January 27, 2012 / 7:05 AM / 8 years ago

Japan CDS show bonds not pricing in fiscal risk

* JGB yields set to stay low for at least few more years

* Banks committed as long as BOJ keeps ultra-easy stance

* Foreign ownership unlikely to rise enough to shake mkt

By Chikako Mogi

TOKYO, Jan 27 (Reuters) - Japan’s fiscal risks are not as low as government bond yields seem to imply, but for now Tokyo has no shortage of buyers even as its large debt pile increases, meaning the disconnect with market pricing of sovereign credit default swaps will persist.

The low JGB yields reflect the Bank of Japan holding rates near zero and keeping liquidity flush, domestic banks needing to invest an excess of domestic savings and Tokyo’s massive current account surplus.

The higher credit default swap rates are a measure of the greater foreign participation in the CDS market, concerns about the lack of political resolve to control public debt, and wider jitters about sovereign debt triggered by the euro zone crisis.

“The gap between JGB yields and CDS reflects the difference in how Japanese and foreigners view the time horizon for when Japan’s debt financing becomes unsustainable,” said Naohiko Baba, chief Japan economist at Goldman Sachs.

“Given that the JGB market will remain well bid, such bets will prove to be unproductive at least for the next three years or so.”

The 5-year Japan CDS is trading at around 130 basis points, compared with a 0.35 percent yield on the 5-year JGB.

In contrast, in Italy and the United States, CDS trade below the comparative five-year government security.

Japan’s debt burden is about twice the size of gross domestic product and the worst among industrial nations — well above comparative levels of around 100 percent for the United States and 130 percent for Italy.

“The BOJ’s intention to maintain low interest rates for a prolonged period of time is strongly reflected in current JGB yields, overshadowing the fiscal risk premium that should be priced in,” said Takeo Okuhara, a fund manager at Daiwa SB Investments in Tokyo.

“Japan is only escaping the fiscal risk premium under the current circumstances, thanks to a lower probability of it materialising relative to others,” he said.

Japanese banks are providing the most reliable backstop for containing yields. Goldman Sachs calculates that banks’ net purchases of over 1 trillion yen on a six-month rolling average since 2009 have capped 10-year yields at 1.5 percent.

Very low interest rates and a massive current account surplus also help Tokyo to weather heightening global scrutiny over sovereign refinancing ability.


There is a possibility that foreign speculators might be rewarded for betting on a wide CDS-JGB spread, but rather than one-off events it will likely be a gradual shift as longer-term risks become apparent.

Japan ran its first trade deficit in more than 30 years in 2011, although the returns on the country’s huge portfolio of investments abroad will keep the balance of payments in surplus.

A key gauge for turning bearish on JGBs would be a narrowing gap between banks’ deposits and lending, which would lower bank demand for debt, as the population ages and falls.

Okuhara at Daiwa SB Investments said Japan would face a peak in pension payouts in 2013-2016, pressuring another key buyer to sell JGBs if needed to raise funds.

“There is risk that the ability of the market to absorb JGBs will weaken if the key player on the demand side, pension funds, turns sellers,” Okuhara said.

Overseas investors must sharply boost their bill buying or extend duration into longer-dated JGBs in order to have a material impact to shake the market, Goldman’s Baba said.

Foreign ownership of JGBs, mostly held in treasury bills, has risen to 8 percent. The share of short-term bills held by foreigners had doubled in the past 10 years to just below 20 percent. In comparison, foreign ownership of Italy’s debt was about 60 percent recently.

Until that balance changes in Japan, foreign concerns will remain a secondary issue in government debt pricing.

“When banks’ appetite is strong, the probability of a CDS event risk is low,” said Tomohiko Katsu, deputy general manager of the asset liability management division at Shinsei Bank.

“The gap between CDS and JGB yields reflects a view from overseas that JGB yields are too low and not discounting the fiscal risk, but the levels are ‘correct’ in that it represents the view of the dominant market players, namely banks,” he said.

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