Foreigners abandon JGBs, market sell-off risk rises

TOKYO (Reuters) - Many overseas hedge funds and banks have abandoned the Japanese government bond market as the credit crisis forces them to shrink their balance sheets and give up what had been a favorite playground for leveraged trades.

The retreat of foreign players has left the JGB market short of a crucial source of intraday liquidity, stoking worries among bond dealers that the market could be more prone to volatile sell-offs that could send yields soaring.

Along with the United States, Japan has one of the world's biggest government bond markets.

Data from the Ministry of Finance showed foreign investors were net sellers for 10 straight months through June totaling 8.84 trillion yen ($95 billion).

The U.S. government's stress tests of major banks probably accelerated the deleveraging of hedge funds and U.S. investment banks, prompting them to shed JGBs to secure cash in a process that has played out since the collapse of Lehman Brothers in September, analysts and traders said.

The demise of Lehman Brothers caused the JGB repurchase market -- in which investors and dealers lend out their bond holdings in return for short-term cash loans -- to seize up. That left investors stuck without cash when they needed it most and caused JGBs and some securities, such as inflation-linked bonds, to plunge in price.

At times during the worst of the crisis last October, JGBs tumbled along with the Nikkei share average in the scramble to sell bonds for cash even as investors were rushing into other countries' safe-haven government bonds.

"That scared away other players who had been doing leveraged trades in the market," said a senior bond trader at a Japanese bank.

Japanese domestic investors like banks, life insurers and pension funds held 74 percent of outstanding JGBs in September, according to an MOF paper. The proportion of foreigners was 7.9 percent and is expected to have decreased since then.

The latest MOF data showing weekly capital flows indicated that JGB selling by foreign hedge funds may have finally abated after peaking last October when foreign investors net sold a massive and a record 2.66 trillion yen of Japan bonds for that month alone.

Open interest in JGB futures tells a similar story.

After withering to an end-March low of just 39,676 contracts -- the lowest in more than six years -- it edged back up to 67,470 by end June, but remains less than half the peak levels reached in 2006 and 2007. Foreign players such as model funds tend to dominate trade in futures.

Foreign banks and hedge funds had ramped up trading in JGBs and fixed-income derivatives after the Bank of Japan ended its first quantitative easing in March 2006, with the appeal of JGBs rising along with the prospect of higher yields.

They were looking for big profits by taking positions betting that spreads between the prices of cash bonds, futures and interest-rate swaps rates would converge, traders said.

A "box trade" was one of the most popular and was a way of betting that the JGB yield and swap curve would steepen as the economy recovered and inflation would return.

The box trade involved a bet that swap spreads -- the spread between swap rates and comparable JGB yields -- would widen in the 20-year sector and would narrow in the seven-year sector.

It became a fad among hedge funds but quickly soured after the collapse of U.S. investment bank Bear Stearns in March 2008. Reports said one London-based $3 billion dollar hedge fund, Endeavour Capital, lost a quarter of its value in a day due to box trade losses.

(For a graphic on JGB trade and open interest, see:

here)

MEMORY OF 2003

Market experts who had direct contacts with hedge funds said many of their colleagues or clients with leveraged trades were gone from the JGB market, leaving only a handful of funds which have different investment styles.

Those hedge funds who took positions across yen fixed-income markets provided market liquidity to JGBs because they were able to offer prices through a variety of models to value bonds from Japanese counterparts.

So now domestic JGB investors or traders would have more difficulty finding prices or trading counterparties -- all of which makes the market more at risk of turning volatile, especially in a sell-off.

"The flows will skew to one side with domestic investors, because they tend to act in a same way and share a similar investment outlook. That would increase a risk of an abrupt or sharp price movements," said Tatsuo Ichikawa, chief strategist for RBS Securities Japan.

"Foreign trading in JGBs has declined to about 10 percent of all transactions from 30 percent, making the market look similar to 2002-2003 when only few hedge funds were participating," Ichikawa said.

In 2003, the 10-year JGB yield surged 124.5 basis points in four months after it fell to an historic low of 0.430 percent, one of the worst plunges in the market's history.

(Editing by Eric Burroughs)