Photographer: Noriko Hayashi/Bloomberg

Japan Negative Rates Alchemy Beats Australia's Highest AAA Yield

  • Swap to Japan debt with Aussie gives 1.07 point yield pickup
  • Funds around world show `quite strong demand for JGBs:' CBA

Dislocations in Japan’s debt market are providing investors an unlikely opportunity to turn negative rates into assets that yield more even than Australian bonds.

The Bank of Japan’s policy experiments have pushed local fund managers to seek higher returns abroad, driving the cost of protecting the flood of money moving offshore from currency swings to a record in March. Some investors have spotted an opportunity in taking the opposite side of the trade, using the cross-currency basis swap market to turn Japanese government bonds into high-yielding synthetic assets.

These trades look “most appealing” for fund managers in Australia and New Zealand, though the yield pickup is also attractive for those in the U.S. and Hong Kong, according to a report by HSBC Holdings Plc. Investors in Australia, for example, can asset swap a five-year JGB with a yield of minus 0.22 percent and end up with a yield of 107 basis points over the Aussie swap rate, data compiled by Bloomberg show. That compares with Australian sovereign debt where yields are below the swap rate.

“We think that’s a trend that’s pretty big around the world at the moment,” said Adam Donaldson, head of debt research at Commonwealth Bank of Australia, the nation’s biggest lender. “Fund managers and banks around the world have quite strong demand for JGBs because when they swap it back to their local currency, they typically get a good pickup and that difference in the Aussie dollar case can be more than 100 basis points.”

Global Buyers

This helps explain the increase in international demand for Japanese sovereign debt even as yields on about 70 percent of the market have dipped below zero. The BOJ accelerated the move with its Jan. 29 decision to embrace a negative rate policy.

Overseas investors bought net 2.69 trillion yen ($24 billion) of Japan’s government bonds in February with maturities of two and five years, according to the Japan Securities Dealers Association. That’s the second-largest purchase on record dating back to 2004.

Reserve managers and international investors are the main buyers, largely at the short end, with a wide swath of non-yen investors able to enjoy the additional yield from JGB asset swaps, Koichi Sugisaki, an analyst with Morgan Stanley MUFG Securities Co. said in an e-mail response to questions.

Of 13 base currencies analyzed, nine yielded 50 basis points or more over swaps in such trades, according to a March 29 report by HSBC analysts including Andre de Silva, the Hong Kong-based head of global emerging-markets rates research.

Shorter Maturity

“JGB asset swaps have so far been more popular in short tenors, which may to a certain degree represent as much as 40 percent foreign ownership in Japanese T-bills,” they wrote. “There is evidence of increasing appetite for medium-term JGBs and this could partly be via cross-currency asset swaps.”

The discount offered to U.S. dollar holders to borrow yen for five years in the swap market reached a record 102.5 basis points on March 8 and was at 89 on Wednesday. The Aussie-dollar cross currency basis swap is at 19, giving investors in Australia the combined benefit of both rates in a JGB asset swap.

“A fund that can’t take on credit exposure, or already has enough credit exposure, or wants to fill a sovereign bucket, getting these types of yields on a sovereign risk is really attractive,” said Katrina King, director of research and strategy at Brisbane-based fund manager QIC Ltd. “The yen basis swap is at all-time wides now, particularly for Aussie dollars, so investors are trying to take advantage of that and lock in higher yields.”

The risk in such a strategy largely relates to whether investors need to mark their trades to market and the losses that would arise from a continued widening of the yen basis, King said. Fund managers would also be limited by what types of investments they are allowed to make and whether they can easily and dependably access the basis swap market.

One group that’s a natural fit is Japanese with access to foreign currencies. For such investors, repackaging JGBs is providing an attractive alternative to buying foreign paper such as Australian state debt. Western Australia’s 2021 notes yield 28 basis points over the local swap rate, while investors got a 118 point pickup for a new five-year bond sold last week by Australia & New Zealand Banking Group Ltd.

There is a “solid and growing interest” among Japanese life insurance companies in the synthetic Aussie assets, Andrew Ticehurst, an interest-rate strategist at Nomura Holdings Inc. wrote in a March 14 report. “These flows have become a notable feature of the market over the past 12 months and our colleagues estimate that such activity could as much as double over the coming year.”

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