Why Japanese Bonds Yielding 1.3% Offer Highest Return (Update1)

By Wes Goodman
Dec. 14 (Bloomberg) -- Nowhere are yields as low as in Japan’s debt market and nowhere are returns higher as Prime Minister Yukio Hatoyama’s government fails to stop deflation.
The combination of the fastest drop in consumer prices in five decades and the yen trading at about a 14-year high has turned Japanese government bonds into the past month’s best performers among the 26 markets tracked by Bloomberg and the European Federation of Financial Analysts Societies. The debt returned 3.6 percent in dollar terms and 5.6 percent in euros.
So-called JGBs rose 0.83 percent this year in local currency.
Deflation, or a persistent decline in consumer prices, is sparking demand even as Hatoyama boosts borrowing to a record
53.5 trillion yen ($607 billion) in the year ending March 2010 to pay for fiscal stimulus. Mitsubishi UFJ Financial Group Inc.
and Yasuda Asset Management Co. are buying 10-year notes yielding 1.275 percent, lower than in the U.S., U.K. and Germany, for so-called real yields of 3.78 percent after accounting for deflation. The comparable rate in the U.S. is 3.70 percent.
"The deflation trend could continue until 2011," said Hideo Shimomura, who helps oversee about $56.5 billion as chief fund investor in Tokyo at Mitsubishi UFJ Asset Management Co., part of the world’s biggest bank by assets. "There might be an expansion in the government budget, but when people start to look at the fundamentals, yields are going to move down."

Yen Boost

Mitsubishi UFJ, the largest private holder of Japanese government bonds among companies that make regulatory filings, bought in November, Shimomura said.
Investors outside Japan are profiting from the yen, which has appreciated 8.3 percent against the dollar and 3.9 percent versus the euro since mid-year. The Vanguard Japan Government Bond Index Fund, with about $22 billion in assets, returned 8 percent over the past year, versus 2.3 percent for the Vanguard Intermediate-Term Treasury Fund.
History suggests there may be more gains to come. Bond prices would have to rise to push real yields down to the average of 2.17 percent over the past 20 years. Yields on 10- year notes dropped to 0.43 percent on June 11, 2003, after a government report showed the gross domestic product deflator, the broadest measure of prices, fell by a record amount.

Rate Outlook

"In Japan there is no inflation, but deflation," said Osamu Koizumi, the chief investment officer in Tokyo at Yasuda Asset, which manages the equivalent of $5 billion. The central bank will keep its benchmark rate unchanged "for a long time, maybe two years," said Koizumi, who holds a greater percentage of bonds than the benchmark index he uses to gauge performance.
The Bank of Japan will maintain the target for overnight lending at 0.1 percent at least through March 2011, according to a Bloomberg survey of banks and securities companies, with the most recent forecasts given the heaviest weightings. The U.S.
may raise rates in the third quarter of 2010 to 0.5 percent from a range of zero to 0.25 percent, according to a separate survey.
Hatoyama’s government said Nov. 20 the country was mired in deflation for the first time in three years after a measure of prices that excludes the cost of imports fell the most since 1958. Prices likely fell 1.2 percent in 2009 and will decline by the same amount in 2010, according to the median estimate of 10 economists surveyed by Bloomberg.
The prime minister unveiled a 7.2 trillion yen plan two weeks ago to bolster the economy, which shrank 0.9 percent last quarter. While Hatoyama told reporters that the package "reflects our intention to resuscitate the economy," Morgan Stanley Asia Chairman Stephen Roach said it isn’t enough.

‘Tiny’ Plan

"It’s tiny," Roach said in a Dec. 8 interview on Bloomberg Television. "This is an economy that went into its worst recession, the second lost decade, late last year and is barely coming out. The new government is not off to a good start in formulating policy strategy."
Japan experienced three recessions between 1990 and 2002 as unemployment more than doubled and the Nikkei 225 Stock Average plunged by 77 percent.
Hatoyama’s stimulus doesn’t guarantee Japan will be able to stop prices from falling, Mitsubishi Research Institute Chief Economist Yasuo Goto said last week. He predicts it will increase GDP by 0.5 percentage point.
The yield on the benchmark 1.3 percent bond due in December
2019 fell one basis point last week to 1.275 percent, according to Japan Bond Trading Co., the nation’s largest interdealer debt broker. The price rose 0.089 yen to 100.221 yen. The yield was
1.29 percent today as of 10:47 a.m. in Tokyo.
Japan’s 10-year bonds yield the most of any Group of Eight industrialized country after accounting for deflation. Real yields climbed from negative 0.90 percent in August 2008, the biggest increase since at least 1985, Bloomberg data show.

Beating Treasuries

Japanese government bonds are generating bigger returns than their U.S. counterparts for the first time in a decade. So- called JGBs returned 1 percent this year, versus a 2.2 percent loss for Treasuries, according to indexes compiled by Bank of America Corp.’s Merrill Lynch unit.
Investors outside Japan own about 6 percent of the nation’s government bonds, according to central bank data as of June 30.
The figure has been less than 8 percent for the past decade.
"We have a hard time remembering when we last held JGBs, as they trade at such low yields," said Michael Hasenstab, who runs the $23 billion Templeton Global Bond Fund for Franklin Templeton Investments in San Mateo, California.
Japanese bond bears say the ballooning deficit will hurt returns. The nation’s debt, currently $11.8 trillion and equivalent to about 219 percent of GDP, will approach 250 percent of the economy in 2014, based on figures from the International Monetary Fund in Washington.
The ratio is higher than in the U.S., U.K., Germany, Canada, France or Italy, IMF figures show. Japan’s debt market is the biggest among 35 nations tracked by the Bank for International Settlements in Basel, Switzerland.

Kokusai Avoids JGBs

"People are concerned about government spending," said Masataka Horii, one of four investors for the Kokusai Global Sovereign Open fund in Tokyo, the biggest bond fund in Japan.
"I’m more bullish on European and U.S. bonds. Japan is the worst of the three."
The $48 billion Global Sovereign Open fund cut its holdings of yen-denominated bonds to 5 percent of assets from 15 percent at the end of 2008. The yen will weaken to 97 per dollar by the end of 2010 from 89 last week, based on the median estimate in a Bloomberg survey of 40 banks and securities firms.
Finance Minister Hirohisa Fujii said bond sales for fiscal 2010 ending March 31 will total 53.5 trillion yen, more than the
44 trillion yen budgeted in April. Issuance will exceed tax revenue for the first time since World War II, he said.

Hedging Costs

The price of hedging against losses on $10 million of the nation’s bonds with credit-default swaps soared last month to as much as $80,315 a year, from $37,000 in August. The increase in debt protection costs contrasts with the U.S., where prices were little changed at $32,800 amid a 5.8 percent expansion in the market for Treasuries in the period. The difference in prices reached the widest ever on Nov. 9.
Japanese 10-year yields will rise to 1.51 percent by the end of 2010, based on the median estimate of economists and strategists surveyed by Bloomberg. An investor who bought today would lose 0.6 percent after price declines and reinvested interest payments, data compiled by Bloomberg show. Forecasts for Treasury yields of the same maturity show investors would lose 0.22 percent.
Japan Post Bank Co., the government-owned lender and the world’s largest holder of deposits, helps fill gaps in demand.
The bank held 157.9 trillion yen of JGBs on Sept. 30, equivalent to $1.8 trillion, investing its 176.4 trillion yen of deposits, based on figures from the company’s Web site.
Inflation-Linked Bonds
The difference between Japan’s six-year bonds and inflation-protected securities, which reflects traders’ outlook for consumer prices over the life of the securities, was negative 1.3 percent, the lowest in the world, according to data compiled by Bloomberg.
Deflation is bad for an economy because it discourages investment and spending. Capital expenditures by companies in Japan fell 2.8 percent in the three months ended Sept. 30 from the previous quarter, the government said Dec. 9.
Toyota Motor Corp., the nation’s biggest automaker, aims to cut capital investment by 70 billion yen from the Toyota City, Japan-based company’s initial plans for the year ending March, the most among major companies, a Nikkei Inc. survey showed on Nov. 30. Sony Corp., the electronics company based in Tokyo, said last month it will eliminate 250 jobs to reduce costs.
Dai-ichi Mutual Life Insurance Co., Meiji Yasuda Life Insurance Co., Sumitomo Life Insurance Co. and Daido Life Insurance Co. said they plan to buy yen bonds in the six months ending March 31. Nippon Life Insurance Co., Japan’s biggest life insurer, said Oct. 20 that it will invest 600 billion yen mainly in the bonds in the six months started Oct. 1.
"The core of our investments will be yen-denominated bonds that will generate stable income revenue for us," said Tomiji Akabayashi, general manager of the insurer’s finance and investment planning division.