered its 7% fall. That compares with a yield of 0.315% in early April. 

“Investors are confused because many believed that the central bank’s aggressive asset purchase programme would ensure that JGB yields would remain stuck at incredibly low yields, at least until the BoJ started talking about an exit policy,” says Bradbury at SMBC Nikko in London. As he says, investors are also puzzled about why the yield curve has steepened at a time when the BoJ has been committed to adding duration to its asset-buying programme.

 “My response is that at the same time, the BoJ has made a huge commitment to pushing the CPI to 2%,” explains Bradbury. “An inflation rate of 2% and a 10 year government bond yield of 0.5% don’t really square, so we have two opposing forces pulling in two very different ways. The consequence is that volatility has been intense, especially at the longer end of the curve.”

For the fleet-footed and strong-stomached, this heightened volatility has created plenty of trading opportunities. “The wild swings in the market mean that traders can make or lose a fortune very quickly,” says Bradbury. “Our advice is that investors trade in the more liquid parts of the curve such as current coupon and cheapest to deliver (CTD) bonds.”

Tim Harris, executive director of fixed income sales at SMBC Nikko in London, agrees that there are good trading opportunities in the JGB market. “There tend to be some very interesting opportunities, especially after big sell-offs,” he says. “Japan is not generally a market where you want to buy and hold for two years.”

Conflicting signals

For those assessing longer term trends in the market, the perverse irony of the recent performance of Japanese bonds is that a rise in the JGB yield to or above 1% can be be interpreted in two very different ways, which have antithetical implications for the Japanese equity market. On the one hand, they can be taken — as some analysts said they were in May — as a worrisome red flag for the equity market. This is because the banks, which are big holders of JGBs, tend to liquidate equity holdings to compensate for mark-to-market losses on bond holdings during volatility spikes. As of September 2012, domestic banks held just over ¥400tr of JGBs, or 42.4% of the market, according to BoJ data.

Conversely, sharply rising bond yields can be interpreted as a signal that investors are anticipating a rise in inflation. In other words, a sell-off in JGBs can, ironically, be regarded as an indication that prime minister Shinzo Abe’s reform programme (see overview) is bearing fruit. 

At SMBC Nikko, Bradbury says it was unrealistic to assume that the magical combination of low JGB yields, a soaring equity market and a weakening currency could be sustained indefinitely. “Some people argue that QE can underpin a rally in all these assets at the same time, as we have seen in the US,” he says. “But the difference between Japan and the US or Europe is that bond yields were starting from a much lower level in Japan.”

History repeating?

The rise in JGB yields in May reminded analysts at Deutsche Bank of the dramatic sell-off in the market in 2003, when the 10 year yield rose from 0.43% in June to above 1.1% in early July and to a heady 1.675% in September. “Past experience suggests that domestic interest rates are likely to continue climbing for around three months in total,” Deutsche advised in a recent research note. “However, we expect the 10 year yield to peak out after less than three months without reaching 1%.”

Deutsche bases this confidence on the effect of the BoJ’s huge asset-buying initiative, arguing that the new dimension of monetary easing will allow the JGB curve to flatten “before players begin to factor in the possibility of the central bank achieving its 2% price stability target”. 

This assumes that the BoJ’s JGB buying binge has the desired result. By the end of May, however, it was becoming alarmingly apparent that the buying spree was not going entirely to plan. This, as policymakers reluctantly conceded, was potentially bad news for Japan and for Abenomics. As economics minister Akira Amari acknowledged at a news conference in May: “Spikes in Japanese government bond yields would affect interest payments, which would impact fiscal reconstruction.” And how. According to Daiwa, the ministry of finance has estimated that a 100bp rise in the 10 year yield over the next fiscal year would lead to an increase in Japan’s debt servicing costs of ¥1tr. 

In a recent analysis, Bank of America Merrill Lynch identified three problems associated with the BoJ’s JGB asset-purchasing programme. First, the large amounts involved have siphoned some liquidity out of the market. Second, these purchases have been “surrounded with uncertainty, because no schedule of operations has been announced”. Third, the purchases are not frequent enough. 

BofA Merrill believes that the BoJ could address these concerns by adopting a clearer communications strategy and strengthening its commitment to liquidity in the secondary market. It added, however, that the recent correction in the JGB market had been caused by “technical factors related to market operations, and there has been no structural change. The correction is likely to abate over time”.

Others say, however, that one of the lessons of the recent turbulence in the JGB market is that there is a limit to the influence that governments can have on secondary bond markets. “The BoJ can’t micro-manage movements in the bond market because there are too many conflicting forces at work,” says Bradbury at SMBC Nikko.

Strategists are confident, however, that the recent volatility in the JGB market does not herald a wholesale sell-off. “The volatility we’ve seen in JGBs is certainly a problem for investors, but I don’t think anybody believes the BoJ’s easier monetary policy will create inflationary pressures, so short term rates are likely to move lower,” says Hiroki Shimazu, assistant general manager and bond strategist at SMBC Nikko in Tokyo.

“Also, although newspapers are reporting that Japanese institutional investors are changing their strategy and selling JGBs to buy foreign bonds, there is no evidence yet of this happening,” adds Shimazu. 

Foreign exposure

How much international investors will have been directly affected by the recent volatility in the JGB market is open to question. Although foreign investors have been increasing their exposure to JGBs over the last two years — to about 9%, at the last count — Shimazu says that their influence on the market has been minimal because the bulk of their holdings are at the short end of the curve.

He adds, however, that one area of the JGB market that may attract the interest of foreign investors is the revived market for inflation-linked bonds. One of the main policies outlined by the ministry of finance when it presented its debt management strategy for FY2013 was the resumption of issuance of linkers “with revised product design, that guarantee principal at maturity”.

It is doubtful that there will be sufficient liquidity in this market to attract international investors. “Activity in the inflation-linked market has almost stalled,” says Harris at SMBC Nikko. “Although the government plans to sell ¥600bn of linkers starting in the autumn, it has not yet released details of the programme. Linkers were always regarded as a very cheap way of borrowing because inflationary expectations were so low, but there has never been much domestic demand, for the same reason.”  

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