Japan's $9 trillion bond market is on the verge of disruption as a shortage of paper, caused by the central bank's extensive buying, is expected to impact the settlement of derivatives used by investors and dealers who underwrite the nation's debt sales.
Decades of battling deflation have driven the Bank of Japan (BoJ) to engage in substantial asset purchases, making it the majority owner of the country's national debt. With a balance sheet larger than the $4 trillion economy and five times the size of the U.S. Federal Reserve's, relative to GDP, this has kept yields low and made the Japanese market unattractive to investors, rendering its bonds illiquid and unreliable as a benchmark for interest rates.
As the BoJ begins to reduce its balance sheet in an effort to normalize markets, the long-awaited revival of trading in the debt pool is proving to be a slow and challenging process. A significant test is looming in the futures market from December when 10-year contracts will be linked to the government bond #366 tranche, which is 95% owned by the BoJ.
Participants anticipate that the scarcity of this bond in the open market will interfere with the purchase of the so-called 'cheapest-to-deliver' bonds needed to settle derivatives contracts at maturity, which is crucial for the market to trade smoothly and price with precision. "The lack of the cheapest-to-deliver bonds makes it difficult for investors to hedge risks against rising rates," said Keisuke Tsuruta, senior fixed income strategist at Mitsubishi UFJ Morgan Stanley Securities. "This complicates overall trading."
Tsuruta noted that this issue will not only affect trade and speculation but also government bond auctions, as primary dealers who bid at these auctions primarily use futures to offset their exposure. With the BoJ on a rate hike path, investors are also seeking the cheapest bonds to settle short positions in futures, and distortions in the derivatives market could harm them.
A shortage of such bonds implies that "hedging with futures is not functioning," according to Masayuki Koguchi, executive chief fund manager at Mitsubishi UFJ Asset Management. The dysfunction in derivatives, particularly Japanese government bond (JGB) futures listed on the Osaka Stock Exchange, is a significant concern. Benchmark 10-year futures, which are contracts that run for three months, are used to speculate on future yield movements and are linked to an underlying cash bond.
These futures are the deepest part of the market and vital for participants, from hedge funds to corporations, who want to bet on interest rate movements or use the market to offset exposure. Unlike stock futures, sellers of JGB futures must physically deliver bonds at the end of a contract, rather than merely settling the difference in prices.
The rules allow sellers to deliver bonds with between seven and 11 years to maturity against 10-year JGB futures. Under the conversion factor used by the exchange, government bond #366 will become the cheapest-to-deliver in late December for contracts that mature in March. This tranche was the 10-year benchmark in 2022 when Japan's central bank was buying billions in bonds to defend a 0.25% yield cap against speculative short sellers.
The result is that the BoJ owns more than 95% of #366, leaving futures sellers scrambling to obtain it or opting for more expensive bonds to settle their deals. This situation echoes the distortion in JGB futures in June 2022, when a surprise BoJ intervention at the cheapest-to-deliver tenor caught dealers off guard. Futures collapsed along with bidding at JGB auctions, resulting in some of the poorest auction outcomes in over 30 years.
At that time, the BoJ relaxed rules to make it easier to borrow bonds. A similar move, or if the finance ministry reopened the tranche to sell more debt, would alleviate pressure on the market. However, it would also highlight its fragility. "This situation reflects the adverse effect of the BoJ's easy monetary policy," said Miki Den, a senior Japan rate strategist at SMBC Nikko Securities.
It is also likely to persist next year as subsequent tranches are also heavily owned by the BoJ. A bearish outlook for bonds is keeping large JGB traders out of the cash market, making it likely that normalcy will return to Japan's debt markets only over an extended timeframe. "They're essentially trying to unwind, let's call it the last decade, decade and a half or so of policy," said Norman Villamin, chief strategist at Union Bancaire Privée. "When you put it in the context of these decade-plus types of time horizons … normalization, which has been underway for about two years, is not particularly out of kilter with those timelines."
