Fighters of BOJ Missing Safest Returns Since 1993

Investors that chose to fight the Bank of Japan’s effort to drive down sovereign bond yields are missing out on the best risk-adjusted returns in two decades.

JGBs returned 2.6 times the market’s volatility this year on an annualized basis, poised for the best year since 1993, according to data compiled by Bloomberg and the European Federation of Financial Analysts Societies. BOJ Governor Haruhiko Kuroda has said about 7 trillion yen ($68 billion) of monthly debt purchases will shrink Japan’s risk premiums.

Strategists have had to throw out fundamental analysis of bonds and the economy in the face of Kuroda’s binge. The 10-year yield of 0.5 percent on Aug. 15, the lowest globally after Switzerland, is negative 73 basis points in real terms indicated by the expected increase in the cost of living by inflation swaps. Societe Generale SA estimates the benchmark yield would be 80 to 90 basis points higher without quantitative easing.

“Investors should be thinking about the risk of not holding JGBs -- the opportunity cost of what they could have earned by holding them,” said Jun Ishii, the chief fixed-income strategist in Tokyo at Mitsubishi UFJ Morgan Stanley Securities Co. “We can’t explain the current low yields with an economics textbook.”

Yale University economist Irving Fisher divided nominal rates into two components: the real rate of interest and those that take into consideration anticipated consumer-price gains over the life of the bond contract. Under his theory, increases in the cost of living erode what bondholders earn after inflation.

Risk Premium

Japan’s 10-year yield fell to 0.495 percent today, matching the lowest since April 2013. The same-year zero-coupon inflation swap was at 1.23 percent. The implied real yield plunged to negative 78 basis points on June 25, the lowest on record in data going back to March 2008.

The risk premium, based on the nominal 10-year yield, potential growth rate and inflation expectations, was minus 1.5 percent at the end of March, the Cabinet Office said in a report last month. The long-term interest rate continues to be repressed at lower levels than what overseas borrowing costs, domestic stock prices and the inflation outlook suggest, the report said.

“Low funding costs are supportive of economic growth,” said Takafumi Yamawaki, chief rates strategist at JPMorgan Chase & Co in Tokyo. “We just have to cope with low yields because policy makers’ priority is the real economy rather than financial markets.”

Policy Unforeseeable

The BOJ on Aug. 8 maintained its pledge to increase the monetary base to 270 trillion yen by the end of the year. Half of the 34 economists in a Bloomberg News poll said an end to stimulus was unforeseeable, while 68 percent expected further easing that may come as early as October.

Consumer prices excluding fresh food and the effects of a sales tax increase in April rose 1.3 percent in June from a year ago. The government raised the levy to 8 percent from 5 percent and has yet to decide on whether to boost it to 10 percent in 2015 as planned.

The current low yields despite the pickup in pace of inflation imply that “the BOJ easing is close to optimal,” said Takatoshi Kato, a former top currency official at the Ministry of Finance, who is now the president of Japan’s Center for International Finance. “Further easing could cause yields to surge instead as investors rush to the emergency exit out of JGBs.”

Fair Value

The BOJ will start tapering its stimulus program in the April-June quarter of 2017 after its 2 percent inflation target is met, according to Takuji Aida, the Tokyo-based chief economists at Societe Generale. That would push the 10-year yield toward “fair value” based on fundamentals to around 2.4 percent, he said.

More than 92 percent of JGBs are owned by domestic investors, with banks, insurers and pension funds making up 59 percent of the total, Ministry of Finance data show. Overseas investors accounted for 49 percent of U.S. debt holders, according to Treasury data.

“Most of the JGB supply can be absorbed domestically,” said Tetsuya Inoue, chief researcher for financial technology and markets at Nomura Research Institute Ltd. in Tokyo and a former BOJ official. “Japanese investors in the JGB market are oligopolistic so unless some big players panic, stability is here to stay. Panic-selling will backfire as investors will end up breaking the market and taking losses.”


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