The return of the Central banks’ dovish mode, especially the recent Fed’s U-turn, prompts investors to reassess the risks of investing in high-yielding stocks and pay attention to fixed-income securities, i.e. bonds. One of the most exotic assets for amateur investors is probably the Japanese government bonds (JGB), which have a negative yield to maturity. A dollar invested today in Japan’s sovereign debt is cheaper than a dollar received in the future, which, for example, contradicts the concept of interest rate as the price of money as a store of value.

Nevertheless, Japanese bonds enjoy strong demand among overseas investors, which seems pretty strange if we compare them to US Treasuries. The Ministry of Finance of Japan reported on Thursday that the inflow of foreign capital to JGB was $ 5.8 billion in the week ending February 1. The growth in demand for Japanese debt was the highest in three weeks. Investors also showed a good appetite at the auction of 10-year Japanese securities on Tuesday, where bid-to-cover ratio was the highest in 13 years.

A pause in the tightening cycle of global central banks, primarily of the Fed, somewhat alleviated concerns about the yield differential between JGB and government bonds in Eurozone and US, but still the difference in yield to maturity, for example, between 5-year notes of the US Treasury and the United States is 2.645%. What is the point of investing in JGB?

The answer lies in the supply and demand of the dollar in the cross-country money market. The cost of borrowing is determined by LIBOR rates. Accordingly, from the position of the lender in the United States, there are two alternative possibilities for yield seeking – domestically or abroad, i.e. comparing LIBOR and the yield of domestic asset with same degree of risk.

Dollar liquidity began to shrink as the Fed’s tightening process accelerated, which led to an increase in the cost of borrowing dollars in the money market. The latest data shows that the LIBOR dollar rate is higher than the risk-free rate on US treasury bonds considering the same maturity date:

Treasury yields

 

Dollar LIBOR rates

(Of course, comparing LIBOR rates and yield to maturity is not entirely correct, since treasury bonds are “the riskiest in the world”, so the difference in spread is actually smaller)

However, here we recall the concept of covered interest rates which says that by investing in a profitable asset abroad, the difference in yields is “neutralized” by the cost of currency risk hedging (for example, by a forward contract), therefore, it will not be possible to extract risk-free profits.

But in currency swaps, which are currently used by US lenders for profit, there is minimal currency risk, as the parties undertake to exchange the same nominal amount of currencies at the time of start and end of the contract.

At the same time there is a mysterious premium called cross-currency basis which Japanese borrower must pay to the lender, besides LIBOR rate at the time of entering into a currency swap.  What it basically means is that there is sustainable violation of the CIP condition! Theoretically, it should be eliminated by the efforts of US arbitrageurs who borrow in the money market, lend at LIBOR rates and receive the additional premium.

Of course, this premium could express the counterparty’s credit risk abroad or a shortage of dollars in the market, but in the first case there should have been a connection, for example, with Japanese CDS (insurance against default). With the growth of CDS, the premium was supposed to grow, but a steady relationship between them was observed until 2014, after which it disappeared. Probably, the arbitration activity of banks in the US decreased due to regulatory reforms, at the same time the Fed’s position in tightening the policy began to diverge from the course of excessive softening of the Bank of Japan, which led to an increase in the premium.

It turns out that the demand for Japanese bonds from foreign investors is formed precisely due to the attractive LIBOR rate, the currency cross basis premium and the ability of US lenders to enter into currency swaps, where there is no currency risk. Of course, the question arises about the need to invest yen proceeds from a currency swap into Japanese bonds which has negative yield. After all, an investor can just keep the yen until the end of the period and then exchange them back for dollars. However, the reason for buying bonds is probably the high cost of storing money, or the potential return on capital from the rise in the price of bonds against the background of bond-buying program by the Bank of Japan.

Thus, despite the negative nominal yield, Japanese bonds may have an even higher return than US Treasury bonds with almost the same level of risk.

Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.

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