Treasuries Yielding 0% Becoming Reality Again for Japan's Buyers

Updated on
  • To yen-based investors, hedged 10-year yield sets one-year low
  • Citi sees lack of Japanese demand as reason to sell long bonds
Flattening Curve Caused By Inactive 10-Year, Says Riley

Treasuries are on a fast track to yielding nothing for investors from Japan. And that could spell trouble for bond bulls.

For Japanese buyers who use swaps to shield their returns from currency swings, the yield on 10-year Treasuries fell as much as 12 basis points Wednesday to 0.24 percent, the lowest in more than a year. It sparks flashbacks of mid-2016, when hedging costs got so steep -- and U.S. rates so low -- that Treasury yields fell below zero for yen-based investors for the first time since the financial crisis.

As a result, it came as little surprise that Japanese investors looked elsewhere. From August to December 2016, they sold Treasuries for five straight months, matching the longest streak since 2000. To Jabaz Mathai at Citigroup Inc., the risk is they’ll do it again, crimping demand and supporting his straightforward trade idea: “Sell the long bond.”

“We see no fundamental reason for real yields to break lower,” Mathai wrote in a note Wednesday. “Not only are real yields at the low end of the range, but the yield pickup for foreign investors, especially on an FX-hedged basis for Japanese investors, has vanished.”

Japan owned $1.1 trillion of Treasuries as of August, second only to China for international buyers, Treasury data show. For institutional investors with conservative mandates, hedging out currency risk when buying U.S. debt saves them from having to worry about daily swings in exchange rates, which can be more volatile than yields. 

For European investors in a similar position, the prospect of buying U.S. debt looks even worse. The yield on euro-hedged 10-year Treasuries fell six basis points Wednesday to minus 0.01 percent, turning negative for the first time since October 2016.

Investors often hedge via cross-currency basis swaps. A Japanese investor pays both the U.S. Libor rate (now 1.42 percent), in addition to their local Libor rate, at minus 0.04 percent. On top of that, they have to cover the basis, as it’s known, in the transaction. It stands at around minus 0.52 percentage point for yen-based investors, close to the most expensive since January.

Do The Math

Adding it all up, hedging currency risk these days takes away a big chunk of the 2.32 percent yield on 10-year Treasuries for yen-based buyers. In comparison, similar-maturity Japanese debt yields about 0.04 percent, after years of massive monetary stimulus.

For Japanese investors, “Treasuries have become much less attractive after hedged costs,” said Tetsuo Ishihara, U.S. macro strategist in the fixed-income division of Mizuho Securities USA in New York. He said they’re shifting to either European sovereign bonds or U.S. corporate securities.

Many clients seek yields “of at least 1 percent after hedging,” Ishihara said.

They had their shot earlier this year. In February and March, the hedged 10-year Treasury yield exceeded 1 percent for Japanese investors. That was enough to stem the trend of outflows seen in the second half of 2016.

Yet Japan’s Treasury holdings are down from their 2017 peak. And with the allure seemingly waning, bond bulls ought to be on alert for diminished demand from a usually reliable source.

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