IN FOCUS6-8 min read

Yields are back – but what does this mean for investing in Japanese government bonds?

After years of yield scarcity in the Japanese government bond (JGB) landscape, things are looking up. We consider what this means for Japanese asset owners.

25/07/2023
Japanese government bonds

Authors

Keith Yu
Investment Director, Multi-Asset, Hong Kong Multi-Asset Product

The bond landscape has been akin to a zen garden in recent times. These Japanese rock gardens are often made of gravel, sand, minimal plants, and no water, and offer very low yields.

But times are changing, as we discussed in our recent regime shift article about how the end of the zero-interest rate environment would affect strategic asset allocations.

So, for Japanese asset owners, will higher Japan government bond yields provide a more attractive return and risk profile?

Looking back over the past 20 years, Japanese 10-year government bonds (JGBs) had provided a positive nominal yield prior to the implementation of yield curve control in the start of 2016. Yield curve control (YCC) was initiated in September 2016 to control the shape of longer-dated yields by suppressing short-term rates and keeping the JGB 10-year bond target yield at 0%. The launch of YCC was a tool used in the first arrow of Abenomics, named after the late former prime minister Shinzo Abe, to try and break the deflationary cycle of the previous two decades.

Japanese government bonds

With the short and medium end of the yield curve being controlled by the YCC policy, the result was a period of low-to-negative nominal and real yields. This left Japanese investors looking abroad for additional sources of more attractive yields.

As of 31 March 2023, the real yield of a 10-year JGB was -0.298% while the nominal yield was 0.324% (source: Refinitiv, Japan 10-year inflation linked benchmark real yield-compound method).

Table of Japan forecasts

In regards to the return of inflation, its path and pace in Japan over the coming months will provide insight as to the setting of further monetary policy. Low or negative inflation has been persistent historically and under the 2% inflation target set by the BoJ. This has been a driver in keeping rates interest rates low.

When taking into consideration a shrinking demographic (from 2022 to 2060 the population is expected to decline by more than 25%), the level of inflation which historically in Japan has been under the target rate may continue with a low overall birthrate (in 2022 yearly births fell below 800k for the first time since 1899). However, in the near term, the inflation rate in Japan has risen (as of April 2023 the annual inflation rate in Japan is 3.5% vs 2.5% in April 2022). 

Japanese government bonds

What about yield curve control (YCC)?

Whilst BoJ Governor Kazuo Ueda has been provided room to further reduce yield curve control policies, we think the path towards normalisation will take time. With a lifting of the control cap from 0.25% to 0.5% in December 2022 for 10-year JGBs, the BoJ provided an opening to continue with further loosening. However, the BoJ expects inflation to remain close to its 2% target with “the year-on-year rate of change projected to be at around 2.5 percent for fiscal 2023 and would likely undershoot again in 2024 and 2025,” according to the Bank of Japan April 2023 outlook.

Japan’s post-pandemic recovery continues as Covid-19 restrictions unwind. While the global backdrop is set to be less supportive, domestic demand should more than offset this, underpinned by wage growth and the drawdown of excess savings.

Alongside this, the re-opening of the tourism industry ought to benefit from a combination of yen weakness and the dropping of China’s zero-Covid policy.

These factors may place strain on the labour-intensive services sector, as it has in other advanced economies, causing wages and inflation to rise in tandem. In response, the Bo J could start to normalise policy as many of its peers have done in recent years.

With higher yields in JGBs domestically, should Japanese investors increase the allocation to JGBs to reduce currency risk while yields become more attractive?

To address this question, we look at some possible scenarios and impacts.

Scenario 1: Assuming an increase in nominal yields from the removal of YCC with a higher inflation environment, real yields may possibly remain flattish or remain negative. In such a scenario, developed market economies further along in the tightening cycle may begin to drop interest rates, leading to more attractive opportunities offshore to Japan.

Scenario 2: Assuming an increase in nominal yields from the removal of YCC, a low inflation/deflationary environment real yields can lead to a more attractive environment for investment into JGBs. This is an ideal “goldilocks” scenario that would benefit JGBs whereby yields increase and become a more attractive investment for the Japanese investor. In such a scenario, an increase in yields would be beneficial to new buyers, and those investors that hold JGBs may find an unrealised loss on their books. This leads us to a third scenario.

Scenario 3: Removal of YCC without further government support in an interest rate hiking environment could significantly increase volatility on JGB prices. Looking at the recent regional banking sector risk events such as the SVB collapse in the US, the impact of government bond yields without support can lead to unintended consequences on the book value of existing JGB bond holders. In contrast, much of that price discovery in developed market government bonds would have been priced in relatively as per developed markets’ monetary policy normalisation.

Scenario 4: The BoJ, which holds over half of the total issuance (1,065.6 trillion yen) of JGBs (as of Sep 2022, prelim), would take a slow and methodical approach to the easing of YCC. This would be to maintain stability for holders of JGBs and limit the impact of devaluation on holders such as Japanese pensions, insurance, and banks other than the BoJ. Fun fact: foreigners only held 7% of JGBs for the same period. We think this would be a more likely scenario, drawing out the length of time it takes to provide an orderly and controlled removal of YCC.

Conclusion

Much has been written on the topic of Japan’s super-easy monetary policy and 2% inflation target looking at linkages between household consumption, wage growth, and demographics. This is while factors such as wage growth are beginning to change, household consumption and structural issues with demographics persist.

Other developed and emerging market economies tackling higher inflation are ahead of the cycle relative to Japan therefore should provide more attractive yield opportunities and diversification benefits. Taking advantage of dynamic asset allocation to invest into asset classes and sectors to manage macroeconomic risks can continue to provide a stable and diversified source of return generation in all four scenarios above.

Additionally, should inflation become under control in the US and Europe this year, the possibility of easing US and EU interest rates towards the end of 2023/2024, can ease the cost of currency hedges, providing for more attractive opportunities towards higher yields abroad.

Whether looking at the current environment or at the past, the one thing in common is change. The size and pace of change that we have seen over the past year has generated both market opportunities (such as Japan equities year to date) and risks that can result in asset owners needing to review their allocations more often.

For managing portfolio risks and returns in what could be a more volatile requirement, what is required is fundamental research, an understanding of the behaviour of various assets through different economic cycles, and a dynamic allocation.

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Authors

Keith Yu
Investment Director, Multi-Asset, Hong Kong Multi-Asset Product

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