After Japan's Prime Minister Abe tried to goad the Group of Seven leading industrial powers into concerted stimulus to avert a looming economic crisis, FinanceAsia looks at how the Bank of Japan's experiment with negative interest rates has impacted financial markets in the world's third-largest economy.
When the Bank of Japan adopted sub-zero rates earlier this year it hurled investors and borrowers into unknown territory. Meanwhile the country's economy is still skirting recession, consumer prices fell in April for the second month in a row and the yen has soared to an 18-month high.
No wonder Abe appears to be paving the way domestically for another delay to a sales tax hike by saying world leaders shared a sense of crisis about the global economic outlook.
In capital markets, the few deals that have made it over the finish line since show what still works in markets governed by sub-zero interest rates: domestic bonds with record-long tenors; any kind of real estate deal; subordinated debt and overseas mergers and acquisitions.
“It’s clear Japanese corporates will now be more aggressive in acquiring global assets,” Haruo Nakamura, the deputy president of Mitsubishi UFJ Morgan Stanley Securities told FinanceAsia.
The BOJ shocked markets on January 29 by voting to apply an interest rate of minus 0.1% to nearly a tenth of the ¥253 trillion in reserves parked by financial institutions at the central bank. The move pushed interest rates down across the entire yield curve in combination with its existing programme of large-scale purchases of Japanese government bonds.
It was the latest salvo in a three-year-long war by the Japanese government against deflation using super-easy monetary policy and fiscal stimulus. What’s more, the BOJ has repeatedly signalled it will do whatever it takes in its fight. “There is plenty, plenty of room to push down the negative rate,” the BOJ’s governor Haruhiko Kuroda said on April 28.
Much is at stake. The government is trying to push banks away from keeping money on deposit and instead lend it to companies to shake off the economic malaise that has gripped the country for over two decades.
However, this will be tough without capital markets that function properly. “Now everyone has lost clear guidance on where their interest rate should be,” said Shohei Takahashi, head of international DCM and FIG DCM at Nomura.
Japanese companies that have worked hard over the years to build out their yield curves are now finding it harder to price bonds accurately as investors are focused on the absolute yield in a negative interest rate environment.
“Negative interest rates have crushed the concept of credit spreads,” Gen Sakai, head of the Japan DCM syndicate, at Bank of America Merrill Lynch told FinanceAsia.
In the longer-term, the BOJ risks damaging the Japanese financial system. On April 22 the BOJ’s own Financial System Report noted that if negative interest rates continue for a protracted period and earnings at financial institutions keep falling, this could weaken their role as financial intermediaries.
Investors such as pension funds, asset managers, and life insurers are scrambling to find high-yielding products to meet pay-out obligations to their clients, so are piling into the few asset classes such as real estate that meet their criteria, potentially creating bubbles.
“We see high valuations in real estate and private equity,” Hideo Kondo, the asset management director of Tokyo-based DIC Pension Fund, which looks after about $1 billion of retirement savings for the employees of the world's biggest ink maker, said at AsianInvestor's conference in Hong Kong on Thursday. Kondo is seeing some exits from private equity funds he invested into after the 2007-2008 crisis but continues to allocate capital to the asset class.
Insurance companies and banks are also likely to double down on one of their few growth stories in recent years: an expanding overseas portfolio of assets. They could in addition be drawn to more complex, securitised products.
The nine largest life insurers increased their foreign securities exposure to 26% of their total invested portfolio by end-March 2016, from 25% a year earlier. Credit rating agency Fitch Ratings said on Friday in a report that it expects Japanese life insurers to further increase their investment allocations to high-grade foreign bonds but with stricter currency hedging given the yen's recent strengthening against the dollar to 18-month highs.
“We’ve seen more interest from a wide range of Japanese investors in global products, which we are well positioned to advise them on,” said Bank of America Merrill Lynch’s Sakai.
Traditionally conservative Japanese asset owners will tend towards investment grade bonds when venturing overseas but are also starting to go down the credit curve as well, aiming for BBB and high yield in the US markets and even go more into structured products, said debt bankers in Tokyo.
“We’ve seen more interest from Japan bank investors in [collateralised loan obligations] in the US,” said another senior DCM banker in Tokyo.
Investment bankers in Hong Kong already report seeing more Japanese investors come into private placements of debt from Chinese issuers. According to these bankers, investors from Japan are less keen on public format deals because in private transactions they are more likely to get the allocations they ask for even if they have to pay a higher fee.
Some lessons on the likely longer-term behaviour of Japanese investors can be gleaned from markets where negative interest rates have been in place for longer.
Central banks in Denmark, Sweden, and Switzerland have paved the way for their larger peers to adopt sub-zero rates, including the European Central Bank and now the BOJ.
Some bankers in these economies point to investors’ flight to property as a result of negative interest rates.
“You should expect investors to find real assets more attractive, so they will be looking for buildings, real estate, infrastructure because cash burns holes in pockets if you have negative interest rates,” said Tidjane Thiam chief executive officer of Credit Suisse, in response to a question from FinanceAsia.
The Swiss-headquartered bank is bolstering its investment banking team in Japan as it seeks to help investors at its private bank find high-yielding products. Last year Thiam joined Credit Suisse from British insurer Prudential Plc, where as CEO he oversaw the insurance company’s global investment plans.
In Japan long-term investors were already piling into real estate as a result of Abenomics, the sobriquet for the stimulus policies of the Japanese government led by Abe. As a result, Japan’s commercial land prices rose for the first time in eight years in 2015, up 0.9% from a year earlier, according to an annual survey by the Ministry of Land, Infrastructure, Transport and Tourism.
In one pricey deal last year Goldman Sachs bought property next to Tokyo station for about ¥40 billion ($376 million) on behalf of a major insurance company for a net rental yield of about 2.6%, according to two people familiar with the deal.
The hunt for real estate assets since January has been turbo-charged, say dealmakers. “The price will go up even more because what else are regional banks going to do?” said one big real estate investor based in Japan. “It’s a good time to sell.”
Alternative asset owners are watching Japan’s biggest bank by deposits, Japan Post, with bated breath. Most of them are hopeful that it will dedicate more of its portfolio into higher-yielding assets such as real estate.
“When they move they move big,” said one hopeful beneficiary. “Japan Post could be one of the largest investors in alternatives globally, like [Singapore wealth fund] GIC.”
Japan Post hired Kazunari Yaguchi from the Development Bank of Japan on March 1 to be its head of real estate on March 1. According to a person that knows him, Yaguchi is planning ways to put money to work at home and abroad but internal permissions in the government-controlled group will probably take six to nine months.
Credit rating agency Moody's said it expects Japan Post Bank to further increase, over the
next two years, its non-JGB portfolio to around ¥70 trillion. As it diversifies its investments the average risk weight of its assets will continue to rise pressuring its capital. Moody's estimated that for each additional ¥1 trillion in its satellite portfolio assets, the ratio of tangible common equity to risk weighted assets would fall by just under 1 percentage point.
Japanese banks seem more comfortable lending against Japanese residential real estate than Japanese office property because occupancy rates in the country are generally around 90% to 95%.
Whilst not dangerously out of kilter with fundamentals as yet, the leverage deployed in some real estate deals looks risky for lenders and unattractive for investors.
Foreign real estate investors are inking some of their most leveraged property deals globally in Japan; with loan-to-value ratios of 70% to 80%. Banks are offering them covenant-lite terms, according to the real estate investor in Tokyo.
To be sure, one difference between Japan and other countries that have adopted sub-zero rates is that corporate financing in Japan is overwhelmingly dominated by bank loans. The BOJ’s super-easy policy over recent years has exacerbated the preference for cheap loans over bonds.
“You’ve seen a few European countries adopt negative interest rates as well, but the big difference here is that the Japanese have a lot more cash on their balance sheets to put to work,” said Merrill Lynch’s Sakai.
Click below for Page 2 to see how negative interest rates are impacting samurai bonds and outbound M&A
Japanese domestic corporate bond issuance last year fell by 20% year-on-year to ¥6.94 trillion, marking the lowest annual volume since 2006. Such reliance on loans could limit the financial flexibility of chief financial officers if they did need to tap bond or equity markets in the future.
Very mature bonds
In Japanese capital markets the refrain by dealmakers in the months following the BOJ shock was one of confusion and dismay.
An investment grade Japanese corporate borrower issuing a bond that matures in five years time would in the recent past have paid 15 basis points over JGBs. Following the BOJ’s move to negative interest rates JGBs are trading at around minus 20 basis points and investors are not interested in a negative yield.
So some parts of the country’s capital markets froze as borrowers and investors tried to fathom the wider implications of the BOJ’s interest rate policy.
The samurai bond market, for one, was gridlocked, not helped by an unfavourable basis swap price for overseas issuers. So far there have only been three issuers braving the market, the largest being ¥120 billion in samurai bonds by Societe Generale.
Yen-denominated issuance by foreign companies sank by 48.4% in the first quarter from a year earlier.
It has been a similar story for equity and equity-linked deal-making, which has dropped by 22.7% over the same period as companies eschew volatile markets or hold out for cheaper rates, despite pressure from investors to maintain a semblance of the yield seen on deals prior to the BOJ shock.
As one frequent issuer in the samurai market put it: “I’m not stupid.”
Investors that had used the 0.1% the BOJ previously paid for deposits as a yardstick for credit spreads have been left confused.
The repercussions have been felt across JGB tenors, where yields have slipped into negative territory from one year out to over ten-year tenors.
In an effort to get deals done investment bankers marketing bonds have changed tactic. Instead of talking about the spread over benchmark rates, they focused on the coupon and absolute yield on a bond.
“We had to find the new way to market deals to investors after the BOJ shock,” Jun Nakagawa, in Nomura’s syndication team in Tokyo for Nomura told FinanceAsia.
The latest SocGen samurai bonds were marketed on a coupon basis rather than on spreads for example.
One group of borrowers and investors that managed to pair up were utilities in need of capital and life insurers in need of long-dated investment products.
West Japan Railway issued 40-year bonds in February, the first private-sector company to issue such a long tenor.
Investors flocked to the deal, among them banks, which had previously been active investors in five- and 10-year bonds but have now shifted to longer tenors to help meet investment targets.
West Japan Railway’s ¥10 billion deal was nearly three times oversubscribed, especially by life insurance companies but also regional banks and a few asset managers. And in the aftermarket, the bond price has soared to 126.80 as of May 27 after hitting a high of 129.187 on April 21.
The deal demonstrated there was demand in size for this part of the yield curve, so was followed quickly by other super-long-term bonds including a 30-year bond by Tokyo Metro and a 20-year bond from food and chemical company Ajinomoto.
Japanese corporate debt issuance in the month after the BOJ shock was up 89% from the same period a year earlier, as corporate borrowers rushed to lock in ultra-low interest rates.
However, for a healthy market, the tenor should match the issuer’s needs and willingness to commit to borrowing for such a long time. Such companies are limited in number.
“I don’t want to encourage just any company to issue a 40-year tenor just because the interest rate is so low. They have to have a real need for that tenor,” said Shohei Takahashi, head of international DCM and FIG DCM at Nomura.
Another product that attracted yield-hungry investors was subordinated debt.
Blue-chip name Mitsubishi Estate issued ¥250 billion worth of hybrid bonds, which priced on January 28 (the day before the BOJ move) and attracted ¥600 billion of demand with a 60-year maturity, the longest period ever in the Japanese hybrid market.
For many Japanese companies a discussion of pricing in Japanese capital markets is largely irrelevant as they are already flush with cash, and in any case would have little enthusiasm for investment in Japan’s sluggish economy.
However, many are realising that to grow they will probably need to look overseas as Abenomics, after three years of trying, has not produced meaningful results.
The BOJ shock has handed them the means to use some of their cash on hand and lever it up to buy that big foreign brand that will transform the company.
“Right now Japanese blue chip companies can borrow at less than one percent and as much money as they want. If they keep cash on deposit they may be charged, so it is time to borrow and buy,” Koichi Ito, head of investment banking and capital markets, Japan at Credit Suisse told FinanceAsia.
In many ways the subordinated debt issue by Mitsui Sumitomo Insurance encapsulates many of the trends in the wake of the BOJ’s trip into negative territory.
The Japanese insurer announced it was buying UK-listed insurer Amlin for ¥635 billion (£3.468 billion) on September 8 to help it diversify its business portfolio and grow. On February 4, Mitsui Sumitomo priced ¥1.5 billion of subordinated debt to help finance the acquisition. The debt was subordinated to all other senior debt and the term was 60 years.
It was the largest-ever hybrid issuance by a Japanese insurer.