Japanese Bond Investor Flows and Thoughts

Harry Ishihara
Harry Ishihara US Macro Strategist, Mizuho Americas Fixed Income
September 15, 2016

Japanese investors are currently the second largest holders of foreign bonds in the world after the US, according to IMF data. The shift from domestic to foreign bonds began in earnest in 2013, spurred by the Bank of Japan (BoJ)’s Quantitative and Qualitative Easing (QQE) program. A key aspect of Abenomics, Japanese Prime Minister Japan Shinzō Abe’s "three arrows" of fiscal stimulus, monetary easing and structural reforms designed to jolt the economy out of suspended animation and into growth, QQE involved massive purchases of Japanese government bonds (JGBs) by the central bank in order to raise asset prices, lower yields and simultaneously increase the money supply. The resulting lower interest rate environment and weaker yen was a boon for exporters, consumers and Japanese equity market sentiment. While equities eventually became so correlated with the yen that the direction of causation became hard to tell – was the weaker yen causing the Nikkei to rise, or vice versa? – the effect on bond investors was equally dramatic.

Chart 1: Investment Securities Held by Japanese Banks

Source: Macrobond, Mizuho Securities, Bank of Japan

Exodus of Funds
As chart 1 shows, Japanese investors were literally chased out of the domestic bond market as yields fell. And in a historic move, Japan’s government pension fund, the largest in the world, was forced to diversify out of JGB’s and into foreign bonds and equities. Ministry of Finance data confirms that Japanese investors prefer bonds to equities, and rate risk to credit risk. This is especially true for institutional investors, but less so for retail investors, who have been large buyers of US high yield funds historically. The flows into foreign equities, investment funds and foreign bonds in all currencies are outlined in charts 2 and 3 below, with the bulk traditionally directed into the US or Europe. The line graphs in both charts, which reflect gross purchasing and selling activity, have risen since 2013, in line with the start of Abenomics and the BOJ’s QQE.

Chart 2: Japanese Flows into Foreign Equities and Investment Fund Shares (All Currencies)

Source: Macrobond, Mizuho Securities, Japanese Ministry of Finance

Chart 3: Japanese Flows into Foreign Bonds (All Currencies)

Source: Macrobond, Mizuho Securities, Japanese Ministry of Finance

Investor Behavior
In 2016, with QQE and Abenomics largely failing to stimulate the economy as planned, the Japanese central bank went a step further with monetary easing by adopting a Negative Interest Rate Policy (NIRP) for the first time. Intended to spur banks to lend more, increase spending and inflation, and push the currency down, NIRP has instead seen the yen surge to highs against the USD. NIRP has also led to a number of other unforeseen changes in Japanese investor behavior in the pursuit of yield. Japanese corporate bonds are being hoovered up in USD, Euros and AUD and all hedged into yen, with investors going as far down as Triple B rather than single A as was the previous norm. There is now more diversification, with one major life insurer buying bonds from Mexico and New Zealand, and US muni funds and US MLP’s (energy master limited partnerships) drawing retail investor interest earlier this year. Abenomics has also continued to drive demand in equities, and the BOJ’s purchases of ETFs are seen as a source of market support.

Looking Forward
In summary, yield suppression caused by the BOJ’s aggressive purchases of JGB’s since 2013 is forcing Japanese investors abroad. The BOJ is determined to end deflation, but there is no solution in sight. Japanese institutional investors are largely debt investors, and the renewed pressure on interest rates from NIRP provides further support for outgoing fund flows to continue. However, the increased demand for dollars has caused USD/Yen hedging costs to rise this year. We estimate that the typical hedge cost has caught up to yields on the ten-year Treasury. For now, this should cause flows to the US to slow, but bond investors in search of yield will continue to remain hungry for US products.

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