One Investor’s Poison is Another’s Windfall

The introduction of negative interest rates in Japan and the subsequent chance for yields has seen domestic investors move further out on the curve.  They have also stepped up their purchases of foreign bonds.

In three weeks (through March 4) since the negative deposit rate went into effect, Japanese investors bought JPY4.4 trillion of foreign bonds.  This is the second most since at least 2001 (when Bloomberg's time series began), trailing slightly behind the August 2010 flurry.

In the three weeks to the end of February, foreign investors bought the most Japanese bonds since last August.  Japanese Securities Dealers reported foreign interest in the short-end of the Japanese coupon curve reached a decade high last year.  Ministry of Finance data suggests foreign purchases of Japanese bonds in February was twice the pace seen in January.

What is going on?  Why would foreign investors be attracted to the negative yields offered by Japanese government bonds?

Essentially, swapping dollars for yen provides a significant discount (cross currency basis swap) so that the total return is above comparable US Treasury yields for two-five year tenors.  The two-year cross currency swap of dollars to yen was a little more 78 bp last week and is near 75 bp now.  It provides a return of about 80 bp over two-year Treasuries.

The five-year cross currency swap is near 100 bp now, having been at a record low near 102.5 bp last week.  It translates to a fixed coupon equivalent of owing five-year JGBs at near 2.25%.

Due to interest rate differentials and supply and demand, it can be lucrative to lend dollar and borrow yen.   The levels cited here are indicative and meant to illustrate one institutional strategy as investors seek to find opportunity in a negative interest rate environment under the conditions of divergence.  It explains why one market segment (some dollar-based investors) may find opportunities in the short-end of Japan's coupon curve, while other investors (yen-based domestic investors) are fleeing to positive coupons at the long-end of the JGB curve or foreign bonds.

There are many moving parts and to glean more insight investment strategies, one needs to take into account two markets.  Many observers typically look at relative interest rates and do not understand why some foreign investors may be attracted to Japan.  Incorporating the cross currency basis swap into the calculation shows the opportunities some are seizing.