This Sure Thing Isn't So Sure Anymore

A yield play may come undone

Could Wall Street's hedge funds spoil the party in the U.S. bond market? A growing number of experts fear it's possible. The trigger: a wildly popular arbitrage trading strategy involving Japanese and U.S. securities.

The risky play was inspired last September, when the Bank of Japan halved short-term interest rates to just 0.5% to boost the country's economy and its crippled banks. Officials hoped bankers would invest their low-interest loans in U.S. Treasuries yielding 5% to 6%. The implicit understanding: The central bank would minimize currency swings that could lower the return.

Japan's banks remained skeptical. While they profited from the wider yield spread at home between short-term bills and long-term bonds, they largely have shunned U.S. Treasuries. But hedge fund managers just loved the play. Such leading moneymen as George Soros, Julian Robertson, Paul Tudor Jones, and John M. Meriwether are thought to have plowed their yen borrowings into U.S. Treasuries, primarily 2- to 10-year bonds then yielding from 5.6% to 5.95%.

SEVEN-YEAR HITCH. The strategy is working beautifully so far. The U.S. bond market has rallied, increasing the value of the hedge funds' holdings. Also, the dollar is flirting with 106 yen, up from 101 in September. And the yield spread is still around four percentage points. By leveraging as much as 100% of the trade and not hedging against currency risk, the funds are believed to be reaping 30% to 60% annualized returns. "This trade is a good deal as long as you believe Japan is not going to tighten [credit] anytime soon," says one fund manager.

But their gamble could backfire. For one thing, a critical assumption behind the strategy--that Congress and the White House will agree to balance the budget in seven years--now looks dicey. Some currency traders worry that if the budget talks collapse, the dollar might fall as much as 10% against the yen. At that point, the highly leveraged funds would have to repay the yen they borrowed to buy Treasuries with. The result could be a rush for the exits as traders dump Treasuries to meet their margin requirements. "If the budget negotiations collapse, get out of the way," warns Daniel J. Fuss, head of fixed income at Boston-based Loomis, Sayles & Co. Some funds are already rumored to be frantically trying to unwind their Treasury holdings.

The U.S. budget is not the only great unknown. Japan's banking crisis is now the problem of newly appointed Prime Minister Ryutaro Hashimoto. If a proposed bailout plan for the troubled housing-loan companies unravels, says Soros, "you would be back to a crisis situation in Japan." The long-awaited economic recovery could be choked off for lack of credit. That would stifle imports, drive Japan's trade surplus back up, and push the yen higher again.

Alternatively, Japan's cheap-money strategy could revive the economy sooner than the hedge funds expect. In that case, the Bank of Japan would have to raise rates to prevent a surge in speculative activity. It wouldn't be the first time fund managers got burned by a monetary about-face. In 1992-93, when the Federal Reserve kept rates on overnight loans at 3%, hedge funds made billions borrowing short-term and investing in long-term bonds. But in early 1994, the Fed began raising short-term rates, tightening all year until they hit 6%. Many hedge funds, caught off guard by the Fed move, absorbed huge losses and had to dump Treasuries to make themselves whole. The result: a bond-market tailspin unseen since the 1920s, as funds sold off Treasuries in droves.

How much is riding on the dollar-yen bet? Exact figures are hard to come by because many hedge funds bought swap and repurchase agreements, which don't show up in government capital-flow reports, rather than the underlying securities. But market pros estimate that the combined exposure could top $70 billion. Ronald Bevacqua, economist at Merrill Lynch & Co. in Tokyo, says that yen-denominated borrowing from abroad jumped by more than 30% from the third quarter of 1994 to the third quarter of 1995, when Japanese short-term rates fell.

For now, the yen-dollar arbitrage looks like a sure thing. But that's often a sign that the easy money has been made. If either the U.S. government or Bank of Japan changes course abruptly, the gamblers may have to fold their cards.

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