Bond ladders a hit with Japan investors seeking higher returns

Tue Aug 5, 2014 3:01am EDT

* Bond ladders spiced with foreign sovereigns prove a hit

* Regional banks take to simple structure of the funds

* Low JGB yields, slack lending drive foreign bond demand

By Shinichi Saoshiro

TOKYO, Aug 5 (Reuters) - Japanese fund managers spiced up a simple investment product known as bond ladders with high-grade foreign sovereign debt and created an instant hit with domestic banks and credit unions.

Confronted with low interest rates and sluggish lending at home, these investors were eager to look beyond traditional investments in low-yielding Japanese Government Bonds (JGBs).

The popularity of bond ladder funds highlights the struggle of regional banks to earn income with domestic yields driven to rock bottom levels by the Bank of Japan's easy monetary policy.

Bond ladder funds invest in debt with maturity dates that are spaced out over a number of years. When bonds with the shortest maturities mature, the funds are rolled over into the longest maturities in the portfolio. Bond ladders are designed to diversify risk arising from interest rate fluctuations.

The key behind the bond ladder funds' popularity is their simplicity and all-in-one packaging welcomed by regional banks and credit unions that often do not have the resources available to their larger peers.

"Many regional banks ceased to become active foreign bond investors after the Lehman crisis. And even if they wanted to invest, some only have an extremely limited number of staff available for the task as their internal resources have been shrinking," said Koji Ezura, head of the institutional sales department at Nikko Asset Management.

"So they became interested in funds that are very simple and managed by others. There are no derivatives involved and decision making is not required. This was a very big factor."

Nomura Securities, which led the way by launching bond ladder funds in June 2012, has seen investment by regional financial institutions top 500 billion yen ($4.87 billion) as of end-June. It said about two-thirds are in foreign sovereign bonds from the United States, Germany, France and Britain.

"Private placements attracting 500 billion yen in two years - that is a pace we have never seen before," said Toshiyuki Ochiai, deputy managing director at Nomura Securities' fixed income marketing department.

Pressed to follow suit, Nikko Asset Management offers Belgian government bonds in addition to Treasuries, Bunds, Gilts and French government debt in their bond ladder funds. It has drawn several dozen billion yen in investment from regional institutions since launching foreign bond ladders last year.

SUPER LOOSE POLICY SPURS DEMAND

Asset managers estimate that bond ladders as a whole have attracted roughly one trillion yen in investments.

Demand for foreign bond ladders increased rapidly after the BOJ launched its super loose monetary policy in April 2013 to combat deflation and kick start the economy, depressing domestic bond yields and credit spreads.

The benchmark 10-year JGB yield has drifted down to a low 0.5 percent under this policy. A U.S. Treasury note of the same maturity yields more than 2.5 percent.

Many Japanese regional banks have been struggling to find new creditworthy borrowers in their own turf as many regions bear the brunt of the country's declining population.

Indeed, Japan's financial watchdog has been putting pressure on banks to consolidate due to concerns they may not be able to survive as the population in some prefectures could drop up to 25 percent in the next two decades. In Tokyo, the population is expected to fall only about five percent in the same period.

"Lending might have recovered a bit but the situation remains very tough for banks, as seen by their low loan-deposit ratios. They are thus looking at foreign bonds. It's easy to see this as a theme dominated by the BOJ's monetary policy, but it is also a macro story of a country with a dwindling population," said Ezura at Nikko Asset Management.

Loan-deposit ratios have fallen significantly over the years as banks have kept attracting more deposits from savers while loans stagnate.

"There are two factors behind demand for bond ladders, first being expectations of ongoing ultra-low interests rates and continued investment demand from the banks as they struggle to find lending opportunities," said Katsuhiko Nagasaka, deputy managing director, regional financial institutional and public sector clients consulting department's retail division at Nomura Securities.

"Second, if the BOJ succeeds in achieving its 2 percent inflation target, concerns over rising domestic yields will make it easier for regional banks to shift away from their traditional focus on JGBs and raise the weighting of foreign bonds in their portfolios," he said.

As simply designed as bond ladder funds are, they are not without potential risks.

Asset managers say profit taking by investors enticed by low yields, already taking place with euro zone sovereign bond rates such as those of Bunds recently hitting record troughs, could disrupt the stability of the funds.

There could also be other reasons to sell the funds, such as investors offloading their foreign bond holdings to offset any losses suffered in the widely-held JGBs.

Still, demand for foreign debt as a whole looks likely to remain strong.

"When we visited regional institutions a few months back, they appeared full on bond ladders but were eager for a different kind of product that is safer and offers yield," said Shogo Yoneyama, head of the marketing planning department at Daiwa Asset Management.

Ezura at Nikko Asset Management concurred.

"We get requests from regional investors who want tailor-made products investing in bonds from developed economies and Antipodean countries," he said.

($1 = 102.5900 Japanese yen) (Additional reporting by Hideyuki Sano; Editing by Jacqueline Wong)