Doubts about stability of JGB market
Where fixed income fund managers are very often in agreement is in their lack of enthusiasm, verging on utter disdain for Japanese government bonds. Survey after survey reveals fund managers underweighting JGBs. Ten-year JGBs yield less than 2% and the currency’s overvalued; not an enticing combination.
But it’s tricky when Japan accounts for around 30% of many benchmarks. In answer to the question ‘How do you get around this?’ one fund manager glibly replied “We get our investors to change their benchmarks to exclude Japan.” And he was only half-joking.
Since 1990 JGB 10-year yields have glided down from around 7% to today’s 1.4%. What’s perplexing – and reinforcing the whiff of suspicion many investors have of Japanese bonds – is huge fall in yields occurring over a decade which has seen JGB issuance rocket and the outstanding volume more than double.
As Magdalena Korb of Deutsche Bank Research in a recent report points out: “Bond prices are supposed to fall when risk grows or the supply of paper increases; in Japan’s case the two factors coincide.” The unbridled pace of public sector borrowing, the prospect of a government bail-out of the banking sector’s huge non-performing loans and downgrades from the international rating agencies ought to have de-stabilised the bond market or at least damaged demand for government bonds. But, it has not happened.
Korb suggests one reason is that because JGBs are concentrated in the portfolios of the top 10 large commercial banks, the government, using its close links with the banking system, can thus ensure that these banks buy the issues. In addition, Korb argues that the government has hindered the development of new financial products, which in turn has left the banks with little alternative to investing in the government bonds. However, today the financial sector holds nearly three-quarters of total volume in circulation, and this is what should make markets nervous.
“So far the Japanese banks have ignored the considerable risks inherent in their relatively large bond holdings, which would materialise if yields were to rise significantly for a sustained period and the holdings had to be written down, and such a decline would substantially erode their capital bases,” says Korb.
Given the increasing debt load, reaching perhaps 150% of GDP in 2003, the risks of a setback in the JGB market are growing. It has been estimated that a yield of 2.5% could set off a round of write-downs at banks and insurance companies. Deutsche Bank argue that a sell-off could and would be prevented by the Bank of Japan, despite its present objection to such action. Although there is currently rather little evidence of money moving abroad, problems may also arise should major investors consider opting for other investment instruments, particularly outside Japan.
“The renewed downgrading by Moody’s underscores the continuing deterioration in Japan’s situation,” states Korb. “And it prompts us to wonder how long the stability of the JGB market will hold up and whether potential price declines in the JGB market will hurt the business activities of Japanese banks.”