"The Widowmaker" shadow reappears! Japanese bond yields break 21st-century record

Source: JIN10 Data

Japanese government bonds are experiencing a continuous sell-off. Driven by rising interest rates, massive fiscal stimulus, and concerns about inflation, the yield on 10-year JGBs has surpassed 2.5% for the first time this century.

Since the beginning of last year, the yield on 10-year Japanese government bonds has risen by 1.6 percentage points, making Japan the worst-performing major bond market in the world over the same period. Rising yields mean bond prices are continuously falling.

Higher yields are beginning to attract some international investors, but risks associated with elevated energy prices and government spending plans are keeping many asset management firms cautious.

Allianz Investment Senior Portfolio Manager Ranjiv Mann said, “We have been dipping our toes into long-term Japanese government bonds, (but) our buying size is quite small.” The institution recently purchased a small amount of 20-year JGBs.

Mann stated that before increasing his bet, he hopes to see more evidence, such as a more hawkish policy signal from the Bank of Japan. For many investors, Japanese government bonds may still become the modern version of the “widow-maker” trade. Note: The “widow-maker” trade refers mainly to a high-risk short-selling strategy in financial markets, particularly shorting Japanese government bonds. Short sellers have repeatedly suffered huge losses due to being caught out by the market, leading to the term as many traders have lost everything, hence the name.

The shadow of the “widow-maker” remains

For a long time, Japanese government bonds have been a difficult market for foreign investors to navigate. Hedge funds and other traders have repeatedly shorted JGBs, betting on rising yields. However, Japan’s previous negative interest rate environment, along with years of yield curve control around 0% by the Bank of Japan, have thwarted these trades time and again.

Such operations have led investors to suffer huge losses. Now, some fund managers fear that the exact opposite long trades could be similarly dangerous.

If the market believes that the $2 trillion long-term spending plan proposed by Japanese Prime Minister Sanae Takaichi will fuel inflation, and the Bank of Japan is slow to respond with rate hikes, the funds flowing into JGBs could be swallowed by a new wave of sell-offs.

Insight Investment’s Head of Fixed Income, April LaRusse, said, “I believe that since Japan has been synonymous with the ‘widow-maker’ trade for the past thirty years, no one wants to be the first to test the waters.”

After the Japanese Minister of Finance called on domestic pension funds and the public to increase local investment, Japanese government bonds have rebounded in recent weeks. The current market focus is on whether the $1.8 trillion Government Pension Investment Fund (GPIF) will increase its allocation to Japanese assets.

LaRusse noted that Insight is considering buying JGBs but is still waiting for clear indications of a return of domestic investors’ funds. The Government Pension Investment Fund is one of the largest retirement savings pools in the world.

Mizuho Bank Fixed Income Strategist Jordan Rochester said, “When GPIF acts, you should act as well.” He added, “Ignoring this would be a fatal flaw in your investment strategy.”

GPIF allocation and fiscal outlook become key variables

Although the Government Pension Investment Fund is unlikely to adjust its long-term asset allocation before its scheduled 2030 review, analysts pointed out that the fund may still use its day-to-day operational flexibility to purchase large amounts of domestic assets.

If GPIF increases its allocation to domestic bonds to the 31% upper limit, Royal Bank of Canada Capital Markets Asia Macro Strategist Abbas Keshvani calculates that, without considering the effect of “smaller asset managers following the fund’s cue,” the market would see an inflow of 12 trillion yen ($75 billion) in additional funds.

Fidelity Portfolio Manager Terrence Pang said, “Historically, GPIF has operated quite independently.” The fund’s investment principles clearly state that it “will never use reserve assets to influence the stock market or implement economic policy.”

Recent bond auctions have also shown signs of a recovery in demand. Mizuho Bank Senior Strategist Masayuki Nakajima stated that the 30-year and 20-year bond auctions held earlier this month “performed strong enough that many market participants interpreted it as evidence of growing interest from large, traditional real-money investors, including overseas accounts.”

Kevin Thozet, a member of the Carmignac Investment Committee, noted that his institution has been buying long-term JGBs in recent weeks, “but the positions are not large.” He pointed out that volatility in oil prices and domestic policies such as tax cuts create uncertainty for Japan’s fiscal outlook.

Thozet said he would like to see “the Japanese government show more restraint in spending” before increasing his wagers. Energy prices and fiscal spending plans remain important variables for investors in Japanese government bonds.

Other large international fund managers continue to underweight JGBs relative to benchmarks. They believe that uncertainties over government fiscal policy and whether the Bank of Japan can set policy independently of the government could keep yields elevated.

Some investors are also concerned that rising borrowing costs will add pressure to Japan’s massive debt stockpile. Currently, Japan’s debt stands at around 200% of GDP. The Bank of Japan is still buying bonds, but the pace of purchases has slowed compared to before.

DoubleLine Capital Global Bond Portfolio Manager Bill Campbell said he’s not willing to “stand in the way” of a JGB sell-off by buying. He added, “Unless there are more fundamental changes to seriously address the long-term debt-to-GDP ratio and fiscal concerns, it will be very difficult to get involved.”