Why Japan's Negative Yields Are Drawing Record Global Investment

  • Foreign investors on track to buy record mid-term JGBs in 2015
  • Basis swaps give them discount to buy bonds: Sumitomo Mitsui

Why would global investors buy Japanese government bonds with negative yields when U.S. Treasuries offer the highest premium since 2010? The answer lies in swap markets.

The yield on two-year JGBs dropped to minus 0.03 percent on Nov. 20 for the first time since January after the Bank of Japan stuck to its unprecedented stimulus. Adjusted for payments to lend dollars and borrow yen, the fixed-coupon equivalent was 1.66 percent on Wednesday in Tokyo. That far exceeds similar-maturity Treasury yields, even after they surged to a five-year high of 0.95 percent amid speculation the Federal Reserve will raise interest rates next month.

Foreign investors are on track this year to buy the most medium-term yen sovereign debt since the Japanese Securities Dealers Association began collecting the data in 2004. They purchased a net 2.4 trillion yen ($20 billion) in October, the most in 13 months, further tightening supply and curbing liquidity in the world’s second-largest bond market. Returns from swapping dollars for yen look set to widen as monetary policy diverges even more, Barclays Plc predicts.

“When overseas investors buy mid-term JGBs amid a considerable widening in currency swaps, it becomes a very attractive investment,” said Naoya Oshikubo, a rates strategist at Barclays in Tokyo. “The widening in dollar-yen basis swaps is being driven by increasing dollar funding needs as expectations for a December Fed liftoff become entrenched. We expect the trend for foreign demand for Japan’s mid-term sovereign debt to continue.”

Fed Actions

With odds in the futures market around 74 percent that the Fed will raise rates for the first time since 2006 at its next meeting on Dec. 15-16, cross-currency basis swaps show a deep discount to borrow yen for dollar holders. Interest payments were 88 basis points below the London Interbank-Offered Rate in a five-year swap of dollars for yen, after reaching 99 basis points on Nov. 9, a level unseen since December 2011.

Foreigners have snapped up a net 10.46 trillion yen of JGBs with maturities of two- and five-years in the 10 months to October, the most over the period in JSDA data from April 2004. In 2014, they bought 10.5 trillion yen, the biggest amount on a full-year basis.

Buying at Discount

“For overseas investors, basis swaps allow them to buy JGBs at a discount,” said Ayako Sera, a market strategist at Sumitomo Mitsui Trust Bank Ltd. in Tokyo. “For domestic investors, the BOJ’s stimulus has depressed yields for a long time, pushing them to invest abroad. That leads to a widening in basis swaps.”

BOJ Governor Haruhiko Kuroda said on Nov. 19 after he and his board left stimulus settings unchanged that negative yields are evidence that the policy is working, and he doesn’t see a problem continuing with record debt purchases.

Yields on bonds as long as five years in maturity have turned negative this year. The two-year note yielded minus 0.005 percent Wednesday, with the spread to equivalent Treasuries widening to 93 basis points. The lowest the yield has been is minus 0.04 percent in December last year.

The BOJ’s quantitative easing, which has scope to absorb every new bond the government issues, has sapped market liquidity. The current benchmark two-year note has changed hands on only about half the days since it started trading on Oct. 23.

The central bank bought 300 billion yen of two-year debt from the market Tuesday, a quarter less than it purchased at the previous operation on Nov. 18.

Another reason global investors are drawn to Japan is that, while yields on 10-year notes are the lowest in the world after Switzerland, two- and five-year debt yields more than sovereigns including Germany, France and the Netherlands.

European Central Bank President Mario Draghi set the scene last week for expanding the region’s own stimulus on Dec. 3, saying the monetary authority will do what’s necessary to reach its inflation goal rapidly.

“Short-term JGBs will tend to attract foreigners on a relative value basis, because yields in Germany are dropping without limits,” said Barclays’s Oshikubo. “And compared with short-term Treasuries, currency basis swaps mean you can get more yield from JGBs, which is why demand is strong.”

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