JGB yield curve steepens as big buyers’ faith dented

By Rika Otsuka and Shinichi Saoshiro – Analysis

TOKYO (BestGrowthStock) – Japan’s yield curve is at its steepest in a decade and could rise further as core local investors, worried about mounting supply, are in no hurry to buy and may demand higher premiums for longer-dated government debt.

Domestic investors hold 95 percent of Japanese government bonds (JGBs) but doubts about the ruling coalition’s willingness to tackle the country’s massive debt, which is roughly double the size of the economy, are making fund managers at Japanese life insurers nervous.

Few market watchers see a Greece-style debt crisis around the corner, but the savings rate is falling and households are expected to start drawing on their nest eggs later in the decade as the population ages, meaning Japan will ultimately need more foreign buyers for its bonds.

That, in turn, means eventually it could no longer enjoy the low borrowing costs afforded it by domestic investors, which keep its 10-year bond yields some 230 basis points below U.S. Treasuries.

While that is still some way down the road, some fund managers at large life insurers already say they are thinking twice about when to buy, and once the economy picks up they will look for alternatives in corporate bonds.

East Japan Railway Co (9020.T: ), rated AA plus by a Japanese rating agency, sold 15 billion yen of 20-year bonds last week with a coupon set 11 basis points above the 20-year JGB yield.

Big insurers are core investors in 20-, 30- and 40-year JGBs to help meet longer-term obligations such as expected policy payments, but the country’s prolonged economic malaise and weak investment returns are squeezing the indust2ry.

“The risk premium from the government’s fiscal health is rising. Investors are worried about how bad the problem can get,” said Yuuki Sakurai, president of Fukoku Capital Management, part of Japan’s ninth largest life insurer Fukoku Mutual Life.

“The aging population will start to withdraw the principal of their savings sooner or later as Japan’s low interest rates offer little return. Knowing that, institutional investors cannot feel fully secure about piling up government debt.”

Japan’s savings rate has already fallen to about 3 percent of household income from 10 percent a decade ago.

The five-year/20-year JGB yield spread widened to a decade-high 167.5 basis points (bps) last week, a reflection both of easy monetary policy at the short end and growing disquiet among long-end investors. It is currently around 164 bps.

Tax shortfalls and government spending to lift the economy from recession mean debt supply to the market will hit a record 144.3 trillion yen ($1.6 trillion) in the fiscal year from April.

Investors fear supply could stretch further if declines in popularity polls persuade the government to spend even more.

As the most indebted industrialized nation, Japan aims to produce a fiscal reform plan in June. But rumblings in the coalition about more stimulus and a pledge not to hike a sales tax for several years have cast doubt on its fiscal credentials.

“Investors feel uncomfortable about picking up 20-year and 30-year bonds as the government is shy about rising the consumption tax needed to fix Japan’s fiscal problem,” said Yukio Takaike, general manager of asset management at Asahi Mutual Life Insurance. Asahi Life has about 5.7 trillion yen in assets.

SUPPLY TESTS ABSORPTION CAPACITY

As long as the economy is stuck in deflation, investors don’t see a big jump in government borrowing costs right away.

The yield on the 20-year bond is at 2.16 percent, not far below last year’s peak of 2.2 percent, and bond analysts say buyers might wait for a rise to 2.2-2.5 percent.

But rising issuance at the long end is testing the capacity of long-term buyers, as the size of the auctions has crept up due to extra budgets to fund stimulus and sliding tax revenue.

“The 10-year/20-year yield spread has widened beyond 80 basis points from around 70 basis points six months ago, showing the superlong sector is already oversupplied,” said another fund manager at a big Japanese life insurer.

Fixed income strategists say the steepening curve is not all down to fiscal concerns.

Easy monetary policy from the Bank of Japan is helping keep short-term rates low while banks, which tend to buy shorter-dated debt, have been recycling deposits into JGBs.

The five-year yield is just 10 basis points above a five-year low of 0.425 percent in December and the two-year hit a four-year trough this week at 0.135 percent, after the central bank expanded a fixed-rate funding operation.

Bank deposits neared 200 trillion yen at the end of 2009, their highest in eight years, but lending is still contracting due to a lack of demand for funds from Japanese firms amid tepid economic growth.

Analysts say banks could extend their buying further along the curve this year if they want to match last year’s income, because shorter yields have fallen.

WAITING GAME

Longer term, though, credit rating agencies have warned Japan needs to do more to address its debt mountain.

Last year foreign investors bought credit default swaps and used yen interest rate swaps to bet on higher yields, sending the 20-year swap rate to a 14-month high above 224 bps. The swap rate has since come down to 215 bps.

Foreign fund buying of payers’ swaptions, essentially a bet that rates will rise, has subsided but it doesn’t mean they have abandoned their positions, fixed income players say.

“Some foreign investors, like macro funds, appear to be placing such positions with a span of a few years in mind,” one trader at a Japanese bank said.

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(Additional reporting by Masayuki Kitano; Graphics by Catherine Trevethan; Editing by Charlotte Cooper & Kim Coghill)

JGB yield curve steepens as big buyers’ faith dented