May 2, 2017 9:00 am JST
Gordon French

Japan's search for yield is an opportunity for Asia

Hard-pressed investors need the returns that emerging bond markets can provide

A sign shows the yield on the 10-year Japanese government bond on April 19.

Japan is steering a course for new galaxies. If finance was science fiction, Japanese pension funds and insurance companies would be the inhabitants of a planet where the most precious commodity -- return on investment -- has all but disappeared. Now they must leave behind their familiar planet and search outer space for these elusive returns.

Japan is not alone in this respect: Investors from across Europe and other developed Asian economies face similar challenges. But this exodus from mature markets can bring exciting new opportunities for Japanese investors -- and to the Asian domestic bond markets I believe they will access -- helping emerging economies in the region to finance much-needed infrastructure.

Japan's investors are driven by the inexorable force of demographics, with the country's population expected to shrink from 127 million to about 83 million by 2100. A declining population, deflation and low growth suppress returns from the domestic economy, while the rising average age of Japan's citizens creates an ever-greater need for investment returns to fund retirement plans. Again, this problem is not unique to Japan, and is one of the reasons we can expect long-term interest rates to remain low.

The good news is that Japan has plenty of financial resources to put to work. The total assets of its pension funds and insurers, combined with the securities investments of its banks, amount to a colossal 1,123 trillion yen ($10.83 trillion), by some estimates.

For decades, much of this was invested in Japanese government bonds. Generating returns by doing that is much more challenging today: Purchases by the Bank of Japan have helped to drive some modest price gains, boosting existing portfolios, but yields are close to or below zero out to 10 years, and investors' new money also needs to generate returns.

When returns became harder to find in Japan, these investors turned first to government and investment grade bonds in mature, highly-rated markets such as those of the U.S. and Europe. Compared to Japan, these markets offered some incremental yield for a while. So far, so good.

But there was a snag. With most of the capital rushing out of Japan, the so-called dollar-yen basis (the cost of using yen to borrow dollars for investment) grew wider and wider, making it more expensive for Japanese investors to fund their portfolios. Then the yen started to strengthen, putting more pressure on returns from foreign investments.

Assailed on all sides by forces beyond their control, are Japanese investors doomed to failure in their mission to find returns overseas? They do not have to be. Let us consider the choices for these Japanese investors.

Corporate cousins

JGBs are unlikely to meet their return targets, for the reasons I have mentioned. Many observers expect two more rate hikes from the U.S. Federal Reserve this year, but that still only takes the target range for the Federal Funds rate to 1.25-1.50% -- which is nothing to get excited about. There is little prospect of European rates rising either. So the familiar, highly-rated markets will not generate much yield -- particularly when you factor in the dollar-yen basis and hedging costs.

The answer for Japanese investors may be to strike out into emerging markets bonds, much as their corporate cousins have done through mergers and acquisitions.

We are already seeing greater Japanese participation in U.S. dollar bond issuance from emerging markets in Asia, which offers diversification and sometimes a yield premium over the best quality U.S. and European bonds, and I believe this will continue. Japanese investors are also important participants in the international market for privately placed bonds, both in U.S. dollars and Japanese yen.

There are also attractive returns to be found in local currency bonds from China, India and members of the 10-country Association of Southeast Asian Nations. The dollar-yen basis is not a problem in these markets. In fact, Japanese investors can turn currency swaps to their advantage with bonds from places such as South Korea, Thailand and -- further afield -- South Africa and Mexico.

Some Japanese retail investors are already familiar with these currencies because of their experience with uridashi notes sold by Japanese issuers. However, institutional investors entering the offshore markets in scale will need to negotiate a degree of credit risk and illiquidity that will be unfamiliar to those accustomed to investing in Japan. Indonesia's domestic bond market is worth $152 billion; more than $10.6 trillion is invested in outstanding JGBs (although $3.8 trillion is locked away on the Bank of Japan's balance sheet).

So Japanese investors need the returns that emerging bond markets can provide. And emerging markets in Asia need deeper, more efficient bond markets to reduce reliance on bank lending, deepen capital markets to fund much-needed infrastructure investment and provide greater investment options for their own citizens.

There is a clear convergence of needs here, but the unfinished work of liberalizing and opening the region's bond markets is preventing more of Japan's capital from being deployed where it is needed around Asia.

Much progress has been made on this front, but the development, depth and liquidity of Asian local currency bond markets is still restricted by structural issues. With domestic asset management still in its infancy in many Asian markets, one of these issues is limited retail investment.

Savers often prefer to keep their money on deposit at banks, which means that local banks tend to be extremely liquid and happy to do the kind of large-scale, long-term lending that would be funded by the bond markets in many developed economies. There is also a wide variation between markets in terms of taxation of fixed income investments, regulations governing foreign exchange transactions (such as those concerning the convertibility of currencies), settlement cycles for trading bonds, documentation standards for new issuances and approaches to credit ratings.

All of these factors make entering these markets a real challenge for conservative Japanese institutions. But I believe that these investors will continue their exploration of brave new worlds in Asian emerging markets bonds in a disciplined and incremental way.

And it is to be hoped that policymakers around Asia will facilitate this by continuing reforms that make their bond markets more investable for foreign institutions. For markets across the region seeking long-term funding for growth projects, this is a golden opportunity.

Gordon French is Asia-Pacific Head of Global Banking and Markets for HSBC.

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