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The Japanese bond market has suffered one of its worst weeks in years. An auction on Japan’s 20-year government bond saw its bid-to-cover ratio, a measure of demand, sink to levels last seen in 2012, while the auction’s tail, the gap between average and lowest-accepted prices, widened to the longest since 1987, in another sign of a dearth of buyers.
The shocking weakness in demand for Japanese government bonds, traditionally seen as a safe and reliable asset, has sparked investor unease over the wider state of Japan’s financial markets, and the health of bond markets globally.
“There’s a lot of focus on this – I’ve had more questions than I’ve ever been asked on Japan rates,” said Stephen Spratt, Asia rates strategist at Societe Generale, adding that even clients with no exposure to the bonds were calling him up. “They see it moving a lot and they want to know what’s happening. It’s definitely grabbed everyone’s attention.”
The slump in demand has sent bond yields, which move inversely to prices, rocketing to levels not seen in decades. The 20-year yield hit its highest level since 2000, while the 30-year rose to its highest since 1999 and the 40-year hit an all-time high, as investors demanded greater returns for holding government debt, pushing up the cost of borrowing.
The moves are thought to have been caused by a slowdown in bond purchases by large banks and life insurers, the most common bondholders, some of whom have now turned to become sellers. The trend has coincided with an unusually high spate of long-dated bond auctions over the past four weeks, which has made it even harder to find buyers.
Investor uncertainty has intensified ahead of the Bank of Japan’s upcoming review into its quantitative tightening programme, where it will make a call about the pace at which it buys government bonds. Investors have been canvassed by the Bank on its next steps – but responses have varied wildly, stirring up uncertainty over the Bank’s strategic direction.
“When you put in a date like that, it inevitably leads to speculation in the market,” Spratt said.
While bond yields have been rising globally, none have jumped quite as much, and in such a short period, as those in Japan. But contagion effects in other markets are likely to be muted. This is in part because foreign investors account for only a small share of Japan’s long-dated bond holders, while the use of interest rate swaps will have cushioned the blow of bond losses.
Mini-budget reminder
It’s not too long ago that the UK’s gilt market was caught up in a storm of its own following the so-called Liz Truss mini budget in 2022 – turbulence which pushed some pension funds to the brink thanks to their comparatively high exposure to long-term bonds, forcing the Bank of England to intervene. But Japan is unlikely to suffer similar problems.
“During that period what was exposed in the UK was the use of leverage by pension funds – but in Japan the leverage use is much lower and the ratio of cash deposits to total assets is relatively high to what we would see in the UK, so the risk of liquidity problems or of leveraged unwinds or losses is much lower,” Spratt said.
Japan’s government bonds pared back some of the previous week’s losses when markets reopened on Monday, raising hopes that the debt instruments would escape a full-blown crisis.
In a worst case scenario, a further sell-off in bonds could threaten the government’s ability to refinance its debt, forcing the Bank of Japan to step in.
While it has built a reputation for being hands-off since the coronavirus pandemic, Japan’s central bank has always reserved the right to make a major intervention in the market should conditions deteriorate, Spratt said, adding that the Bank of England’s previous moves could offer a useful blueprint.
“While liquidity has been worse, markets have still been functioning fairly well, so if we do hit that criteria for what they would consider abnormal bond moves then they would step in, but we think that’s some way off,” he said.
All eyes now turn to the next meeting of the Bank of Japan in June, where investors await the Bank’s next move.