To a Japanese bond investor, the world truly is flat. Not only in the sense that they can invest around the world at the click of a button, but that the choices available to them have become extremely compressed.
For instance, benchmark bond yields in the US, UK and Germany are some distance apart, a reflection of their different economic trajectories and central bank policies.
Yet, for a buyer in Japan, once the cost of including currency movements is calculated, a 10-year UK gilt offers a hedged annual yield of 0.8 per cent, according to Nomura, more than the 0.71 per cent available from US Treasuries.
Viewed from this angle, German Bunds represent a very slightly better option, with a hedged yield of 0.83 per cent.
The compression points to the importance of Japan’s capital to the rest of the world. A rich country with a large population of elderly savers, it was also the first to embrace quantitative easing-like policies in 2001. With interest rates close to zero for many years, a lot of money heads overseas.
Evidence of renewed buying this week came as the Bank of Japan signalled a commitment not to let benchmark Japanese yields rise above 0.1 per cent, meaning that domestic investors must continue to venture abroad to seek a better fixed-rate return.
“Typically, the investors that do the most of this currency-hedged investing into sovereign bonds is investors in Japan”, says Matthew Hornbach, interest rate strategist for Morgan Stanley.
Not every Japanese investor wants to avoid currency risk. The nation’s large banks, with operations around the globe, raise funding locally and so buy bonds without thought to the currency exposure. Pension funds, including Japan’s largest, the Government Pension Investment Fund, do not appear to hedge their currency exposure.
Significant users of the market are instead the big life assurance companies. As of September 2016, the most recent data available, the seven largest life assurers had hedged just over two-thirds’ of their non-yen assets, says Mr Hornbach.
The implication is that, for Japanese investors to get excited about buying US sovereign debt, bond yields might have to rise from today’s 2.38 per cent to heights last seen in March, says Renuka Fernandez, interest rate strategist for Nomura: “If you wanted to get 1 per cent, say, then the Treasuries yield would need to be 2.6 per cent before they start to look attractive”.
The difference represents the cost of hedging movements in the dollar, of about 1.5 per cent to 1.75 per cent a year, by using forward contracts to lock in payments in Yen.
For European bonds, however, hedging works in the Japanese investor’s favour, gaining about 0.3 per cent to lock in euros, hence a higher Bund yield than that available to German investors, a shift that has happened this year.
Reasons include a shift away from what was perceived to be an international scarcity of dollars at the start of the year, says Kit Juckes, currency strategist for Société Générale. “It’s become more attractive for a Japanese investor to hedge his foreign exposure”, he says.
Japanese bond investors have stepped up their purchases of European government debt, buying ¥591bn of French sovereign debt in May, up from ¥197bn the previous month, according to data published by Japan’s finance ministry this week.
The buying can be taken as a sign of confidence in the European project, and in prospects for France under President Emmanuel Macron. Also, because preferences for the different Eurozone economies are not affected by currency risks beyond that of the euro.
A return of Japanese investors reverses a three-month sell-off earlier this year, the longest since the height of the eurozone crisis, when foreign investors braced for European political turmoil.
Japanese buyers have also turned positive on Bunds, purchasing ¥315bn of German government debt in May after selling ¥632bn-worth in April.
Combined purchases of French and German bonds are usually half the value of US Treasuries, but in May they represented 65 per cent — a historically rare situation, according to analysis by UBS, suggesting that a shift in sentiment towards European government bonds and away from Treasuries may be under way.
Gilts were also in demand in May, before the UK held an election which returned a weakened Conservative government to power, reversing a sell-off since January.
Yet Europe was not uniformly in favour. Many investors have questioned what will happen when the European Central Bank begins to trim its monthly programme of bond buying, a strategy that was designed to reduce borrowing costs for governments and businesses, particularly for Italy.
The country has the largest stock of debt in the euro area, and is also set to hold an election within a year in which Eurosceptic and populist parties are expected to perform well.
Selling of Italian sovereign debt by Japanese investors stepped up in May. “This suggests Japanese investors are focused on the next potential risk in Europe and an inevitable ECB taper in 2018,” says Ms Fernandez.
Additional reporting by Alice Woodhouse