Yen Drop Seen Triggering Calls on Japanese Notes, Skewing Swaps

The yen’s drop against the dollar may be triggering early redemption of billions of dollars of structured notes tied to interest rates in the currencies, skewing swap rates as the issuers unwind their hedges.

The affected securities pay higher coupons when the yen depreciates and the interest-rate differential between the Japanese currency and its counterpart widens, according to Morgan Stanley. The products, mostly issued before the 2008 financial crisis, have options for the sellers to cancel the contracts early when the yen’s losses exceed certain levels. The Japanese currency has slid from the fourth quarter, probably causing about $10 billion of the notes to be called with more possibly following, according to UBS AG.

The developments are pushing up long-term swap rates and making it costlier to insure against interest changes. When the so-called 30-year power reverse dual currency, or PRDC, notes are called, the issuers exit rate hedges by paying fixed interest in the dollar for periods matching the maturities. In the U.S., 30-year swaps have jumped more than 45 basis points since the start of October, compared with a drop of about 2 in the one-year contract, according to Bloomberg data.

“There actually have been exotic hedging flows, which have pushed up the super-long swap rates,” Yuya Yamashita, a Tokyo-based rates strategist at JPMorgan Chase & Co., said by phone. “If the dollar-yen approaches the 100 level, or more specifically 99, then hedging activity may pick up, because 99 is a psychological level, and there should be some PRDCs that set such levels as trigger points.”

BOJ Changes

The yen slid to a 3 1/2-year low of 96.71 this week, driven down by Prime Minister Shinzo Abe’s stimulus pledges. The yield on the Japanese government’s benchmark 10-year notes fell to an almost decade low of 0.585 percent on March 5.

Changes at the Bank of Japan have sparked speculation that the yen may face further downward pressure. Haruhiko Kuroda was confirmed as governor today, after he committed to enough stimulus to reach a 2 percent inflation target in two years.

The PRDC securities were sold to individual and institutional investors over the counter through private placements, said Yamashita, who previously worked in the rates-structuring business at Deutsche Bank AG’s local unit.

There may be about 500 billion yen ($5.2 billion) currently locked up in PRDC notes, even after as much as 90 percent of the securities have been redeemed, according to Akito Fukunaga, chief rates strategist at Royal Bank of Scotland Plc in Tokyo.

Higher Yields

The products combine interest-rate payments with options that grant the right to buy and sell currencies, paying fixed coupons the first year, then linking payouts to foreign-exchange rates for the yen. They are called in the Japanese currency and redeemed at maturity in higher-yielding counterparts such as the U.S. or Australian dollar.

The call options embedded in the notes become more valuable when the yen depreciates, making it more attractive for the issuers to exercise the right than holding the securities through maturity, according to the Morgan Stanley report. The issuers of the Australian dollar-linked securities also probably contributed to the steepening of the swap curve in the South Pacific nation’s currency, following the yen’s post-crisis losses against the Aussie, according to the report.

Investors shunned the U.S. dollar-linked products as the yen’s gains after 2008 eroded returns, while banks stopped issuing them because of their complexity and risks, Yamashita said.