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Capital Markets

North Korea prompts silent retreat from junk bonds

Investors also wary of impending Fed tightening

TOKYO -- The threats arising from Pyongyang's provocations and the U.S. central bank's looming decision to shrink asset holdings are quietly sapping the appetite to invest in junk bonds, a trend that could ensnare Japanese equities.

Signs of the shifting tides appeared Aug. 8, a day before North Korea revealed it was "examining" a missile strike in the waters surrounding the U.S. territory of Guam. Yield spreads widened sharply for contingent convertible, or CoCo, bonds issued by European banks and other risky debt. The spread relative to government bonds with comparable maturities represents the instrument's risk premium.

"Stock prices will likely slump tomorrow," Tetsuro Ii, president of Commons Asset Management, predicted at the time.

CoCos are one type of debt that financial institutions are empowered to employ to shore up finances under international capital requirements set by Basel III rules. Holders of these bonds enjoy outsized returns in exchange for being low on the totem pole as creditors.

Investors seeking to improve portfolio performance have flocked to CoCos for the past few years. But those bonds are often the first to be jettisoned whenever a crisis approaches.

The American high-yield debt market also has seen values tank recently, suggesting the problem is not limited to European banks. The timing indicates "it has become a real possibility that the Federal Reserve Board will shrink its balance sheet, and allocations of low-graded bonds and other high-risk assets are starting to be adjusted," said Mana Nakazora at BNP Paribas.

The emergence of the North Korea threat provided just the opportunity investors sought to sell equities and junk-rated bonds, the thinking goes. This would square with the presumption that market players are retreating from their risk-on mood seen from the beginning of the year. The clues are visible in the fixed income market -- and in the Japanese stock market.

Stocks with high price-earnings ratios had posted healthy gains in Japan, but members of this class have reversed course recently.

Machine tool supplier Trusco Nakayama dove 9% on Aug. 8 after downgrading projected full-year earnings and announcing a dividend cut. The company turned in a bigger quarterly profit, but the share price has been slow to recover.

Other stocks trending lower include Harmonic Drive Systems, which manufactures semiconductor equipment, and server-leasing company GMO Cloud. Nintendo and Nidec have become top heavy. Each of these components has slid further than the 1.2% dip in the Nikkei Stock Average since Aug. 8.

It remains to be seen whether these outcomes will spread.

"Markets in emerging nations have not deteriorated, but if such developments do materialize, de-risking activities could proliferate throughout all equity markets," said Commons Asset Management's Ii.

Though the Nikkei average closed sharply lower Monday amid North Korea fears, benchmarks in South Korea, India and elsewhere finished higher. Lower U.S. long-term interest rates have relieved fears of capital flight from developing nations, propping up equity and bond values. But the party may end if American and European central bankers send stronger signals of monetary tightening as they convene for the Federal Reserve's annual conference next week in Jackson Hole, Wyoming.

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