Waiting for growth

A change in accounting rules for Japanese inflation-linked bonds is the latest attempt by Japan's authorities to encourage buying by a broader range of investors. But the country's pension funds have yet to embrace inflation-linked bonds with any real enthusiasm. By Duncan Wood

Short of launching a glitzy advertising campaign, it's hard to know how Japanese officials could do a more obvious job of promoting the country's inflation-linked Japanese government bond (JGBi) market. Since the energence of linkers in April 2004, the Bank of Japan (BOJ) and the Ministry of Finance (MOF) have taken a series of steps to promote the market, first lifting restrictions that froze foreign investors out of the sector, then campaigning for accounting changes that allowed JGBis to compete on an equal footing with standard government bonds, and most recently announcing an increase in issuance that will see Yen3 trillion ($26.2 billion) of JGBis sold this fiscal year, up from Yen2 trillion in fiscal 2005 and Yen900 billion in 2004.

All this promotional activity has had some success. Japanese pension funds have dipped their toes in the JGBi market, although not yet on any significant scale. A small amount of inflation-linked paper has been issued outside the JGBi market - one deal was launched by a supranational and two by a Japanese government-affiliated agency last year. And foreign investors have been encouraged to invest in the market - although the offshore accounts have mostly been hedge funds that identified relative value opportunities.

On the back of this, there has been some derivatives market activity. In February, Barclays Capital transacted Japan's first five-year inflation swap, and market participants say that March saw the first execution of a five-year forward-starting swap in Japan. But dealers admit this is still very much a nascent market.

It's not for want of trying. The accounting rule change in March in particular "sent a strong signal to the market that the authorities are quite happy to address problems that domestic investors have", says Alex Duering, a relative-value analyst at Deutsche Bank in Tokyo.

However, while domestic investors have warmed to the market, they have stayed, for the most part, on the sidelines - so much so that some analysts aren't convinced that the extra issuance will find a ready home. "I was doubtful about the decision to issue more linkers at this stage and I'm not sure who is going to absorb this increase unless pension funds step in," says Akihiko Yokoyama, chief bond strategist at JP Morgan in Tokyo.

Pension funds are widely seen as the bedrock of any inflation-linked bond market. In Europe - and the UK in particular - pension funds have snapped up long-dated inflation-linked paper as a way to offset real liabilities. In Japan, however, pension funds have been reluctant to embrace JGBis as a linchpin of their asset-liability management (ALM) strategy. "I haven't seen any real demand from Japanese pension funds," says Yokoyama. "Pension funds have started to buy linkers as pilot investments, but I don't believe that they're ready to invest on any real scale."

There are good reasons for this. Most obviously, the supply of JGBis is still nowhere near sufficient to allow genuine hedging of pension funds' inflation-linked liabilities. In Japan, the total outstanding amount of linkers is roughly Yen3.5 trillion - a small proportion of the Yen117 trillion in total assets held by the country's pension funds as of year-end 2005, according to BOJ figures.

Even in Europe's more mature inflation-linked markets, "if all pension funds decided to allocate 5% of their assets to linkers as part of a systematic ALM strategy, they would immediately absorb all outstanding linkers", says Volker Wellmann, global head of inflation trading at BNP Paribas in London. The potential for the linker market to grow on the back of pension fund ALM buying is huge, he says: "Currently, though, the proportion of assets allocated to linkers in Japan is very low."

The solvency regime for Japanese pension funds is also less focused on matching assets with liabilities than in some European countries. In the UK, for instance, the introduction of accounting rule FRS17 last year means companies now have to value their pension liabilities using a discount rate based on AA-rated corporate bond yields. Under pressure from the UK Pensions Regulator to eliminate pension deficits within 10 years, pension funds have been flocking to the bond markets to match liabilities, pushing the yield on the 1.25% 2055 index-linked gilt to a record low of 0.38% in January.

"In the UK, pension funds have to match assets and liabilities very closely, and if there's a move in the mark-to-market value of a liability, that has to be reflected in the assets as well. In Japan, most pension funds can still use book value on both sides of the balance sheet," says one Tokyo-based analyst.

Adding to the lack of interest is the fact that pension funds also typically take an index-based approach to investing, where they try to match their own returns to those generated by benchmark indexes. Ordinarily, that means buying the assets that are included in the index, but Japan's most widely used benchmark for fixed income - the Nomura BPI - doesn't include linkers. If that were to change, "pension funds would be highly likely to start buying JGBis", says Takehiro Sato, an economist at Morgan Stanley in Tokyo.

Despite these obstacles, pension funds are still seen as integral to the long-term success of the JGBi market. The recent accounting rule change was hailed as a positive step in encouraging these firms to get more involved in the market. The new rules were introduced on March 28 by the Accounting Standards Board of Japan - but behind the scenes, it had been the MOF that had pushed for change, says Alan James, head of inflation-linked research at Barclays Capital in London. "Under the previous regime, there was a disincentive to hold JGBis as opposed to nominal bonds and, ultimately, the MOF was keen for linkers to compete on an equal footing."

The difficulty centred on the lack of a principal guarantee on Japanese inflation-linked bonds. JGBis are designed so that the coupon is fixed, while the principal is adjusted for inflation, which means the bond could redeem below par in a prolonged deflationary environment - a fact that closed the JGBi market to vast numbers of domestic institutions prohibited from investing in instruments without a guarantee on principal.

The absence of a principal guarantee meant investors could not classify the bonds as hold-to-maturity, but instead had to account for them as tradable securities, with the derivatives component measured at fair value and reported in the profit and loss account. In effect, investors were required to treat any drop in inflation as an impairment of JGBi assets, with that impairment being carried through to earnings - a mark-to-market approach. Standard JGBs, in contrast, could be held without any earnings impact.

There was some debate about how best to level the playing field between JGBis and nominal Japanese government bonds. The general tide of accounting standards worldwide is moving in the direction of mark-to-market, so a partial roll-back of this approach in Japan would have been somewhat unorthodox, say analysts. There were even market rumours that officials were thinking of relaunching the JGBi using a new floored structure so they wouldn't have to rewrite the accounting rules - a move that would have left holders of the old bonds badly disadvantaged. In the end, the decision was taken to exempt JGBis from mark-to-market requirements, and the change was pushed through before the start of Japan's 2006 fiscal year.

Pension funds have already had an opportunity to signal their approval of the rule change in the only way that really matters - by buying more linkers. The eighth and most recent JGBi auction was held on June 6 and saw a further Yen500 billion of 10-year bonds hitting the market. Opinions differ on the level of pension fund buying. One analyst says that, in the run-up to the auction, the bank's clients had been "more active and vocal than usual", and have been steadily raising their interest over the past nine months.

Koji Kato, head of Nomura's London-based JGB trading team, tells a different story: "After the accounting change, we expected domestic buyers to get involved, but we didn't see any big buying."

Despite this, the auction itself went smoothly. The sale achieved a bid-to-cover ratio of 3.6, more or less in line with previous auctions. The coupon of 1% was the highest since the first two JGBi issues, which had coupons of 1.2% and 1.1%, respectively.

In the absence of substantial demand from Japanese pension funds, the growth in supply over the past 12 months has been driven by hedge funds. The funds were drawn to the market last August when the spread between JGBis and nominal government bonds had shrunk to 45 basis points, its narrowest level since foreign investors were allowed into the market in April 2005. This spread, known as the breakeven rate, reflects the expected inflation rate plus a risk premium. When the breakeven spread is narrow, it suggests that inflation will be low - and if investors expect inflation to exceed this level, it signals a buying opportunity. With many economists forecasting the end of deflation in Japan last year, hedge funds swooped. Some dealers suggest that hedge funds bought around 80% of the JGBis issued in last August's auction.

This trade is looking pretty solid. Japan's core inflation index rose last November - its first monthly rise since 2003 - and has now racked up six consecutive increases. The last time Japan saw a period of sustained price inflation of that length was in 1998. The clearest sign that Japanese officials are satisfied that deflation is over came in March, when the BOJ announced an end to its quantitative easing policy - a strategy that had seen interest rates set at zero and liquidity poured into the money markets since March 2001 in an attempt to stimulate economic growth.

All this helped drive up breakevens to 94bp on March 29, and although the breakeven of the latest issue was a more modest 85bp, market participants say that has more to do with seasonal inflation trends than any fundamental change in inflation expectations.

Does this mean that JGBis are dead as a relative value play? "At these levels, there's not much opportunity," says JP Morgan's Yokoyama. However, that doesn't mean that hedge funds are ready to sell up and move on. Yokoyama says that when breakevens hit their March high, it triggered a wave of profit-taking, but many funds are hanging on to their positions on the view that a rise in Japan's consumption tax rate is inevitable - something that should have an immediate effect on inflation.

Some strategists believe the tax hike could materialise ahead of the 2007 fiscal year - with the tax rate possibly doubling from its current level of 5%. Morgan Stanley's Sato is more cautious and argues that the hike will be delayed until 2009 and may be as small as a 2-3% increase due to political compromise. While the country was mired in deflation, these questions seemed distant to the point of irrelevance - but they're now assuming real significance, not least for hedge funds that remain long inflation.

"If you believe the long-term stable level of inflation to be 1% and also believe that consumption tax could add 2 to 3 percentage points to absolute price levels, that's worth 20-30bp of breakeven on a 10-year linker," says Barclays Capital's James. "From that point of view, you might conclude that the fair value for JGBis is nearer 120bp rather than the current 85bp, so it's understandable that hedge funds may still see asset values as quite cheap."

However, James characterises these expectations as quite aggressive. He believes the tax hike may arrive later than some investors expect and may also be smaller than they're hoping. As such, he says, "breakeven in the mid-90s seems relatively fairly priced". So, there may be some juice left in JGBis from a relative value perspective, but perhaps not much.

Opposing views on the proposed tax hike and its impact on inflation have already been expressed via Japan's embryonic inflation derivatives market. Barclays Capital transacted the market's first five-year inflation swap for a hedge fund client in February - the deal had a notional size of Yen5 billion.

Stefan Liiceanu, inflation structurer at Barclays Capital in Tokyo, says the transaction is effectively like buying a five-year inflation-linked bond: the hedge fund believed that inflation would rise relatively rapidly over a five-year horizon, thanks largely to the prospective increase in consumption tax.

Dealers say the market also recently saw its first forward-starting five-year swap, which was executed in March. In this case, the counterparty had the opposite view - believing that the tax increase would be less aggressive, and deciding that it would be smarter to have exposure to inflation starting in five years' time. Again, the deal's notional size was Yen5 billion.

Other types of instrument have also been transacted. Total return swaps linked to individual JGBi issues had been popular among foreign investors as a means of getting exposure to Japanese inflation before they were allowed to buy the bonds directly - but the lifting of that restriction has resulted in demand drying up, says BNP Paribas' Wellmann.

Similarly, bespoke structured notes incorporating a floor were bought by some domestic investors that wanted inflation exposure but didn't want to mark their assets to market under the old accounting rules. The Tokyo-based head of exotics at one investment bank says his institution executed around five of these deals. The rule change has removed one of the supports for this kind of transaction, he says.

There was also, briefly, some life in the market for non-government issuance of inflation-linked bonds in Japan. The European Investment Bank raised Yen50 billion via BNP Paribas in November 2004 and the Japanese Finance Corporation for Municipal Enterprises - a government-affiliated agency - used Credit Suisse and then Goldman Sachs to issue inflation bonds in February and July last year, respectively. Both issues raised Yen20 billion. However, no other issuers have been tempted to follow suit.

To some extent, it's a bit of a chicken and egg situation - it's doubtful domestic pension funds will become a major force in JGBis until the market is more liquid, but the MOF is unlikely to crank up its issuance of inflation-linked paper until there's strong demand from a wide array of investors. Even with signs that inflationary pressures are emerging in Japan for the first time in 10 years, analysts reckon a major pick-up in trading activity in the short term is unlikely. "There are great arguments for the market to be successful in the medium term and the long term," says JP Morgan's Yokoyama. "Right now, though, it is still waiting to happen."