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Dollar Crunch Boosts Yen Debt Demand as S&P Warns: Japan Credit
Perspective | 01 December 2011

Currency-swap spreads are offering the biggest discount on yen loans in at least 14 years, supporting demand for Japan’s bonds even as Standard & Poor’s and the International Monetary Fund warn of its debt load.

The interest rate on a two-year basis swap to exchange dollars for yen has fallen to 0.85 percentage point below the three-month London interbank offered rate for Japan’s currency, the lowest since at least June 1997, Bloomberg data show. Japan’s two-year debt, which has the second-lowest yields among developed markets, offers higher rates than equivalents in the US, UK and Germany for investors who use the swaps.

Yen funding has become relatively cheaper as concern about the outlook for the euro union spurred a rush for dollars, driving Libor in the US currency to 0.51%, the most since July 2010. Demand for a haven prompted overseas investors to buy the Asian nation’s debt at the fastest pace in four years. Even so, mounting fiscal strains prompted the IMF and S&P to say Japan’s borrowing costs may surge.

“The negative yen basis swaps allow dollar holders to get yen funding cheaply,” said Makoto Noji, a senior debt and currency strategist in Tokyo at SMBC Nikko Securities Inc., a unit of Japan’s second-biggest banking group by market value. “Investors holding dollars can use the basis swaps to buy yen assets, such as two-year government bonds.”

Bond Demand
Rising demand for the nation’s bonds has helped Japanese policy makers close deficits without tackling the world’s biggest debt load. Prime Minister Yoshihiko Noda hasn’t given a detailed timetable for a planned sales-tax increase and he’s failed to explain how he’ll curb swelling expenditure for social security.

Yields on 10-year bonds in Japan, where public borrowings are twice the size of the economy, climbed three basis points to 0.995% on 23 November, the second lowest globally. The 10-year rate was at 0.87% in Switzerland, where the ratio of debt to gross domestic product is 38%.

Japan’s 0.13% yields on two-year notes rise to 0.78% after subtracting three-month yen Libor and negative basis swaps. The rate is higher than 0.26% in the US, 0.44% in Germany and 0.47% in the UK, assuming the interbank rate doesn’t increase before the notes are repaid.

Overseas investors increased holdings of yen-denominated debt by 17 trillion yen (US$220 billion) this year through October. Net purchases are poised for the biggest annual increase since 2007, according to data from the Ministry of Finance. The pace of purchases is almost the equivalent of Singapore’s annual economic output.

European Crisis
The yen has outperformed all of its 16 major peers this year as the spread of Europe’s sovereign-debt crisis to larger economies spurred demand for haven assets. France risks losing its top credit rating in the event of further economic shocks, Fitch Ratings said on 23 November. The same day, Germany’s 10-year debt slumped the most since 1990 after the nation failed to get bids for 35% of the securities that it offered for sale.

Three-month yen Libor advanced to 0.198% on 18 November, the highest since April. Twelve of the 16 banks that contribute to the rate’s fixing are non-Japanese companies, with WestLB AG in Germany offering the highest rate of 0.25%, followed by Societe Generale SA’s 0.23%, according to data compiled by the British Bankers’ Association.

Two-year yen interest-rate swaps, a fixed payment made to receive Libor, closed at 0.406% on 23 November, 28 basis points more than the yield on similar-maturity government bonds, set for the most in a year on a closing basis. The so-called swap spread has widened amid concern losses on European debt will impair the fiscal health of banks acting as counterparties in the deals.

Swap Spreads
“People are talking about widening swap spreads caused by rising interbank rates,” said Katsutoshi Inadome, a fixed- income strategist in Tokyo at Mitsubishi UFJ Morgan Stanley Securities Co. “There’s concern about the financial system overall.”

Elsewhere in Japan’s credit market, Daiwa Securities Group Inc. topped Mizuho Financial Group Inc. as the biggest manager of Samurai bond sales. Daiwa, Japan’s second-largest securities company, arranged 20.2% of the 2.07 trillion-yen sales of the notes in the country this year, according to data compiled by Bloomberg. Mizuho had a share of 18.8%.

The extra yield investors demand to hold Japanese corporate debt instead of government bonds was 47 basis points on 23 November, compared with 266 basis points globally, according to indexes compiled by Merrill Lynch.

Pension Spending
Expenditure for social security makes up of the biggest portion of Japan’s 92.4 trillion-yen budget for the fiscal year ending 31 March, accounting for 31% of the total. A quarter of Japan’s population is over 65 years old, making it the most rapidly aging nation in the world, data compiled by Bloomberg show.

Japan’s pension system is “failing,” said Ayako Sera, a market strategist in Tokyo at Sumitomo Trust & Banking Co., which manages the equivalent of US$298 billion. “Voters say no to policies that effectively reduce their disposable income.”

Noda backs former Prime Minister Naoto Kan’s proposal to raise the 5% consumption tax by the end of the decade to cope with Japan’s debt burden. He said in a speech last month that the nation “cannot continue to indefinitely postpone a response” to its debt issue.

The IMF said in a report on 23 November that concerns about Japan’s fiscal sustainability may result in a “sudden spike” in bond yields.

Downgrade Closer
Takahira Ogawa, Singapore-based director of sovereign ratings at S&P, said that Japan’s finances are “getting worse and worse.” S&P rates Japan at AA- and has had a negative outlook on the rating since April.

Ogawa said that it “may be right in saying that we’re closer to a downgrade. But the deterioration has been gradual so far, and it’s not like we’re going to move today.”

Five-year credit-default swaps on Japanese government bonds were 127.5 basis points on 23 November, CMA prices in New York show, almost the same level as those for the Netherlands, where 10- year yields are more than twice as high as Japan’s.

“The country’s bond market isn’t working as an alarm that should say ‘Japan’s finances aren’t sustainable’,” said Sumitomo Trust’s Sera.

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