Japanese Bonds: From Promising Trade to Growing Challenges

Following a sharp sell-off in Japanese government bonds (JGBs) late last year, Brendan Murphy, a fund manager at Insight Investment, identified what appeared to be a “can’t lose” trade.

A Bet That Hasn't Paid Off Yet

Murphy aggressively bought 30-year JGBs when yields were near historic highs due to rising inflation. He also added foreign exchange derivatives to capitalize on the interest rate differential between the US and Japan, locking in an attractive annualized return of 7%. The strategy hinged on the Bank of Japan (BOJ) successfully suppressing inflation. So far, the trade has backfired. Since January, the BOJ has not raised interest rates again, and persistent high inflation continues to cloud the outlook for long-term bonds. Amid broader pressure on global bond markets, the yield on 30-year JGBs surged to a new record high above 3.2%, eroding most of Murphy’s earlier profits.

Value Trap or Opportunity?

Japan is the world's third-largest bond market, after the US and China, so its turbulence extends far beyond domestic borders. After the BOJ abandoned its yield curve control (YCC) policy, uncertainty in global fixed income markets increased. In the first seven months of the year, overseas fund managers poured a record 9.3 trillion yen (about $63 billion) into long-term JGBs, but now they are at the center of the storm. Bond prices are heading towards historic lows, while the BOJ is reluctant to raise interest rates due to concerns about economic growth. At the same time, the ruling coalition's defeat in the July Senate election raised expectations of a new round of government fiscal stimulus, fueling fears of further increases in government bond issuance. Even domestic buyers, such as pension funds and life insurance companies, are hesitant.

Global Structural Challenges

In addition to domestic challenges, the Japanese bond market also faces global structural pressures. An aging population means lower demand for ultra-long-term government bonds from life insurance companies to cover long-term liabilities. Furthermore, the Japanese bond market is affected by the global bond sell-off. Roger Hallam, global head of rates at Vanguard Asset Management, believes that long-term JGBs remain an "attractive investment opportunity." However, he also points out that the key risk they face is "not unique to Japan, but is a globally rising term premium."

Is There Hope?

Despite this, there are still some positive signals that make bond market bulls reluctant to give up. The Japanese government has begun to reduce long-term bond issuance, which helps to ease supply and demand imbalances. In addition, some bargain-hunting funds have entered the market, betting that JGBs are about to bottom out. At the same time, Murphy from Insight Investment chooses to stick to his position. He expects the yield on 30-year bonds to return to around 2.75%. If this happens, an investor entering the market now would receive a total return of over 10%.