Costliest Hedges Since 2008 Hurt Japanese Buying Debt Abroad

Updated on
  • Demand for debt from overseas has surged as JGB yields dropped
  • Hunger for U.S. dollars comes as potential supply waning

Japanese investors are paying the highest hedging costs since 2008 on foreign bond purchases, thwarting efforts by the central bank to spur overseas investment by boosting dollar supplies.

The surge in costs has prompted Japanese insurance companies and banks to turn away from Treasuries as U.S. sovereign debt now can offer negative yields once they are hedged back into yen. That threatens to add to upward pressure on the yen, which has risen 24 percent in the past year, and limit options for investors facing negative yields on most domestic bonds since the Bank of Japan started charging fees on lenders’ reserves. 
“Currency protection costs for Japanese investors are rising to the point where the profitability of hedged U.S. bonds is close to zero,” said Naoya Oshikubo, a rates strategist at Barclays Plc in Tokyo. “That’s erasing the appeal of the securities.”

The BOJ on July 29 doubled the size of its U.S. dollar lending program to $24 billion and set up a new facility for lending Japanese government bonds to financial institutions as collateral so they could access dollars in a squeeze.

The following charts show how those measures have been overwhelmed as the interest rate gap between the U.S. and Japan widens, demand for overseas assets surges in Japan and U.S. money market funds lose the capacity to supply dollars to the Asian nation.

Chart 1

Higher interest rates in the U.S. help make yen forward rates stronger than spot levels, to compensate for the gap in returns. That drives up hedging costs for those who choose to use foreign-exchange swaps -- where an investor buys a currency in the spot market and simultaneously sells it using forwards. The Fed has raised rates once in the past year, while the BOJ is making debt yields negative and making record asset purchases, driving the spread between money-market rates in the two economies.

For a guide to currency-hedging costs for Japanese investors, click here

Chart 2

The climb in hedging costs has also been spurred by Japanese investors flooding into foreign debt. Yields are below zero on more than 60 percent of the world’s second-biggest sovereign bond market, with those on benchmark 10-year notes touching an unprecedented minus 0.3 percent in July. Life insurers’ net purchases of long-term foreign debt topped 2 trillion yen ($20 billion) in July, a record amount in Ministry of Finance figures to 2005. That swells the pool of investors seeking currency hedging and drives up costs.

Chart 3

U.S. prime money-market funds, which used to be reliable buyers of Japanese banks’ short-term assets and a source of dollars, have less capacity to supply greenbacks. These funds’ total assets have shrunk by a third in the past year, according to the Investment Company Institute. Investors are shifting away from such plans -- which can buy a range of paper -- to ones that invest only in government securities before the Oct. 14 implementation of tighter industry regulations. Prime funds owned some $145 billion worth of Japanese bank-issued paper as of end-June, government data show. The drop-off in money-market funds has coincided with basis swaps approaching record lows -- another gauge of Japanese investors desperation for dollars.

“Lower global yields and a blowout in yen hedging costs mean that there are almost no attractive FX-hedged bond markets left for Japanese investors,” Adam Cole, head of global foreign exchange strategy at Royal Bank of Canada in London, wrote in a note Friday.

— With assistance by Shigeki Nozawa, and Kevin Buckland

(Updates yen rate change in second paragraph.)
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