World’s Biggest Bond Traders Undeterred by Negative Yieldsby and
Quirk in hedging markets transforms Japanese debt returns
Soaring Japanese bill holdings signal Chinese interest
It might be considered absurd, if not for the unprecedented contortions in global financial markets.
Pacific Investment Management Co.’s largest international bond fund and China are piling into negative-yielding Japanese debt, buying securities that pay out less than the purchase price. And there’s a way to turn a tidy profit off the trade.
At the heart of the strategy is the world’s insatiable appetite for dollar assets, which is presenting an opportunity for investors with greenbacks to spare: the chance to pick up extra yield, a luxury in an era of record-low interest rates. For dollar lenders, even three-month Japanese bills, trading at a rate of negative 0.24 percent, offer juicy returns through a swap transaction that locks in exchange rates.
Pimco, which manages $1.51 trillion, is one dollar-rich investor looking to tap into the phenomenon. Its Foreign Bond Fund, which protects against currency swings, added short-dated Japanese government debt in the first quarter, data compiled by Bloomberg show. China’s been another big buyer, accumulating a record amount of bills last quarter, Japanese Ministry of Finance data show.
“We can in some markets buy even negative-yielding assets and hedge them into U.S. dollars to create attractive positive yields,” said Sachin Gupta, who helps manage the $7.8 billion Pimco fund from Newport Beach, California. Short-dated Japanese debt “is as close to a risk-free instrument as is possible” in the country, and, when held to maturity, the profit is locked in from the start, he said.
The trade shows how negative interest-rate policies outside the U.S. are turning the world’s bond markets upside down by stoking demand for dollar-denominated securities and complicating longstanding investment strategies. The flip side of the opportunity is that global investors fleeing $9 trillion of below-zero sovereign yields need to pay up to protect against currency risk when buying American debt. For Japanese and euro-based asset managers, 10-year Treasuries yield practically nothing after factoring in hedging costs.
The upshot is that those with dollars to lend are the belles of the bond-market ball, and that’s where China may come into play.
The People’s Bank of China holds $3.2 trillion of currency reserves, the world’s largest hoard, and about 60 percent of that is in dollars. That makes the central bank a strong candidate to enter into this kind of trade.
“Their dollar reserves are sitting in U.S. Treasury bills, making whatever returns, but they can get much more than that lending the dollars,” said Peter Stella, a Falls Church, Virginia-based consultant who spent 25 years at the International Monetary Fund, leading the central-banking and monetary and foreign-exchange-operations divisions from 2005 to 2009.
“The risk is pretty much zero to the central bank,” he said. “Providing liquidity in dollars is absolutely something central banks have been doing.”
Statistics show a burgeoning Chinese appetite for Japanese debt. Cumulative Chinese flows into Japanese bills tallied an all-time high of about 10 trillion yen ($99 billion) in June, data from Japan’s Finance Ministry show.
China’s State Administration of Foreign Exchange, which manages the nation’s reserves, started liquidating some Treasuries and buying Japanese debt after the Federal Reserve raised rates in December, according to people with knowledge of the matter. SAFE boosted holdings further in the past three months as it sold some pound assets before and after the U.K.’s June vote to leave the European Union, said the people, who requested anonymity because the information isn’t public.
SAFE didn’t respond to a fax seeking comment on the issue.
The trade is just one example of how unprecedented central-bank stimulus -- from negative interest rates to bond buying -- has pushed investors into uncharted territory. Consider that Swiss debt maturing in almost 50 years yields around zero, or that Unilever, the Anglo-Dutch consumer products maker, has securities due in 2020 yielding negative 0.19 percent.
A dollar-based investor needs just a few steps to turn Japanese three-month bill returns positive.
To buy the bill, yielding negative 0.24 percent, a fund manager can borrow yen, lending dollars in return. As part of that agreement, they’d pay the three-month yen London Interbank Offered Rate -- now at about negative 0.02 percent -- and receive dollar Libor -- at 0.82 percent.
But the trade becomes especially lucrative because of the basis spread on the cross-currency swap, which determines the cost to convert payments from one currency to another. The swelling appetite for dollars has led that spread to roughly double in the past year, to 64 basis points, or 0.64 percentage point, close to a 2011 high. The dollar lender also receives that amount.
All in, the dollar-hedged yield on three-month Japanese bills is 1.24 percent, near the highest in at least five years, Bloomberg data show.
“This is a quasi-money-market trade, and it looks like a very efficient and appealing thing to do,” said Quentin Fitzsimmons, a money manager in the global fixed-income group in London at T. Rowe Price, which oversees $777 billion. “Yet that distortion has been present for quite a long time -- it hasn’t been arbitraged away.”
The appeal of the trade may explain why three of the top 11 holdings in Pimco’s Foreign Bond Fund as of March 31 were Japanese bills due in May and June. Over the next three months it raised its allocation to Japan by four percentage points, to 38 percent when weighted by duration, the biggest increase of any region. The fund’s roughly 7 percent average annual return for the past three years tops 99 percent of peers, Bloomberg data show.
Yet many American banks and money managers are forgoing the opportunity. For one thing, not all funds hedge currency exposure. Other institutions are constrained by Japan’s credit rating, which is four steps below the U.S.’s Aaa ranking from Moody’s Investors Service.
The trade, short-term by nature, also involves reinvestment risk, if the aim is to roll over the position. When the money manager gets the cash back three months down the road, market gyrations in the interim may have made the yield pickup less attractive.
“The short-term Libor arbitraging isn’t really something that we’re doing,” said John Lovito, who oversees international bond funds in New York at American Century Investments, which manages $154 billion. “We’re more medium to long-term investors. It’s more about the bond placement and the sectors we want to buy.”
Yet for the intrepid global bond investor with dollars to put to work, there are ways to exploit the quirk with longer-maturity debt, and not just in Japan. The same distortions in the hedging market have created opportunities in euro debt as well.
Standish Mellon Asset Management, for example, liked the interest paid on Moroccan bonds. Yet, rather than buy the North African country’s dollar-denominated debt for its $2.8 billion Global Fixed Income Fund, it added securities issued in euros.
After factoring in hedging with currency forwards, the trade generated an extra 30 to 40 basis points of yield pickup, said Raman Srivastava, managing director of global fixed income in Boston.
“We definitely find a lot of opportunities in the market where you can take advantage of the same risks -- same maturity, same issuer, and you can even hedge the currency -- but you get paid a premium simply by looking at a non-dollar security,” he said. “There’s much more demand for dollar-denominated assets.”