Yen Refuge From China Rout Revives Global Buying of Japan Bonds

  • Basis swaps help dollar-based funds boost yen debt returns
  • Foreign demand for nation's debt will continue, Nomura says

Foreign buyers are returning to Japan’s bond market after a two-week hiatus as global turmoil drives a rally in assets perceived as safer, including the yen.

International funds bought a net 218.5 billion yen ($1.9 billion) of Japan’s mid-to-long-term debt in the week ended Jan. 9, Finance Ministry data show, as the yen completed its biggest five-day rally since August 2013. That’s a reversal from 1.75 trillion yen of net sales in the period ended Dec. 26, driven by holidays and the Federal Reserve’s interest-rate increase. Benchmark 10-year yields fell to a record 0.19 percent on Jan. 14 as China’s slumping yuan sparked a global equity rout.

“Overseas flows into Japanese bonds via basis swaps have continued since the start of the year,” said Takenobu Nakashima, a quantitative strategist at Nomura Securities Co. in Tokyo. “There was a seasonal-related drop in buying around Christmas and positions were pared toward the end of the year with the Fed raising rates, but I think foreign demand for JGBs will continue.”

Foreign investors were net buyers of Japan’s medium-term debt for a 10th straight month in November, the longest bullish run since May 2014, as the spread on cross-currency basis swaps expanded to the widest level in four years. Although the gap has contracted since then, it suggests dollar-based holders of Japanese two-year notes are still able to get a yield that’s 65 basis points higher than similar-maturity U.S. Treasuries.

Vulnerable Market

As long as spreads on basis swaps remain relatively wide, foreign demand should stay supported, said Takafumi Yamawaki, the chief rates strategist in Tokyo at JPMorgan Chase & Co. International ownership of JGBs jumped 16.5 percent to 102 trillion yen at the end of September from a year earlier, accounting for a record 9.8 percent of the market, BOJ data show. The central bank was the biggest holder, owning 30.3 percent.

The growing presence of the BOJ and foreigners is making the JGB market more vulnerable, said Hidenori Suezawa, an analyst at SMBC Nikko Securities Inc. in Tokyo.

“There may not be a problem as long as the BOJ is buying, but when domestic investors are no longer in the market, when the BOJ stops buying, foreign demand will also likely disappear, creating a huge risk that yields will soar,” Suezawa said. The share of long-term JGBs held by private Japanese investors could shrink to about 40 percent from 60 percent should the central bank continue its stimulus program into 2018, he said.

Domestic Cost

Japanese investors are becoming reluctant to buy bonds with yields near unprecedented lows as those abroad using asset swaps flock to short- to medium-term JGBs, Suezawa said. Two-year yields reached a record minus 0.06 percent last month, compared with negative 0.03 percent as of Jan. 14.

Domestic investors are essentially subsidizing the enhanced yield that foreign buyers get, as the highly-rated debt becomes extremely cheap for overseas holders, according to Reiko Tokukatsu, a relative value strategist at BNP Paribas SA in Tokyo.

The cost of JGBs for dollar-based investors is “effectively collapsing,” Tokukatsu said. “Japanese are paying the price.”

While JGBs may tumble if foreign funds unwind holdings, higher yields would attract Japanese back to the domestic market, JPMorgan’s Yamawaki said.

“Japanese are holding a far bigger amount of foreign assets, and an increase in JGB yields could eventually work to pull money back home,” he said. “Foreign ownership may have a short-term impact, but for long-term stability, holdings of overseas securities by Japanese investors will probably play a bigger role.”

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