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Beware the $300 billion shift into Treasuries from Japan

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(Bloomberg) — Back in the 1980s, the billions of dollars that the Japanese plowed into U.S. government debt reflected the Asian nation’s burgeoning economic might.

Now, they’re at it again, only this time it’s to eke out any return they can.

Yields on Japanese debt have been pinned near zero ever since the Bank of Japan embarked on its latest attempt, in April 2013, to end the two decades of stagnation that followed those go-go years. Europe isn’t much of an option, as yields turned negative this year on the region’s own quantitative easing.

So why the U.S.? For one, with the Federal Reserve poised to raise interest rates, Treasuries offer the highest yields among debt from the world’s most-industrialized economies. Then there’s the dollar, whose meteoric rise against virtually every currency has made U.S. assets even more appealing. HSBC Holdings Plc says Japanese investors may funnel $300 billion into Treasuries over the next two to three years, double the pace of the nation’s purchases since 2012.

“The BOJ is crowding out private investors,” said Yusuke Ito, a fund manager at Mizuho Asset Management, which oversees $33 billion in Tokyo. “They have to find alternatives.”

Mizuho’s overseas bond unit, which stepped up buying of Treasuries in mid-2014, has signed up more clients looking for higher-yielding alternatives to Japanese debt, he said.

Japan first began to exert its influence in the U.S. government bond market more than three decades ago, when its booming export-driven economy produced trade surpluses that it then plowed into Treasuries year after year.

Creditor nation

Japan has since built a stake of $1.23 trillion, making it America’s second-largest overseas creditor, just behind China’s $1.24 trillion.

For the U.S. government, maintaining Japanese demand in the $12.6 trillion market for Treasuries is more important than ever, particularly after China pared its own holdings last year by the most on record and as the Fed prepares to raise rates.

The good news is that Japanese purchases are poised to accelerate. Of the $500 billion that investors will pull from Japan’s debt market to put abroad through 2017, about 60 percent will flow into Treasuries, said Andre de Silva, HSBC’s Hong Kong-based head of global emerging-markets rates research.

Much of the allure has to do with the U.S. tightening monetary policy at a time when more than a dozen nations around the world are cutting rates or increasing stimulus to boost growth. The European Central Bank this month followed Japan in buying government bonds to pump money into its economy.

Yield premium

As a result, 10-year Treasuries yielded as much as 1.2 percentage points more than the average for Group of Seven countries last week, the biggest premium since 2006. Compared with German bunds, the advantage reached the most in more than 25 years. The U.S. 10-year note yielded 2.09 percent as of 7:54 a.m. in London.

“U.S. Treasuries are more attractive than other markets,” Yoshiyuki Suzuki, the head of fixed income at Fukoku Mutual Life Insurance Co., which oversees about $52 billion, said from Tokyo. Fukoku has lifted its foreign bond holdings, composed mostly of Treasuries, to more than 20 percent of assets at the end of December, from about 18 percent a year earlier, he said.

And it’s not as if investors in Japan have much choice at home. Under Governor Haruhiko Kuroda, the BOJ is buying 80 trillion yen ($659 billion) of debt a year, pushing down yields and constricting available supply.

The BOJ already owns more than 20 percent of Japan’s government bonds. At least 60 percent of the $8.28 trillion market, including notes due as far out as a decade, yield less than 0.5 percent, data compiled by Bloomberg show.

Forced out

“They are forcing everybody out of JGBs and into something that’s higher yielding,” John Gorman, the head of dollar interest-rate trading for Asia and the Pacific at Nomura Holdings Inc., Japan’s largest brokerage, said from Tokyo. Treasuries will be among the biggest beneficiaries, he said.

Japan Post Holdings Co., the largest owner of the nation’s bonds after the central bank, and Government Pension Investment Fund, are already making the shift. Together, they hold about 218 trillion yen of local debt, equal to $1.8 trillion.

The banking unit of state-owned Japan Post increased its holdings of dollar-denominated debt more than 40 percent to 7.12 trillion yen in the fiscal year ended March 2014.

GPIF plans to boost overseas bonds to 15 percent of its 137 trillion yen in assets from 11 percent to boost returns, and trim its allocation to Japanese debt. Spokesmen at both companies declined to comment on their holdings of Treasuries.

Buying power

Hideo Shimomura, the chief fund investor at Mitsubishi UFJ Asset Management, which oversees $66 billion, says he’s not about to dump his Japanese bonds for Treasuries. That’s because the central bank’s bond buying will cause prices to appreciate and more than make up for the low interest payments.

“The BOJ purchases are powerful and will completely support the market,” he said from Tokyo. “People may come back to JGBs. I don’t think the market will become bearish.”

Japanese government bonds, which have fallen in March and February, posted their biggest annual returns since 1999 last year, index data compiled by Bank of America Corp. show.

The Fed’s rate increases, which traders anticipate will start by September, may also leave Treasury investors vulnerable to losses. Forecasters surveyed by Bloomberg say 10-year yields will rise to 2.7 percent in the coming year as the Fed boosts borrowing costs, based on the median estimate.

If that happened, it would result in a loss of about 2.4 percent for note holders, data compiled by Bloomberg show.

Dollar yen

The dollar’s advance against the yen may far outstrip the losses from any rise in yields.

For yen-based investors, the U.S currency’s appreciation boosted returns on Treasuries to 17 percent over the past six months, the most among 26 bond markets tracked by Bloomberg and the European Federation of Financial Analysts Societies.

The greenback is forecast to climb 4.6 percent further against the yen in the coming year.

“Investors will buy high-yield and high-quality bonds,” Hideaki Kuriki, a fund manager at Sumitomo Mitsui Trust Asset Management, which oversees $40 billion and bought U.S. 10-year notes this month, said from Tokyo. “That’s Treasuries.”

—With assistance from Daniel Kruger in New York and Tomoko Yamazaki in Singapore.