Japan Prizes U.S. Property Again

Currency risk makes agency-backed securities more attractive than Treasuries.

Investors are methodically squeezing yield out of every corner of the global debt market.

They've devoured government bonds. They've hoarded corporate bonds. And now they're exploiting every bit of extra yield from the U.S. mortgage market.

Take a look at yields on U.S. agency-backed mortgage securities. These rates are near the lowest since 2007 relative to similar-maturity Treasuries.

Closing the Gap

As investors plow into mortgages, yields on the debt are shrinking relative to Treasuries

Source: Bank of America Merrill Lynch index data

This appears to be driven in part by Japan. The nation has been trading its U.S. government debt for property debt. Japanese net purchases of agency-backed mortgages touched the highest levels this year since 2010, according to data compiled by the U.S. Treasury.

Picking Property

Japan is buying more U.S. agency debt, much of which is government-insured mortgage debt

Source: U.S. Treasury

In June, as Japan bought U.S. mortgage debt, it was a net seller of Treasuries.

Losing Allure

Japan was a net seller of U.S. Treasuries in June, even amid heightened macroeconomic uncertainty

Source: U.S. Treasury

This trade is appealing to Japanese investors for good reason: It's becoming more and more expensive for them to borrow dollars or hedge against currency fluctuations. The cost of managing currency risk in some cases now exceeds the extra yield they would receive on Treasuries.

So they're looking for U.S. debt that will provide some additional yield even after accounting for any cross-currency fees. And that's bringing them to a host of different types of dollar-denominated securities that are subject to some risks that are different from Treasuries, including mortgages.

And lest you were suddenly wracked with concern that their selling has caused losses for Treasuries, you can put your mind at ease. Hedge funds have plowed into the U.S. government debt in the meantime, with Caribbean net purchases of Treasuries surging in June to the most in more than a year, as Wells Fargo analysts Boris Rjavinski and Michael Schumacher pointed out in an Aug. 18 report.

The unfortunate side effect of the tremendous compression trade is that at a certain point it looks like everything carries similar risk when that cannot possibly be the case.

And it also quickly eliminates the allure that drew many investors to the securities in the first place. At some point this trend will go in the other way, with the gap between different types of securities widening back out as investors start looking more closely at what they're buying. For now, the yield hunters are like hungry locusts, devouring one fruitful field before moving on to the next, leaving only a barren landscape.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at labramowicz@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

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