Dissecting the big bad Japanese bond bid

The Bank of Japan’s decision on Wednesday to maintain its “yield curve control” gives investors some more time to mull what will undoubtedly be a major event for global financial markets when it finally does occur.

After all, YCC will (surely?) not last for ever. And its role as an anchor for global bond yields and influence over international capital flows means that the end could cause fireworks. As Russell Clark has argued, Japan is the Saudi Arabia of savings, which makes it unusually important to markets.

Fortunately, the Council on Foreign Relations’ Brad Setser and Exante Data’s Alex Etra published a fascinating post on the former’s CFR blog earlier this week that explored the yuge Japanese bid for global fixed income and how it might change.

It is one of the best dissections we’ve seen of the different Japanese investor bases (reserve managers, pension plans, banks, life insurers etc), how they’ve respond to market developments and what might lie ahead. As Setser and Etra write:

The Japanese outflow should not be thought of as a single flow, as it is not driven by a single dynamic. Rather, Japanese institutional investors invest abroad for three distinct reasons:

1. the absolute yield pickup available on unhedged bonds given low Japanese rates.

2. a steeper yield curve outside of Japan than inside, and thus the opportunity to make money on currency-hedged bonds.

3. access to the global corporate bond market, and thus the opportunity to collect credit spreads that are hard to find inside Japan. Japanese companies are (famously) cash rich and thus have a limited financing need.

These distinct motives matter right now: Japanese investors continue to have ready access to an unhedged yield pickup but have trouble making money on hedged investments.

So what now?

On one hand, it would take a massive move in Japanese interest rates to even begin to impact the yield pick-up that unhedged Japanese investors can find overseas. Moreover, a big chunk of Japan’s hoard of overseas bonds is held in vehicles like investment trusts that can be held to maturity (and any losses realised then).

On the other hand, hedged investors like Japanese banks and insurers have pared back their overseas purchases and in some cases started selling. On the whole, this means that Japanese investors have gone from buying about $100bn of foreign bonds a year on average over the past decade to selling close to $200bn in 2022.

If that accelerates it could become problematic, Setser and Etra argue:

The truly catastrophic scenarios for the global market would likely require a large acceleration of these sales, and the rapid unwinding of the $2 trillion plus foreign bond portfolio that Japanese institutional investors still hold. Such an unwind would likely stem from the intersection of unexpected risks: say, if an important set of Japanese investors bet too aggressively on the persistence of low long-term rates and face capital losses in their holdings of Japanese government bonds at the same time they are bleeding income on their hedged holdings of foreign currency bonds.

The Bank of Japan has emphasized (hopefully correctly) that Japanese banks hold many bonds in their hold-to-maturity book and have substantial flexibility about the timing of the realization of any mark-to-market losses on their available for sale portfolio. The Bank of Japan also insists that Japanese pension funds haven’t engaged in the kind of levered derivative bets on Japanese bonds that got British funds in trouble. There is always a risk of an overlooked pocket of leverage that generates a fire sale. However, the most likely outcome in 2023 is a continuation of the roll down in Japanese holdings of foreign bonds observed in 2022, as the large pool of hedged Japanese investors allow maturing bonds to roll off at par rather than reinvest abroad. That more mundane reality still implies the large flow into global fixed income from Japanese institutional investors over the last decade will dwindle to a relative trickle.