Japanese Investors Look to Treasuries After Dropping French Bonds

Updated on
  • Investors to scour for best currency-hedged bonds in new year
  • Japanese cross-currency basis less negative at the front end

France’s loss may be U.S.’s gain.

Yield-hungry Japanese investors have dumped their French bond holdings amid the risks surrounding the presidential election in the euro-zone’s second-biggest economy. This may increase flows toward the U.S. bond market as the yield attractiveness of Treasuries has improved after taking into account the cost of currency hedging.

Japanese buyers have reduced both U.S. and French bond holdings in recent months following the reflationary upswing in yields sparked by Donald Trump’s election, as domestic super-long yields rose. That has considerably tightened the yen cross-currency basis this year, an indicator of dollar funding stress, led by the front-end ahead of the Japanese fiscal year-end. Three-month basis is now at the average levels of the past two years.

As the new year gets under way in April, front-end yen basis is likely to widen with increased demand for dollar funding as the Japanese may resume buying U.S. bonds. Japanese life insurers typically buy domestic bonds in March and foreign bonds in the first half of the new fiscal year. Foreign bond-buying this year may be less than what it was in 2016 unless super-long yields decline especially as the Federal Reserve has stuck to its projection of three rate increases this year.

JPY Cross Currency Basis Curve

The annualized yield pick-up for Japanese investors from 10-year Treasury bonds compared to same tenor domestic bonds on a currency-hedged maturity-matched basis is negative 60 basis points, compared with seven basis points on French bonds. While the yield pick-up for Japanese investors from French bonds on a rolling three-month currency-hedged basis is about 30 basis points higher than on Treasuries, investors need to take into account the French election risk.

Institutional investor demand for cross-currency basis has increased in recent years as the hunt for foreign yield from low interest-rate countries intensified. The yield pick-up gets reduced for Japanese investors who hedge their currency exposure given the negative basis. Shorter-dated yen basis had moved more negative last year than the longer-dated counterparts given that investors used a cheaper three-month hedging strategy.