Will Japanese Bond Investors Come Home in 2023?

14 March 2023

7 min read

Yusuke Hashimoto| Portfolio Manager—Japan Fixed Income

Wataru Araiso, CFA| Managing Director and Senior Investment Strategist—Fixed Income Business Development

The Bank of Japan (BOJ) surprised the market in December 2022 when it doubled its cap on the 10-year Japanese government bond (JGB) from 0.25% to 0.5%, in response to tighter global monetary policies. The widening interest-rate gap between Japan and other developed economies as other central banks tighten has been a growing concern for the BOJ, which has long held an ultra-easy monetary policy. Thanks to that policy, Japanese fixed-income investors have steered away from their home market for decades, seeking the higher yields of global bond markets.

Below, we address two critical questions: First, will Japan exit its ultra-easy policy mode in 2023? Second, in response to BOJ policy actions, will Japanese bond investors shift their holdings out of hedged foreign bonds and into yen bonds?

The Bank of Japan’s Likely Next Steps

Could the BOJ’s past behavior be a guide to its next steps? Historically, the BOJ has modified its monetary policy toward the end of a global policy cycle. For example, during the natural resource boom of the early to mid-2000s, the US and euro area began tightening in 2004 and 2005, respectively, while Japan tightened in 2006, around the time the Federal Reserve finished tightening and just seven months before it started easing.

Unfortunately, whether that pattern holds in 2023 is anyone’s guess, especially with global inflation still not under control. For now, market participants expect the Fed to finish tightening and begin easing later this year, which would imply imminent BOJ tightening. But these market expectations contradict the Fed’s own projections for the policy rate (higher for longer). And we expect the inflation and economic data driving the Fed and other central banks to remain highly variable for much of the year. That doesn’t give us much visibility into the path for the BOJ.

However, we can get a clearer picture by digging into Japan’s unique situation. In Japan, normalization of monetary policy would begin with unwinding two policies that have been in place for close to a decade—negative interest-rate policy (NIRP) and yield-curve control (YCC)—and would eventually entail adopting a more conventional monetary easing policy, such as quantitative easing.

Already, YCC is under pressure. When the BOJ raised the cap on the benchmark 10-year JGB in December, market expectations for the 10-year yield remained above the 0.5% limit, compelling the BOJ to buy up all market inventory of the benchmark bond to preserve the 0.5% cap. This caused liquidity to evaporate and led to the exclusion of some JGB issues from a major global bond index.

To restore liquidity, we expect the BOJ to eliminate YCC before the end of the year. (We think it’s unlikely that, at that point, interest rates will rise above 1% for the 10-year JGB, considering prevailing inflation trends, the correlation between US Treasury bonds and JGBs, and the yield differentials within the JGB market.)

Meanwhile, we expect Japanese policymakers to maintain NIRP, so long as the dollar-yen exchange rate remains below 150. Although transitioning from NIRP to a zero interest-rate policy—a 10-basis-point increase—would theoretically help promote normalization, there aren’t any technical obstacles to maintaining NIRP, and policymakers could continue to use it as a tool for countering any sharp depreciation in the yen, as we saw in 2022.

Thus, the path to higher—and more competitive—Japanese bond yields isn’t likely to be straight.

Japanese Investors’ Preferences Won’t Change Overnight

Predicting whether Japanese investors will shift their holdings out of foreign debt and into yen bonds requires an appreciation of the factors influencing their decision. Japanese investors consider several factors when deciding whether to invest at home or abroad, one of which is the cost of hedging foreign currencies back to yen.

Compare currency-hedged yields. To fairly compare yields on yen bonds to those on non-yen bonds, we must first subtract the cost of a currency hedge. (While there’s more than one method of currency hedging, we prefer the use of currency swaps to mitigate the risk of exchange-rate fluctuations relative to future cash flows. This method is precise and is especially suitable for fixed-income assets, whose future cash flows are predictable. Other currency-hedging techniques may provide somewhat different results.)

JBGs currently yield 25 to 60 basis points more than US Treasuries after currency hedging (Display), suggesting that Japanese investors may consider moving back to JGBs. Investors with ample US–dollar liquidity, such as US banks, also take advantage of such cross-border yield differences. Indeed, most bondholders of shorter-maturity JGBs are non-Japanese investors.

JGBs Currently Yield More than US Treasuries After Currency Hedging

Yield (Percent)

Today, US Treasuries yield many percentage points more than JGBs before hedging but yield less than JGBs after hedging.

Current analysis does not guarantee future results.
*Hedged using currency swaps
Through January 31, 2023
Source: Bloomberg and AllianceBernstein (AB)

Consider the broader universe. While the hedged yield difference between government bonds currently favors Japan, this doesn’t hold true when comparing yields on corporate issuers.

In fact, Japanese corporate issuers’ yen-denominated credits don’t yield much more than comparable-maturity JGBs. That’s because, in a low-interest-rate country like Japan, desperation for income drives local investors into yen-denominated corporate bonds with any decent yield, effectively keeping yields low, in a vicious cycle spun by home-country bias.

At the same time, when Japanese firms raise funds in currencies other than the yen, they lose the advantage of home-country bias and must issue bonds at wider credit spreads. For example, the leading Japanese issuer, Toyota Motor, issued a USD bond due in September 2027, with a coupon of 4.55%. As of February 17, this bond, once hedged into yen, yielded 0.60%. By contrast, the Toyota JPY bond due October 2027 carries a 0.265% coupon and yielded only 0.44%.

What’s more, because few non-Japanese firms issue yen bonds, the yen credit market remains small. As a result, hedged foreign bonds typically provide Japanese investors with a bigger, higher-yielding universe of credits to choose from.

Consider investor objectives. Investors value bonds for their role as a “safe haven” when equity markets are in crisis; government bonds tend to perform well when stocks misbehave. But because the BOJ is the biggest player in the JGB market, the yen market is less sensitive to the risk environment.

As a result, when we compare the historical returns of hedged non-yen bonds to those of yen bonds, we see that non-yen bond returns have often been significantly higher than yen bonds during market upheavals (Display)—a pattern that puts yen bonds at a slight disadvantage to non-yen bonds in the eyes of investors.

Non-Yen Bonds Outperformed Yen Bonds in Most Risk-Off Environments

Total Return (Percent)

Non-yen bonds returned more than yen bonds in the European Debt Crisis of 2012 and in 2020, at the onset of the pandemic.

Past performance does not guarantee future results.
Hedged non-yen bonds are represented by the FTSE Russell World Government Bond Index excluding Japan (hedged); yen bonds are represented by the Nomura BPI.
As of December 31, 2022
Source: Bloomberg, FTSE Russell, Nomura Holdings and AB

Will Investment Flows Increase to Japan?

As the gap grows between Japanese policy rates and those of other countries, so too does the cost of hedging currency for Japanese investors. It’s reasonable, then, to speculate that Japanese investors may sell foreign government bonds. But it’s not a sure thing. When we look at the history of Japanese overseas debt investment flows, we see that the flow volume cycles more quickly than rate levels (Display). There’s even been a temporary increase in flows during expensive hedging environments, such as 2005 and 2016, when the US was hiking rates.

Relative Yield Is a Poor Predictor of Flow Momentum

Momentum of Overseas Japanese Debt Investment Flows and Yield Difference Between Hedged US Treasuryand JGB (Percent)

Comparison of flow momentum to yield difference between Treasuries and JGBs shows little correlation between the series.

Past performance does not guarantee future results.
Flow momentum is calculated by dividing the total flow over the next 12 months following the observation point by the total flow over the prior 12 months; yield difference is the difference between the 10-year US Treasury yield, hedged, and the 20-year Japanese government bond.
Through January 31, 2023
Source: Bloomberg, Ministry of Finance Japan and AB

To us, this suggests that investment objective is a more critical criterion for Japanese investors than yield differential. For Japanese investors seeking “safe” assets or deploying bonds as an anchor to windward in a broader asset allocation, non-yen bonds remain a reasonable choice.

Regardless, the decision about whether foreign or domestic markets serve the investor better is a complex one that’s highly dependent on unique investor needs, investment techniques and objectives. That’s why, in our view, Japanese investors’ behavior won’t change as easily as policy rates do—and Japanese investors aren’t likely to surge back into home markets in 2023.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Yusuke Hashimoto

Yusuke Hashimoto is a Vice President and a Portfolio Manager on the Japan Fixed Income team and is a member of the Global Fixed Income and Asia Pacific Fixed Income portfolio-management teams. Prior to joining AB in 2019, he spent 12 years at UBS in several trading roles, most recently as director of Macro Rates Trading. Hashimoto holds a BEc and a MEc, both from the University of Tokyo. Location: Tokyo

Wataru Araiso, CFA

As Managing Director and Senior Investment Strategist of Fixed Income Business Development, Wataru Araiso co-heads the Investment and Product Strategy Department at AB Japan, leading business development and product management for fixed-income services in Japan. He also heads the Portfolio Strategy Office and is responsible for fiduciary duty pertaining to Japan-domiciled investment trusts. Araiso joined AB as a fixed-income product manager in 2017. Previously, he worked as a senior fund manager for global fixed-income and money-market funds at a Japanese asset-management firm. Araiso holds a BA in commerce from Hitotsubashi University and an MBA from the University of Oxford. He is a CFA charterholder and a certiﬁed member analyst of the Securities Analysts Association of Japan. Location: Tokyo

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