01 Mar 2006, Rahul Jhaveri, Asia Risk
Japan has struggled to find investors for its inflation-linked Japanese government bonds (JGBis) over the past two years. For one, pension funds - by far the biggest potential investors - were reluctant to enter the market due to concerns about deflation and its impact on the principal value of the bonds. But, more importantly, many pension funds faced accounting hurdles that prevented them from buying these contracts. This may be about to change.
The JGBi market has remained very thin and illiquid ever since the Ministry of Finance (MoF) in March 2004 launched the first issue, worth Yen100 billion (US$942 million), linked to the core consumer price index. There is now around Yen2.5 trillion worth of 10-year JGBis outstanding in the market, traded mainly among a small community of trust banks and asset managers, with another Yen2 trillion of JGBi issuance planned for 2006. But this is a tiny fraction of the Yen165.4 trillion yen worth of planned JGB issuance for the year.
Yet dealers believe the JGBi market is set to take off under new accounting rules expected to be introduced by the Accounting Standards Board of Japan (ASBJ) in the fiscal year starting April 2006. The ABSJ incorporated JGBis into a draft for a new accounting treatment of 'compound financial instruments'. The draft, released on January 27, said that under the new rules, the difference between the acquisition cost and face value of JGBis will be recognised as an adjustment to interest revenues, while the embedded derivative and coupon-bearing JGB components will be treated jointly as single instruments. The bonds can be classified as 'available-for-sale' securities that will be stated at amortised cost, and the difference between amortised cost and market value of the JGBis will be treated as unrealised gains or losses in investors' profit and loss (P&L).
At present, the cash component of a JGBi is treated as a 'tradable security', while the derivatives element is measured at fair value with unrealised gains or losses contributing to investors' profit and loss.
The draft of the rules is being discussed by the ASBJ: an official accounting guideline is due for release in March, and the new guidelines will be applied in principle from the fiscal year starting April 2006.
The absence of a principal guarantee means the inflation-linked bonds cannot be categorised as 'hold-to-maturity' securities under both the old and new accounting rules. But the important thing for the pension funds is that they will no longer have to account for the embedded derivatives separately under the new accounting rules, which could well boost their investment in these instruments, say dealers. Pension funds typically have strict internal restrictions that bar investments in derivatives. Japan's employee pension funds also have to follow investment guidelines set by the Pension Fund Association that allow investments in bonds only if these carry no risk of impairment of the principal.
Inflation-linked bonds have emerged as key tools for hedging long-dated exposure by pension funds in the US and UK, and demand for JGBis is potentially huge, given the return of inflation in the Japanese economy. Pension funds had been reluctant to invest in JGBis in the past due to the deflation that wreaked havoc on Japan's economy from the late 1990s to late 2003. But there are signs that deflationary pressure is easing, with Tokyo's consumer price index rising by 0.2% year-on-year in January. Pension funds have consequently become aware of inflation risks.
In late 2005, Japanese pension funds started adding JGBis to their portfolios in anticipation of the accounting changes, says Satoshi Yamada, fixed-income strategist at Nikko Citigroup in Tokyo. "The pension fund community has taken time to prepare for buying the bonds, especially in the current accounting system," he says. "But now they seem ready, and some have already set up the funds to invest in inflation-linked bonds."
Yamada estimates that pension funds hold a total of about Yen100 billion worth of JGBis, and JGBi issuance may rise to meet demand from the pension funds and other investors. "(The government's) aim is to introduce liquidity before creating a curve," he says. "They might increase the size of issues in the latter part of next fiscal year and decrease other bond issuance - such as in the 15-year floater - because there is less demand for it."
The MoF is keen to increase the liquidity and size of the JGBi market and has sought to boost demand. In April 2005, it expanded the list of eligible investors to include foreign corporations and investment funds. US and European governments are already issuing, so investors there are familiar with such products, so they are quick to respond to cheap levels of this bond in Japan, says Yamada - and that is contributing to liquidity.
The Ministry has also been working with accounting bodies to overcome the classification hurdles, and it has also included JGBis in its buyback policy since January 2006. Moreover, the MoF is looking at issuing best-practice guidelines and reviewing the accounting standards relating to repo transactions of JGBis. It is trying to make this bond eligible for buyback, and that can enhance liquidity, says Yamada. The government is also trying to create a repo market, he adds. The repo market has started slowly, but there was no market before, so dealers could not go short on this bond, he says. Now they can go long and short, which will help create liquidity.
Foreign investments in JGBis have been growing since mid-2005. At the end of April 2005, JGBis were weighted at 1.2% on Barclays' Global Inflation-Linked Bond Index. By December, that figure had risen to 2.58%.
Ralph Segreti, New York-based director and inflation product manager at Barclays Capital, told Asia Risk: "You have seen Japan start to develop the 10-year JGBi, and foreign and domestic investors have come into the market and started to view inflation as a new asset class. From this, you will get the derivatives market to develop, and that is really exciting." Segreti adds that 16-20% of debt in the US market will be inflation-linked in the next two years, something he feels the Japanese market will quickly catch up to.
The next step for the MoF, say dealers, will be to issue a range of tenors in order to further develop the real yield curve, which will be a useful tool for the government and dealers to gauge inflationary expectations of the market. In fact, Barclays Capital entered an agreement in February for Japan's first five-year zero-coupon inflation swap (see box). "Japan only issues at the 10-year point, so having a five-year point opens up a lot of possibilities," says Segreti. "First of all, five years is much better for a lot of investors because we can start issuing structured notes at different maturity points." The BarCap deal will presumably not be the first of its kind.
A FIRST FOR JAPAN
Barclays Capital recently entered an agreement for a five-year inflation-linked zero-coupon swap transaction, which combines a variable interest rate and a one-off payment of fixed interest at the time of maturity. This is Japan's first five-year zero-coupon inflation swap. The value of the agreement is Yen5 billion (US$43 million), with brokerage Prebon Yamane as the agent. Until now zero-coupon swaps have for the most part been 10-year transactions.
By lifting liquidity and offering a five-year instrument ahead of other companies, Barclays expects its swap will become utilised as a leading indicator. Zero-coupon bonds are also being used in instruments such as strip bonds, which allow the principal and interest of government bonds to be separated and distributed independently.
Australia was one of the earliest markets to issue inflation-linked bonds, having first launched Linkers in 1983, with just over A$6 billion (US$4.4 billion) outstanding today. But due to a drop in its financing needs, the Australian government suspended the issuance of inflation-linked bonds in May 2003.
Alan James, head of global inflation research at Barclays Capital, says: "The Australian market actually has people that want to invest in inflation at the moment. But the ability to do so is quite limited because the government is not restarting supply. They have a good fiscal situation and want to keep the nominal market liquid."
Since Australia's decision to suspend issuance of inflation-linked bonds, the US and European markets have overtaken its markets in terms of outstanding volume. Australia also has the lowest weighting in Barclays Global Inflation-Linked Bond index, at 0.83%.
Yet there is still a liquid market for the outstanding inflation-linked Commonwealth Government Securities (CGS), due mainly to demand from institutional investors. And while the Australian government has suspended issuance of inflation-linked bonds, there are a lot of corporate issuances domestically. The infrastructure sector has emerged as an issuer, with entities involved in gas and electricity distribution, and roads and airports issuing inflation-linked notes to raise funds.
On a smaller scale, there has also been issuance from the public-private partnership sector, says Francisco Sarmiento, Macquarie's associate director of debt markets. Australian investors will still be most comfortable with investing in inflation in bond form, he adds. Although he believes Australian investors are sophisticated enough to trade in more complex inflation-linked derivatives, this is likely to become more prevalent once more sovereign issuance takes place.
"No single corporate or combination of corporates can replace the Commonwealth Australian Treasury in providing backbone liquidity, but they are maintaining or helping to maintain enough of the market to ensure it doesn't implode."