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Credit downgrade may be positive for Japan's US$10t bond market

A credit rating downgrade is usually bad news for bonds, but not for Japanese government bonds.

[TOKYO] A credit rating downgrade is usually bad news for bonds, but not for Japanese government bonds.

Already buttressed by the Bank of Japan's massive buying under its quantitative easing programme, the US$10 trillion JGB market, according to analysts, will likely weather a downgrade and could even benefit. "Because the BOJ's buying dominates the market, any selling by foreign players who may be sensitive to ratings will be absorbed," said Akito Fukunaga, chief rates strategist at Barclays.

Having run current account surpluses for decades, Japan is the world's top creditor nation, despite its government running debt of more than 200 per cent of gross domestic product.

As a consequence the yen and JGBs are far more sensitive to domestic capital flows than they are to foreign capital flows.

Typically, Japanese investors buy back the yen, and government bonds become their safe havens when risk appetite is hit, as it has been recently due to fears over the fallout from Britain's referendum on whether to leave or remain in the European Union.

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So Japanese investors didn't take fright when fears arose that credit rating agencies would soon downgrade Japan's sovereign debt following the government's decision two weeks ago to delay a sales tax hike that was key to reining in Japan's yawning deficits.

"It's ironic and counter-intuitive but when a risk-off event occurs, it makes Japanese companies and households stop lending overseas, helping to strengthen the yen. It is very different from other countries," said a director at a European brokerage.

Fitch, one of three major global raters, earlier this week warned it could downgrade Japan's A debt rating, changing its rating outlook to negative from stable.

Japan's credit rating is already the second lowest among Group of Seven countries at single A+, and another downgrade would put Japan's rating below countries such as Ireland, which suffered a major debt crisis in 2011.

But such a rating action is likely to trigger a rally in Japanese bonds and currency, rather than cause a crisis.

Indeed, investors are flocking to Japanese assets. Japanese government bond yields have been hitting record lows while the yen has held near its highest levels in more than a year and a half against the dollar.

Some analysts also say foreign investors could step up buying in JGBs after a credit downgrade because of JGBs'lucrative returns when swapped to dollars.

Foreign investors can now earn a hefty return because of elevated spreads on dollar/yen basis swaps, in which players swap dollars and yen for a set period of time.

These spreads have widened sharply over the past couple of years precisely because Japanese investors stepped up investment abroad. Two-year spread, for instance, rose to 0.79 per cent from around 0.27 per cent two years ago.

This means foreign investors can earn 0.79 per cent premium on dollar interest in exchange for paying yen interest, which is almost zero or even slightly negative.

A credit downgrade on Japan could make foreign banks more reluctant to lend to Japanese banks and boost basis swap spreads further.

"A credit downgrade will surely boost fund raising costs for Japanese banks. That means JGBs will likely become even more attractive for foreign investors," said Hideki Kishida, senior fixed income analyst at Nomura Securities.


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