The JGB conundrum

Thanks to bond indices, international bond funds have had little choice but to up their exposure to the Japanese government bond market. New indices could change that.

No country is more mystifying to outsiders than Japan. On the surface it is a modern capitalist democracy. Behind this mask is a society where tradition runs deep and political and economic power is wielded by a bureaucracy with a neo-mercantilist agenda.

Global investors often find Japan baffling, particularly those based in other countries and without a first-hand knowledge of it. Financial laws don’t work in Japan as Western economic theory suggests because Japan doesn’t practice Anglo-Saxon capitalism. Some investors have had to learn this the hard way.

Brian Baker, CEO and director at PIMCO Asia in Singapore, tells a common tale. PIMCO is a California-based fixed-income investment giant, with $200 billion under management. Of that, $9 billion is invested outside the US, and roughly 30% of that goes to Japan, thanks to the influence of leading global bond indices.

“In the past two years we made the wrong call on Japan,” he acknowledges. “We were short Japan and it rallied. The government had been issuing so much debt the price should have fallen. We didn’t realize the government could keep bond prices high by getting pension plans and insurance companies to buy it. We didn’t realize how well they could manipulate the financial industry.”

Phil Galdi, managing director of fixed-income analytics at Merrill Lynch in New York, paints a different picture of Japan’s performance, despite Bank of Japan’s move toward a zero-interest rate policy. “In yen terms in 1999, returns on JGBs (Japan government bonds) were 5.1%. In the same year, still in yen terms, returns on US Treasuries was -2.3%. Returns in Europe were at -2.5%, and on sterling, -1.1%. On a fully-hedged basis, putting this in dollar terms, it’s even worse – Japan was up 10.7% while the others are in the negative. Japan was the big performer last year.”

But global bond investors missed the party – the obvious supply-and-demand warning signs have kept them away. Matt King, fixed-income strategist at JP Morgan in New York, says fund managers have for five or six years believed Japanese bond yield levels were artificially low and could shoot up quickly, causing a bloodbath. They’ve been underweight or absent altogether from Japan.


PIMCO is still wrestling with Japan’s gravity-defying ability to sidestep around the laws of supply and demand. “We expect another government fiscal stimulus package in the fourth quarter,” says Baker. The government has legislated that insurance companies with long-dated liabilities and short-term assets must buy long-dated government debt. As a by-product of a move designed to shore up insurance companies’ balance sheets, this creates natural buyers of JGBs. At the same time the government keeps issuing short-dated paper, limiting the supply of long-term debt, to keep prices higher on the long end of the yield curve.

“No one thought the government could manipulate the market this well,” Baker says. “It’s a stroke of genius to not destroy your bond prices or have to force up interest rates while issuing more debt.” He reckons at some point the price on Japanese bonds will have to fall because local institutions won’t be able to keep on sopping up excess supply. “The economy is still flat. They already have 15% of their GDP driven by fiscal stimulus packages. Internal institutions can’t keep buying debt.”

FA oct 2000: JGB conundrum

Supply and demand

King observes that investors tend to obsess with the supply story but missed the real demand story, which results from the requirements of Japanese banks that have huge amounts of savings that have to go somewhere. This helped keep a lid on yields in 1999 and sparked the rally. JP Morgan has only recently turned bearish, following Bank of Japan’s termination of its zero-interest rate policy.

This year has been just as bad for investors: Japan has been the worst performer of major markets in all the leading global bond indices. Jack Malvey, fixed-income strategist at Lehman Brothers in New York, says the zero-interest rate policy and concerns about the pace of economic reform finally caught up with Japan. In the month of August 2000, Japan was a dog, with the 10-year JGB yielding -1.03% in Lehman’s Asia Pacific aggregate index. Galdi says with interest rates having no place to go but up, benchmark returns don’t look too pretty.

“The paradox is an increase in non-local buying,” Malvey says. “Year to date there has been $54 billion of inflows to JGBs, most of that coming over the past three months. I must confess, we’re not really sure why. It’s inconsistent with what we have heard from large multi-currency investors – I don’t know anyone overweight Japan.”

So when JGBs rally, investors are on the sidelines, and when the market is likely to worsen – as the threat of a jump in yields becomes more acute – they’re going back in. Buy high and sell low. All this at a time when Japan’s weight in global indices is growing, because Japan keeps issuing debt while the United States and Europe are actively buying back their debt. Japan has risen this year from 15% to 22% of the JP Morgan Global Government Bond Index. For Salomon Smith Barney’s World Government Bond Index, Japan’s weighting has risen modestly to 27% while that of the US has fallen from 35% to 27%. At Merrill Lynch, Japan is up 5% to 24%. Those numbers will only continue to rise.

PIMCO, for one, has had enough. The firm is breaking with its tradition of running investments from its headquarters in California and is putting traders and investors on the ground in Tokyo. “We missed the call because we didn’t have local people in touch with the government,” says Baker.

Matt King is philosophical about the rise of Japan in indices. “It’s not a bad thing. The government bond markets are all correlated, except Japan. It’s the last true diversifier.” But investors are demanding a way out.

Carol Sabia, vice president of Salomon Smith Barney’s fixed-income index department in New York, says the firm has responded by looking at cut-offs for minimum issue sizes. Solly was able to reduce Japan’s weighting by 2% in its global index by raising the minimum issue size from Ñ200 billion to Ñ500 billion. “That’s just a reaction to more issuance of large-size debt,” she says.

Salomons is also in discussions with the Bank of Japan and Ministry of Finance to try to make JGB issues more transparent. “We don’t know how much of a Ñ1 trillion issue actually goes to the market, as opposed to the accounts for, say, the Ministry of Finance’s infrastructure projects,” Sabia says. The concept of public and private amounts outstanding in an issue doesn’t exist in Japan. Solly’s index, like its competitors’, is based on market capitalization. But: “We don’t know how much is really out there for investors. We have no way to measure how replicable the market is.” She says the MoF is keen to make the bond market more attractive and has made positive noises to Salomon’s suggestion on transparency, but nothing concrete has emerged.

Japan frozen out

But there is a bigger movement taking place than building a better understanding of Japan’s bureaucracy or urging the government to open up. And that is that leading providers of global bond indices, partly due to prodding by exasperated investors, are finding clever ways to freeze out Japan. These changes will be massive: for example, Lehman Brothers believes $12 trillion of bond fund managers’ money tracks its Global Aggregate Index.

Enter credit. Index providers acknowledge they have this year begun introducing non-sovereign credits into their global benchmarks in part because of investors’ complaints about their rising exposure to Japan. But the index makers are also interested in better representations of the markets.

“Our hottest index has been the Global Aggregate Index,” says Steve Berkley, New York-based managing director and head of Lehman Brothers’ global index business. This product debuted in January 1999, as a global sovereign index plus US and European credit. In June of this year it launched a separate Asia-Pacific Aggregate Index, adding corporate credit, mortgages and so on to the sovereign mix. As of October 1, this index will be incorporated into the Global Aggregate, adding sovereign and credit markets of Japan, Australia and investment-grade Asia to its flagship.

Other providers have followed suit. Last month, for example, Merrill Lynch rolled out Asian and global indices that include credit. JP Morgan has just added Pfandbriefes to its European sovereign indices, although it has no immediate plans to follow suit in Asia. Salomons has just added US mortgage and corporate markets, as well as euroyen paper, to its World Broad Investment Grade Bond Index, and hopes to launch a Japan index including credit next summer for domestic investors.

Japan’s zero-interest rate policy, and the implications for yields when that policy changes, prodded index providers into thinking about credit, says Galdi. Lehman’s Malvey predicts yields on 10-year JGBs will rise from 1.85% today to 2.10-2.25% by the end of the year. Says Galdi: “If you add credit to the mix, the US credit market is larger than the yen credit market, so the yen-denominated portion will decline.” Over the next two years, fund managers will increasingly adopt credit in their benchmark, he believes.

This trend will only get bigger. Berkley says the next index will be a global corporate bond index, and perhaps an all-inclusive global bond index that mixes high-yield paper. “We’ll call it the Lehman Kitchen Sink Index,” he quips.

“The emphasis on credit should help the global bond market,” says Malvey. For the first time, fund managers in New York, London and Zurich will have to buy Japanese corporates. “They’re asking me, ‘Which ones should we own?’ At the same time, Japanese and other Asian investors are asking, ‘What are spread products?’” he says. “This will accelerate the globalization of the bond market. It will create new dynamics for demand.”

Index providers caution that these changes won’t happen overnight. They say it took US fund managers five or six years to get comfortable with incorporating credit into their portfolio. But all agree that in two or three years’ time, global investors will be demanding Japanese corporate bonds.

But perhaps not those issued in Japan. The government levies a 15% withholding tax on corporate bonds. Investors prefer offshore euroyen paper. Malvey believes that now as global index providers add credit, the Japanese government is being presented with a historic opportunity.

One of the great developments in finance since World War II occurred in the 1960s, when international money fled America and its withholding tax on corporate bonds, giving birth to the eurodollar market and establishing London as a premier international financial centre. Tokyo must make a similar choice. With its budget problems, the government is in no mood to cut taxes. But now that global investors will start demanding Japanese corporate credit, will the bureaucrats let this opportunity slip through their fingers? Will all that corporate yen borrowing be syndicated out of Hong Kong to avoid Japanese tax, or will Tokyo see sense?

Share our publication on social media
Share our publication on social media