How global investors turn negative Japan yields into big returns

[TOKYO] Record-low negative yields are no deterrent to overseas demand for Japanese government bonds. In fact, they're an incentive.

The discount offered to dollar holders to borrow yen for five years in the swap market reached a record 102.5 basis points this week, as the Bank of Japan's Jan 29 decision to switch to interest rates below zero widened a divergence from US monetary policy.

Calculations on returns for investors using such funding show the fixed coupon equivalent for owning five-year JGBs was 2.3 per cent on Thursday, despite a yield of minus 0.16 per cent on the debt.

Overseas investors have continued to step up purchases in the world's second-largest sovereign debt market, even as pension funds, banks and households sold as the bonds started burning holes in their balance sheets. The flow of funds has significance for Japan's currency markets as well as its fragile economic recovery.

"Foreign demand for Japan's two- and five-year bonds is very strong on the back of the BOJ's negative interest rate policy," said Naoya Oshikubo, a rates strategist at Barclays Plc in Tokyo. "The widening in basis swaps as monetary policy diverges will continue to be the focus of investors this year."

GOING OPPOSITES

While sub-zero yields on debt up to a decade in maturity are forcing Japanese investors to buy ever longer maturities, foreigners have been heading in the opposite direction.

Investors abroad were net buyers of medium-term JGBs for a 12th-straight month in January, after 2015 saw the largest annual purchases in at least a decade, according to the latest data available from the Japan Securities Dealers Association.

Ministry of Finance figures from February, which pool all Japanese bonds into a single category, show foreign buying more than doubled from the previous month. The five-year note yield plunged to a record minus 0.265 per cent on Feb 10, a day after that on two-year debt dropped to an all-time low of minus 0.25 per cent.

Adjusted for payments to lend dollars and borrow yen, five-year JGBs offered 95 basis points more than yields on equivalent Treasuries as of 9.20am in Tokyo - even though the US securities provided a more-than 150 basis-point premium in nominal terms.

Cross-currency basis swaps also signal two-year Japanese debt would give dollar holders an additional 88 basis points over similar-maturity Treasuries. That's even as the premium in nominal terms offered by US yields widened to 112 basis points this week, the most since the 2008 financial crisis.

"The ones who can buy medium-term JGBs when yields have fallen this much are foreigners, thanks to favourable swap rates," said Souichi Takeyama, a rates strategist in Tokyo at SMBC Nikko Securities Inc.

"Japanese continue to invest heavily in overseas bonds, and that looks set to continue. Demand for dollars will tighten even more."

BLOOMBERG