Preparing for an end to deflation

Japan’s Ministry of Finance issued its first inflation-linked bonds in March, with more planned in June and December. But with Japan still struggling to overcome deflation and with concerns over liquidity, many investors have chosen to remain on the sidelines so far. Nick Sawyer reports

It’s very much early days for Japan’s inflation-linked bond market. The first auction of inflation-indexed Japanese government bonds (JGBi) took place in March, with just ¥100 billion ($915 million) up for grabs – a drop in the ocean compared with the ¥540 trillion in government bonds outstanding as of December last year. The next auction is scheduled for early June, this time with ¥300 billion of paper set for issue.

Nonetheless, despite it being a very young market, something of a Catch 22 is emerging. The Ministry of Finance (MOF) wants to test the water for JGBi demand, limiting issuance to ¥600 billion over this fiscal year – just 2.6% of its planned 10-year fixed-rate JGB issuance. But for their part, Japanese investors – the pension firms, life insurance companies and trust banks – appear reluctant to dip their toes into the market until there is greater liquidity.

“I think it’s a bit of a chicken-and-egg situation,” says Tadashi Kikugawa, fixed-income analyst at Morgan Stanley in Tokyo. “Investors say that the market is too small; but from the Ministry of Finance’s point of view, if there is not strong demand from investors, they can’t really increase the issue size too quickly. For the market to develop, investors need to participate actively in addition to brokers’ proprietary trading.”

Proprietary trading is pretty much what happened in the first auction. The bidding was dominated by foreign dealers, primarily those with experience in the US and European inflation-linked bond markets. The four largest dealers took around 80% of the issue, with Goldman Sachs and Barclays Capital, the two largest bidders, each taking around 25%. French bank BNP Paribas, meanwhile, took ¥15.8 billion, while Japan’s Nomura Securities took around 15%.

“I would say the biggest chunk of the issue was absorbed by proprietary dealers for position-taking rather than market absorption,” says Akihiko Yokoyama, chief fixed-income strategist for Japan at JP Morgan Securities in Tokyo, whose bank bought about ¥5 billion of the JGBi issue.

In Europe and the US, the main players in the inflation-linked bond markets are pension firms with long-term inflation-linked liabilities, life insurance companies that want a hedge against policies linked to inflation, and investors seeking portfolio diversification. However, in Japan, Dai-Ichi Kangyo Asset Management is one of the few investors to have got involved in the JGBi market so far. The firm purchased a small amount of JGBis for its inflation-linked bond fund, launched in March. Junichi Kimura, Tokyo-based manager at Dai-Ichi Kangyo Asset Management, says the firm will probably buy more JGBis at the next auction, although he adds the fund is not yet popular with Japanese investors. He expects this to change as Japan pulls itself out of deflation and retail investors become more aware of inflation risk.

But there is a fair amount of pessimism about when Japan will be able to reverse the deflationary trend that has plagued the country since 1998. “In general, investors don’t have a positive inflation outlook,” says Hidoshi Hara, senior fixed-income portfolio manager at AIG Global Investment Group Japan in Tokyo. “They don’t think that inflation is going to move higher in the near future, so that’s the basic problem.”

Japan’s consumer price index (CPI) excluding fresh food (the index that is used as the reference for the JGBi market) fell 0.2% in the 2003 fiscal year, which ended on March 31; and in its twice-yearly economic outlook, published in late-April, the Bank of Japan forecast that the CPI will fall a further 0.2% this fiscal year. Meanwhile, the GDP deflator, which measures the impact of price changes of real economic growth, fell by 2.6% in the first quarter of 2004, the twenty-fourth successive quarter of decline.

“The growth rate of the inflation-linked bond market in Japan will be gradual while the CPI continues to be negative on a year-on-year basis,” says one Tokyo-based portfolio manager in the fixed-income investment department at Nomura Asset Management. The firm has not yet invested in inflation-linked JGBs, he adds. “We may consider investing in inflation-linked JGBs in the future. It depends on the market situation and the prevailing market price of the bond, which we think is overvalued at present.”

Expectations that deflation will persist, at least for the next year, has undoubtedly affected investor demand, particularly as the bonds themselves are structured so that they do not have a principal guarantee. Like the UK inflation-linked gilt market, the coupon on the JGBi is fixed at issue (the coupon was 1.2% for the first JGBi), while the principal is adjusted for inflation using the CPI reading three months prior. This means that the bond’s principal steadily erodes in a deflationary environment. With the CPI coming in flat in December last year and –0.1% in January compared with the previous year, there was the prospect of the JGBi immediately recording principal losses.

What’s more, because the principal is not guaranteed, investors cannot classify the bonds as ‘hold-to-maturity’ under current accounting regulations. Despite the fact that pension firms and life insurance companies would probably be long-term holders of the bonds, JGBis have to be accounted as ‘tradable securities’, while the derivatives component of the bond has to be measured at fair value, with unrealised gains and losses affecting the firms’ profit and loss (P&L).

“Japan is still in deflation and the CPI is still negative, so there’s a risk for investors to lose their principal if the deflation continues,” says Naka Matsuzawa, chief investment strategist at Nomura Securities, in Tokyo. “And there are some mark-to-market accounting issues involved. When the price of the inflation-linked bond fluctuates, the profit and loss for that period has to be included on the P&L. Investors do not want to record the profits and losses in every quarter, so those potential buyers are relatively reluctant right now to buy.”

Furthermore, the CPI is not seasonally adjusted, and historically dips to its lowest point in January and February. The mark-to-market value of the bond is therefore potentially affected at the end of the fiscal year in March due to the three-month lag in the CPI reading. This was a particular concern ahead of the first JGBi auction in early March, with the seasonal factors potentially causing a drop of as much as half a point on the principal, assuming all other conditions remain the same and yields are otherwise unchanged, says John Richards, Japan strategist at Barclays Capital, in Tokyo. “You’d make up this loss later in the year [when the CPI rebounds]. But while it averages out over a calendar year, it cannot be arbitraged between fiscal years. So if you are sensitive to mark-to-market losses, you would not be particularly thrilled to be taking that position.”

For those investors whose first priority is hedging against inflation risk and that aren’t so sensitive to mark-to-market volatility – in other words, the pension funds – the dip in CPI each January and February might represent a good buying opportunity, adds Richards. “If you weren’t sensitive to it and your P&L was okay, it wouldn’t have mattered. In fact, if it had come cheap, you could take advantage of it,” he says. However, market-to-market losses are a touchy subject for Japanese financial institutions – particularly domestic banks, whose balance sheets have been under pressure from non-performing loan and cross-shareholding disposals over the past few years.

Another factor affecting investor demand was that many institutions did not have trading and risk management systems in place, while others just wanted to sit on the sidelines and see how the first bond was priced. That’s not really surprising given the range of price estimates floating around from the various investment banks before the bond was issued.

However, now there’s a precedent and market participants have a clearer idea of where these bonds will trade, it may prompt more investors into the market, say dealers. “At the first auction, no-one knew where the market was,” says Koichi Fukumura, head of long-term interest rates at BNP Paribas, in Tokyo. “Now, everyone knows where the market is, so I think Japanese financial institutions, including domestic banks, will participate in the next auction.”

The first JGBi came in with a breakeven inflation rate (the spread between nominal yields and real yields, representing expected inflation and a risk premium) of 14 basis points (implying an average inflation rate of around 0.1% a year over 10-years), according to Barclays Capital’s Richards. It’s since widened to close to 40bp in the secondary market, despite little fundamental change in inflation outlook. That’s different from the US experience when the first Treasury inflation protected securities (Tips), auctioned in 1997, were priced with the breakeven inflation rate well above the actual inflation rate due to strong investor demand, and then subsequently cheapened in the secondary market.

Some dealers report more enquiries from investors ahead of the June JGBi auction, and Fukumura says that at least two pension firms – one trust bank and one asset manager – are ready to invest. “At the beginning of the year, everyone thought deflation would continue, but now people are starting to think about the end to deflation,” he says. Strong economic data in Japan over the past few months has really highlighted the improvement in the Japanese economy. First-quarter GDP, for instance, grew by 5.6% on an annualised basis, and by 3.2% over the 2003 fiscal year. These increases are not expected to immediately flow through to the CPI figures, with most analysts still forecasting deflation to persist until 2005/2006 at the earliest. Nonetheless, the strong data, combined with talk of an interest rate hike in the US, has reignited investor awareness of inflation, Fukumura says.

Other dealers agree: “I think the Japanese dealers will play [in the auctions scheduled for this fiscal year,” says Barclays’ Richards. “Pension funds will also start to become more interested in it, so it should be a much more interesting auction.”

However, investors are still concerned about the lack of liquidity in the market. The first JGBi auction attracted bids worth 4.85 times the amount of debt on offer, which compares well with the 5.31 bid-to-cover ratio at the inaugural auction of US Tips. However, this is somewhat misleading because of the small size of the issue, allowing the paper to be absorbed by dealers with little investor participation. Trading in the secondary market is very thin, with about ¥500 million traded each week, according to estimates from JP Morgan Securities’ Yokoyama. And this lack of liquidity has led to distortions in pricing in the secondary market, say investors. “We will not trade now because the market is still illiquid,” says one fixed-income manager at a Japanese asset management company. “It is liquidity that is needed.”

In mid-April, a group of JGB dealers and investors met the MOF to request greater issuance of inflation-linked JGBs, beyond the ¥600 billion planned for this fiscal year. However, even if the MOF agrees to increase issuance, a crucial factor is a restriction on foreign investors from buying the product in Japan. Current regulations prohibit those foreign investors that are liable to withholding tax from participating in the JGBi market – that’s pretty much everyone other than central banks and supranationals. That’s despite an exemption on the withholding tax for fixed-rate JGBs for all non-resident investors approved to deposit their JGBs with qualified financial intermediaries in Japan.

“To me, the greatest problem is the limitation of the eligible investors,” says Reiko Tokukatsu, director of global markets research at Deutsche Securities. “Non-resident investors like hedge funds are very important in the sense that they are risk-takers. For a market to develop, you need real investors and the risk-takers to increase liquidity. If it was just real investors, they would buy and hold and there would be no secondary market. So the non-residents are really crucial in terms of the development of the market.”

Nonetheless, there’s unlikely to be any immediate easing of the restrictions on foreign investors, particularly as the tax laws in Japan can only be altered once a year. Nomura’s Matsuzawa points out that the JGBi market is still very much seen as a pilot scheme by the MOF, and as such, it’s unlikely any changes will be made to allow foreign investors to participate at this stage. “The general stance of the Ministry of Finance is that this is a pilot case rather than a full-scale issuance of these kinds of bonds,” he says.

On the other hand, the MOF is looking to expand the variety of instruments it offers and enlarge the JGB investor base as a means of ensuring its huge debt issuance programme is soaked up by the market. Once the ultra-low interest rate environment looks to be nearing an end – the Bank of Japan has said that it will maintain its low interest rate policy until year-on-year changes in the CPI are consistently above zero – then that could trigger greater issuance of inflation-linked bonds and a relaxation of rules regarding foreign participation, says JP Morgan’s Yokoyama. “As long as interest rates remain low, the MOF does not have an incentive to increase the issuance of this kind of product so much,” he says. “But more JGBi issuance is likely if there is trouble with market absorption [of fixed-rate JGBs]. If there is trouble absorbing all the debt, they may open it up to foreign investors.”

Until then, the market is likely to remain small, with gradual growth over the next few years. “There’s a chance that the inflation-linked bond market may follow the path of 15-year floating-rate JGBs, in which case you could maybe get up to ¥1 billion four times a year,” says Barclays’ Richards. “That’s not all that large compared with other places like the US, but there’s probably more inflation-linked pension liabilities in Japan, so I think the market could take it once it’s well established.”

Total return swaps a likely starting point for derivatives With only ¥100 billion ($906 million) of inflation-linked bonds currently in issue and a further ¥300 billion due to be auctioned on June 3, it’s no surprise that no-one’s expecting a thriving inflation-linked derivatives market to emerge in Japan in the near future. In Europe, inflation-linked derivatives volumes have surged over the past 18 months or so, driven by the hedging of inflation-linked liabilities. Issuers, keen to tap the inflation-linked bond market, have been able to use inflation derivatives to swap the inflation-linked flows into Libor; while inflation swaps have been used by pension firms to tailor cashflows to exactly match their liabilities, without the maturity mismatch constraints of the cash bond market. And dealers expect an inflation-linked derivatives market to fulfil a similar role in Japan. “There is room for inflation derivatives to be developed as long as there is demand for inflation indexed products,” wrote Reiko Tokukatsu, director of global markets research at Deutsche Securities, in a report this year on the inflation-linked bond market in Japan. But the lack of liquidity in the market will obviously hamper the ability to offer inflation-linked derivatives in the near term. “Liquidity of the underlying CPI-linked JGBs is the key,” says Akihiko Yokoyama, chief fixed-income strategist for Japan at JP Morgan Securities, in Tokyo. “If the CPI-linked JGB market is liquid, then CPI derivatives dealers can hedge their delta positions by buying and selling underlying CPI-linked JGBs. But I would say there is some demand for CPI-linked derivatives in Japan.” One source of that demand is from non-residents. Under current tax rules, foreign investors are prohibited from investing in inflation-linked JGBs. Consequently, derivatives such as total return swaps could be offered sooner rather than later to allow foreign investors to participate in the market. “Foreigners are precluded from buying these bonds,” says John Richards, Japan strategist at Barclays Capital, in Tokyo. “We’ve already had an enquiry for a total return swap on inflation-linked JGBs, and we’re going to be offering total return swaps before the next auction [in June]. That will allow foreigners to participate.”