Bankers have a proposition for Japanese investors: Why don’t you put your money into bundles of junk-rated U.S. loans?
It’ll be a classic win-win, as the thinking goes. For Japanese institutions tired of decade after decade of paltry returns on Japanese government debt, they’ll earn higher yields; and for the riskiest U.S. companies, they’ll get access to a cheaper source of financing.
What could possibly go wrong?
To make it easier for Japanese investors to get to this U.S. debt, bankers have repackaged a dollar-denominated collateralized loan obligation into yen-denominated bonds, using derivatives to hedge out risk related to currency fluctuations.
The Repackaged CLO Series GG-A1 Ltd., for example, “consists of a special-purpose entity that will issue Japanese yen-denominated notes and is backed by the U.S. dollar-denominated notes” issued by Kitty Hawk CLO 2015-1 LLC, according to a Standard & Poor’s March 24 pre-sale report.
Essentially, it transforms $249 million worth of a $331 million U.S. CLO managed by Guggenheim Partners Investment Management into highly-rated Japanese-yen denominated bonds, according to an April 15 Moody’s Investors Service report.
The transaction was arranged by Mitsubishi UFJ Financial Group Inc., which is also the counterparty on the currency swap that mitigates the risk of losses from changes in the yen-dollar exchange rate.
Here’s why this is happening now: Yields in Japan are ultra low -- 0.3 percent on 10-year notes -- as the Bank of Japan employs record stimulus in its effort to end decades of economic stagnation, including increased bond purchases.
As the BOJ buys, pensions are selling. Japan’s $1.2 trillion Government Pension Investment Fund, the world’s largest, said on April 2 it hired managers to help shift money from domestic debt into stocks and foreign investments.
Yes, Treasuries remain an easy target for Japanese buyers - - the country just overtook China as the top foreign holder of U.S. government debt, a title it hadn’t held since the financial crisis -- but many of the other typical global alternatives generally aren’t that appealing right now. The universe of negative-yielding assets in Europe has expanded as the region’s central bank pledges to maintain its stimulus until it sees sufficient economic growth.
“If you’re sitting here in Japan, and you need an alternative to JGBs to pick up some return, where are you going to go?” Daniel Smith, a senior managing director at Blackstone Group’s GSO Capital Partners unit, said in a February interview. “You can go to emerging markets, but those look quite risky to us, so by process of elimination, U.S. credit markets are a relatively easy and sober choice.”
This helps in part explain the surging demand for U.S. CLOs, which slice pools of risky corporate loans into pieces of varying risk and return. Firms led by Blackstone’s GSO unit issued a monthly record of $15 billion in CLO sales in March, surpassing the previous high of $13.8 billion in June 2014, according to data compiled by Bloomberg and JPMorgan Chase & Co.
About $35 billion of CLOs have been issued this year after record sales of $124 billion in 2014, according to JPMorgan.
With U.S. corporate-default rates still low on a historical basis, the risk-reward equation seems to work for Japanese borrowers. At least until the cycle turns.