Default Swaps Climb to 6-Month High on Debt Sales: Japan Credit

Costs to protect against a default by Japan reached a six-month high ahead of today’s sale of longer-dated notes and a record 144.9 trillion yen ($1.76 trillion) of bonds next fiscal year.

Credit-default swaps, used to protect against nonpayment and speculate on changes in creditworthiness for five years, climbed to 86.49 basis points on Jan. 18 from as low as 52.78 on Oct. 13, before today’s auction of 1.1 trillion yen of 20-year notes. Japan’s debt load will be double its gross domestic product this year, the most in the world, according to the Organization for Economic Cooperation and Development.

While benchmark 10-year bond yields are the lowest among major markets and swap prices signal little concern of a failure, the gain in insurance indicates increasing concern about Prime Minister Naoto Kan’s ability to control debt and return the economy to growth. Credit-default swaps on U.S. debt cost 49.85 basis points and more than 600 basis points for Ireland and Greece, which required bailouts last year.

“Nobody can explain Japan’s low yields or strong currency from a fundamentals’ perspective,” said Ayako Sera, a strategist in Tokyo at Sumitomo Trust & Banking Co., which manages about $328 billion. “I’m very, very nervous about Japan’s finances.”

Japan’s swap prices equate to $86,490 to protect $10 million of bonds, the highest level since July 19, CMA prices in New York showed. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to bond agreements. The swaps price decreased to 84.5 basis points as of 12:34 p.m. today in Tokyo, according to Citigroup Inc.

Different Perspective

Today’s auction of 20-year debt attracted bids for 4.46 times the amount on offer, the most since the September sale. The yield on the benchmark 20-year bonds slid 7.5 basis points to 1.99 percent, the biggest drop since Dec. 17.

"The result of today’s auction shows Japanese bond investors have a different perspective from foreign credit-default swaps traders," Tetsuya Miura, chief market analyst at Mizuho Securities Co., said in a telephone interview today. "They do have concerns for the future, but they have to invest their cash at the end of the day."

Debt Burden

Government debt will reach 204.2 percent of GDP, compared with 136.8 percent for Greece and 112.7 percent for Ireland, according to OECD estimates. Before today’s auction, the Ministry of Finance sold 5.2 trillion yen of bonds due in five years or more this month.

Ten-year bond yields fell 5.5 basis points to 1.205 percent as of 12:53 p.m. The yields were 0.82 percent on Oct. 6, the lowest since July 2003. Twenty-year yields sank 7.5 basis points to 1.99 percent.

Japan’s “fiscal policy management is deteriorating, and there is concern that long-term government bonds may not be digested as smoothly as they are now,” said Yusuke Ueda, head of credit research in Tokyo at Bank of America Merrill Lynch. “It’s unlikely that corporate CDS will stay low as Japan sovereign prices widen.”

The benchmark Markit iTraxx Japan index on corporate bonds increased 0.5 basis point to 115.5 as of 12:02 p.m., according to Citigroup. That would be the highest since Aug. 17, CMA prices show. The extra yield investors demand to own Japanese corporate debt instead of similar-maturity government securities averaged 27 basis points, the narrowest since Nov. 9, 2007, according to an index compiled by Nomura Securities Co.

Hedge Funds

Rising prices for swaps may have more to do with speculators than with concerns that Japan, which is rated Aa2 by Moody’s Investors Service and AA by Standard & Poor’s, will fail to pay its debt on time, Merrill’s Ueda said.

“The rise is caused by hedge funds, especially those based in Asia,” Ueda said. “They are looking for a scenario to sell Japan.”

Market rates are rising even faster in the U.S. than in Japan. The extra yield on 10-year Treasuries instead of similar-maturity Japanese bonds widened to 210.5 basis points from a low of 144.4 basis points on Sept. 7.

Japanese government officials say they are growing more concerned about the rising levels of debt.

Yoshito Sengoku, Kan’s chief cabinet secretary until a Cabinet reshuffle on Jan. 14, told reporters on Jan. 6 that Japan’s fiscal situation is “approaching the edge of a cliff,” underscoring the prime minister’s call for a national debate on increasing Japan’s sales tax.

Cliff’s Edge

Kan brought former Finance Minister Kaoru Yosano into his group of top advisers, adding an advocate of higher levies. The government will introduce legislation authorizing a change in the tax by March 2012, National Strategy Minister Koichiro Gemba said yesterday.

Japan plans to boost sales of 30-year bonds by 800 billion yen and 40-year debt by 400 billion yen, while keeping total new offerings unchanged to finance the budget for the year from April 1. The spread between yields of 10-year and 30-year securities was at 95.7 basis points today from 87 basis points on Jan. 3, causing the so-called yield curve to steepen.

Yields on Japan’s 10-year notes, the lowest among 32 bond markets tracked by Bloomberg, may shift from about 1.2 percent to between 1.3 percent and 1.5 percent, said Shinji Nomura, chief debt strategist in Tokyo at Nikko Cordial Securities Inc., a unit of Japan’s second-largest banking group by market value. Ten-year yields may rise to 1.75 percent and 20-year yields to 2.3 percent by year-end, he said.

“There will be a time this year when people have to pay attention to fiscal risks,” Nomura said.

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