A Japanese room (Photo: Thinkstock)

It’s easy to see why Japan has soured on Uncle Sam.

After all, returns on Treasuries have been lousy for years. And the sky-high costs to hedge the dollar’s ups and downs mean Japanese investors can often do better at home — despite the minuscule yields there.

But it doesn’t mean they’ve given up on America altogether. In fact, investors from Japan have plowed record amounts into U.S. stocks, corporate bonds and agency-backed securities, pushing investments in those assets past $1 trillion for the first time ever this year. That’s a stark contrast to the big pullback from Treasuries, which has cut Japan’s holdings to a seven-year low.

The shift reflects a sea change in Japanese investing. For decades, the U.S. Treasury market has been the go-to destination for the nation’s historically risk-averse investor base. Faced with ultra-low returns in Japan, the yield pickup from owning the world’s pre-eminent haven asset was a no-brainer, and more than covered any currency-hedging costs. But now, as those expenses soar, traditional Japanese buyers of Treasuries such as pension funds and insurers have been forced to look elsewhere.

(Related: Long-Awaited ‘Asian Century’ Might Not Ever Come)

“The rising hedge cost has pushed Japanese investors out of their favorite foreign product: U.S. Treasuries,” said Tetsuo Ishihara, a U.S. macro strategist at Mizuho Securities USA’s fixed-income unit. “In general, they have had to take more risk to offset that rise.”

Fiscal Consequence

The consequences could be significant. With the U.S. budget deficit forecast to balloon in coming years, any drop-off in demand for Treasuries could increase America’s financing costs. As the second-largest foreign creditor to the U.S., Japan’s standing is too important to simply ignore.

At the same time, Japanese investors are building up risk — echoing the demand for higher-yielding assets globally in response to ultra-low rates of the post-crisis era — just as worries about both stocks and corporate bonds in the U.S. have started to emerge.

Since 2015, Japan’s investments in U.S. stocks, corporate bonds and agency-backed bonds have grown by over $270 billion, or roughly 40%, figures from the Treasury Department show. Investors from Japan have been particularly aggressive in amassing stocks and agencies, relative to buyers from other countries, the data show. Over the same span, their holdings of Treasuries have fallen nearly 20% to $1.03 trillion.

Vanishing Yield

To understand why, consider what Treasuries actually yield for a typical Japanese investor. After taking into account the cost of currency forwards used to insulate buyers against dollar swings, 10-year yields — currently at 2.83% — effectively shrink to about 0.3% for yen-based investors.

Of course, that’s still higher than the yield on 10-year JGBs, which is barely above zero. But looking solely at yield levels arguably misses the point that matters most: what the trade returns after factoring in currency swings.

And this year, it hasn’t been pretty.

Japanese investors who hedged their currency risk lost 3.7% in 10-year Treasuries in the first half of the year, according to bond indexes compiled by Intercontinental Exchange. For those who decided not to worry about currency fluctuations? They lost 4.3% in yen terms as the dollar weakened against Japan’s currency. (For comparison, JGBs due in five years or more all have positive returns.)

While buyers of U.S. government debt can always hold to maturity (and thus insulate themselves from the market’s fluctuations), the scant interest that Treasuries provide offers little cushion against price declines.

Mortgage Preference

Hence the rotation into other U.S. assets. For Ginnie Mae mortgage-backed securities, hedged investors can expect to earn 0.9%. Almost all of Japan’s roughly $250 billion in agency holdings are in mortgage bonds, and Robert W. Baird’s Kirill Krylov says that Ginnie Mae’s explicit government guarantee makes them a popular choice for Japanese buyers.

Investment-grade U.S. corporate bonds yield about 1.5% on a hedged basis, index data compiled by Bloomberg show. As for stocks, the costs don’t apply because Japanese investors tend not to hedge equities, says Torsten Slok, Deutsche Bank’s chief international economist. Japan owns over a half trillion dollars of U.S. equities, the largest holding apart from Treasuries.

While the math alone makes a compelling case, stronger global growth has also coaxed Japanese investors into taking more risk, says Zach Pandl, co-head of global FX strategy at Goldman Sachs.

“The shift away from Treasuries and toward corporates and agencies over the last couple of years reflects improving market conditions and increasing risk tolerance by Japanese investors,” he said.

Yield Pressure

That should be a concern for bond traders and the U.S. Treasury alike, he said. As the sizes of debt auctions swell and the Federal Reserve slowly shrinks its investments of Treasuries, yields have been on the rise.

Since falling as low as 2.01% in September, 10-year yields have soared, reaching an almost seven-year high of 3.13% in May. If Japan’s shift out of Treasuries continues, that could add to the upward pressure on yields.

Slok paints an even gloomier, if somewhat extreme, picture. With the Fed raising rates, hedging costs are bound to climb too, pushing more investors into other U.S. markets. Add to that increased debt supply and the risk of inflation overshooting the Fed’s 2% target, and those buyers may abandon Treasuries altogether.

“The risks are that Japanese investors, and foreign investors more broadly, will simply step away and stop buying U.S. fixed income because it just becomes too risky,” Slok said.

— Read With U.S. Yields This Good, Japan Funds Buy Without Hedging, on ThinkAdvisor.

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