Japanese investors are turning to creative trades using interest-rate swaps to try and squeeze some yield from a volatile global bond market.
(Bloomberg) — Japanese investors are turning to creative trades using interest-rate swaps to try and squeeze some yield from a volatile global bond market.
One such maneuver that’s gaining popularity seeks to lock in the yield premium longer-dated Treasuries have over equivalent swaps, by essentially going long the former and short the latter. Investors buy Treasuries and use the income from the bond to pay the fixed-rate leg of an interest-rate swap and pocket the difference.
The strategy limits the potential for losses on the underlying bonds, though at a cost of also restricting capital gains. Thirty-year Treasuries yielded around 3.66% on Wednesday, about 70 basis points higher than equivalent swap rates.
Last year’s epic bond rout came with a silver lining for many global debt investors as it boosted yields worldwide to multi-decade highs. But Japan’s money managers are still constrained by low rates at home and face return-crippling costs to hedge direct positions in some of their traditional foreign bond investments, like Treasuries.
“The low-yield environment both globally and in Japan meant investors had to get carry, they had to enhance yields” over the past few years, said Naokazu Koshimizu, senior rates strategist at Nomura Securities Co. in Tokyo. “Now we see Japanese investors are flowing into the asset-swap space to get carry, because there’s a difference — a lot of difference — between Treasury cash yields and swap rates.”
The search for new ways of earning extra interest has come about following the more than a decade-long accommodative policy adopted by the Bank of Japan under former Governor Haruhiko Kuroda, who stepped down this month.
In addition to capping Japan’s benchmark 10-year yields at first 0.25% and then 0.5%, the BOJ’s yield-curve-control policy also pushed up the cost for local investors to hedge any investments in US dollars due to its negative ramifications on the yen.
The impact of the BOJ’s super-easy policy on Japanese investors wasn’t that pronounced before last year as global bond yields were falling due to almost unanimously dovish central banks. But the pivot to tightening by virtually all policymakers except the BOJ saw the divide between yields inside and outside Japan become a gulf.
The trade works best for 20- and 30-year Treasuries because they offer yields that are significantly higher than similar-maturity swap rates, whereas the premium shrinks at the shorter end of the curve.
Japanese investors, the largest foreign holders of Treasuries, have other options to beef up their income — albeit ones that carry higher risks.
Funds boosted holdings of US government bonds in the first quarter as yields climbed, but also channeled a significant proportion of their investments into mortgage-backed securities. These offer higher yields than Treasuries but have greater risk, especially given expectations for a US recession later this year.
And those choosing higher yielding longer-dated bonds at home face the threat of the BOJ tightening policy and pushing up yields. The central bank will announce its next policy decision on Friday, the first under the charge of Governor Kazuo Ueda.
“Some may argue for buying Japanese 20-year bonds that offer a yield of more than 1%, but that exposes investors to risks” such as capital losses when yields rise, said Kenta Inoue, a senior fixed-income strategist at Mitsubishi UFJ Morgan Stanley Securities Co. in Tokyo. “Dollar asset swaps, meanwhile, give investors carry while reducing such risks.”
–With assistance from Yumi Teso and Aline Oyamada.
(Adds reference to next BOJ decision in second-to-last paragraph, updates prices.)
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