London Jpy Rates Markets 091109
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London Jpy Rates Markets 091109

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A Description of Yen Fixed Income Markets

A Description of Yen Fixed Income Markets

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London Jpy Rates Markets 091109 London Jpy Rates Markets 091109 Presentation Transcript

  • The Japan Fixed Income Market Instruments, Key Players and Dynamics 09 November 2009 Christian Carrillo Senior Rates Strategist, Asia-Pacific
  • Disclaimer IMPORTANT DISCLAIMER: The information herein is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell, any securities and including any expression of opinion, has been obtained from or is based upon sources believed to be reliable but is not guaranteed as to accuracy or completeness although Société Générale (“SG”) believe it to be clear, fair and not misleading. SG, and their affiliated companies in the SG Group, may from time to time deal in, profit from the trading of, hold or act as market-makers or act as advisers, brokers or bankers in relation to the securities, or derivatives thereof, of persons, firms or entities mentioned in this document or be represented on the board of such persons, firms or entities. Employees of SG, and their affiliated companies in the SG Group, or individuals connected to then, other than the authors of this report, may from time to time have a position in or be holding any of the investments or related investments mentioned in this document. Each author of this report is not permitted to trade in or hold any of the investments or related investments which are the subject of this document. SG and their affiliated companies in the SG Group are under no obligation to disclose or take account of this document when advising or dealing with or for their customers. The views of SG reflected in this document may change without notice. To the maximum extent possible at law, SG does not accept any liability whatsoever arising from the use of the material or information contained herein. This research document is not intended for use by or targeted at retail customers. Should a retail customer obtain a copy of this report they should not base their investment decisions solely on the basis of this document but must seek independent financial advice. Important notice: The circumstances in which materials provided by SG Fixed & Forex Research, SG Commodity Research, SG Convertible Research, SG Technical Research and SG Equity Derivatives Research have been produced are such (for example because of reporting or remuneration structures or the physical location of the author of the material) that it is not appropriate to characterise it as independent investment research as referred to in European MIF directive and that it should be treated as a marketing material even if it contains a research recommendation (« recommandation d’investissement à caractère promotionnel »). However, it must be made clear that all publications issued by SG will be clear, fair, and not misleading. Analyst Certification: Each author of this research report hereby certifies that (i) the views expressed in the research report accurately reflect his or her personal views about any and all of the subject securities or issuers and (ii) no part of his or her compensation was, is, or will be related, directly or indirectly, to the specific recommendations or views expressed in this report. Notice to French Investors: This publication is issued in France by or through Société Générale ("SG") which is authorised by the CECEI and regulated by the AMF (Autorité des Marchés Financiers). Notice to UK investors: This publication is issued in the United Kingdom by or through Société Générale ("SG") London Branch which is regulated by the Financial Services Authority ("FSA") for the conduct of its UK business. Notice To US Investors: This report is intended only for major US institutional investors pursuant to SEC Rule 15a-6. Any US person wishing to discuss this report or effect transactions in any security discussed herein should do so with or through SG Americas Securities, LLC (“SGAS”) 1221 Avenue of the Americas, New York, NY 10020. (212)-278-6000. THIS RESEARCH REPORT IS PRODUCED BY SOCIETE GENERALE AND NOT SGAS. Notice to Japanese Investors: This report is distributed in Japan by Société Générale Securities (North Pacific) Ltd., Tokyo Branch, which is regulated by the Financial Services Agency of Japan. The products mentioned in this report may not be eligible for sale in Japan and they may not be suitable for all types of investors. Notice to Australian Investors: Société Générale Australia Branch (ABN 71 092 516 286) (SG) takes responsibility for publishing this document. SG holds an AFSL no. 236651 issued under the Corporations Act 2001 (Cth) ("Act"). The information contained in this newsletter is only directed to recipients who are wholesale clients as defined under the Act. IMPORTANT DISCLOSURES: Please refer to our website: http:ww.sgresearch.socgen.com http://www.sgcib.com. Copyright: The Société Générale Group 2009. All rights reserved.
  • JGB Background Information Ownership of JGB Market Japan’s Net Worth The JPY Fixed income market is very domestic. We need to know about JGBs Source: BoJ and SG Fixed Income Research
  • JGB Issuance/Absorption Dynamics Japan’s Net Issuance and Seasonality Even as headlines focus on increasing JGB issuance, non-market support and seasonality are critical Source: BoJ, MoF and SG Fixed Income Research
  • Main Participants in the JGB Market Banks, Lifers, GPF, BoJ and Foreigners
  • JGB Demand: Depositary Corporations
    • Short and mid-segments of the curve is where banks are most dominant. Depositary corporations own JPY 245tn worth of JGBs or about 21.3% of their deposit liabilities.
    • This JGB/Depo ratio was 10% in 2000 but has been stable around current levels since 2005. Deposits have continued growing as a result of Japan’s external surpluses and (relatively) high household savings rate.
    • Between 2000-05 increased JGB demand was merely offsetting a decline of private securities (Loans, corporate bonds, equities) in banks’ portfolios.
    • Yields between the 1y-5y segments of the curve only started rising after lending rose again in 2005. These dynamics have recently reversed owing to an economic recession.
    • The key variable too watch is cash available for securities investment (surplus liquidity.) This surplus is very cyclical so “natural” demand can vary from JPY -5 to +15tn per year.
    JGB Ownership Short and Mid Sector Depo Corp Assets and Liabilities (JPY Tn) Source: BoJ, Bloomberg and SG Fixed Income Research
  • JGB Demand: Life Insurance
    • The Life insurance sector is dominant in the long and super-long segments of the curve. They own JPY 113tn worth of JGBs or about 45% of their insurance and pension reserves.
    • Lifers face two problems: being short-duration relative to requirements (12y-15y) and negative spreads owing to old fixed-return guarantees. Variable annuity exposure is small.
    • This mix means Lifers are constantly extending duration buying bonds and de-risking their portfolio. Target to buy 20y bonds or barbell of 10y and 30y is between 2.0-2.25%
    • Such a yield target is typically not enough to compensate for negative spreads but they are pushed in that direction by solvency rules set to be in place by 2011-12.
    • As those rules also encourage asset diversification, Lifers buy bonds opportunistically while shifting towards a greater JGB allocation. Natural demand for JGBs should be JPY 12tn per year given recent trends (see p. 29).
    JGB Ownership Super-Long Sector Lifer Assets and Liabilities (JPYtn) Source: BoJ and SG Fixed Income Research
  • JGB Demand: GPF
    • Japan’s Government Pension Fund (GPF) is the largest single investor in Japan with JPY 121tn in assets. JPY 86.2tn are invested in domestic bonds (JGBs and Fiscal Investment Loan Program bonds.)
    • GPF is unusual in that its performance and (that of its external managers) is measured against the Nomura BPI. This means that it has a relatively low duration (7y) for a pension fund and provides an important bid to that sector.
    • GPF currently targets a domestic bond allocation of 67% +/- 8%. Currently we are close to the top of that allocation but this due mainly to a decline in equity portfolio valuations .
    • We do not expect GPF to have a larger allocation of JGBs but rather expand their holdings in line with growth of their liabilities and decline in FILP bond holdings. This limits potential demand to around JPY 5-10tn per year.
    GPF investment holdings GPF domestic bond allocation Source: GPF and SG Fixed Income Research
  • JGB Demand: The Bank of Japan/MoF JGBs at BoJ vs banknotes issued
    • The Bank of Japan is also another big holder of JGBs, JPY 71tn as of Oct-09 or about 64% of their liabilities.
    • The BoJ has always had a large proportion of JGBs in its balance sheet as this is how much of the issued money supply has been backed.
    • More recently purchases of JGBs have occurred as a support to the budgetary process through outright purchases of long-term JGBs. These were being phased-out since 2005 but were re-started in 2008 at JPY 2.1tn per month
    • The BoJ implemented the “bank-note rule” stating JGB holdings may not exceed banknotes issued as a notional limit. Such rule has not necessarily been held before.
    • In an emergency the BoJ could increase its net absorption of JGBs by about JPY 10tn in the short-term but would look to reverse this activity as soon as possible.
    • The Ministry of Finance also engages in pre-scheduled buybacks often supporting poorly received issues (JGBi, JF)
    JGBs holdings as % of assets Source: BoJ and SG Fixed Income Research
  • JGB Demand: Foreigners
    • Another key participant - rather than sponsor - of the JGB market is the foreign sector. According to BoJ’s flow of funds foreigners hold about JPY 41tn worth of JGBs or about 15% of outstanding. True number is close to 7% as some represent foreigners in Japan using Japanese funds.
    • Steady foreign holders of JGBs would mainly include global asset managers either passive (tightly linked to a global benchmark) or active who historically kept a underweight in their JGB allocation. Most investments happens around 10y.
    • Data implies foreigners were close to neutral on JGBs than they had been in many years in 2008. It appears they are now back to being slightly underweight.
    • While the behaviour of major domestic JGB participants is well defined (banks’ surplus liquidity, GPF target allocation, Lifers target buying) that of foreigners is quite unpredictable.
    • A lot of volatility in JPY rates comes from shifts in foreigners’ (often ill informed) perceptions of Japan’s creditworthiness, BoJ policy expectations or simply crowded trades gone wrong.
    JGB Ownership Long Sector Foreign Investors Investment Position in Japan Source: BoJ and SG Fixed Income Research
  • Overview of Market Dynamics Dynamics and Case Studies
  • A Long term look to the JGB market
    • In spite of the deterioration of public finances seen over the last decade, JGB yields have been stable over this period. This is a puzzle to many observers.
    • There are strong stock and flow considerations that suggest during recessionary periods around JPY 30-40tn in net issuance can be absorbed by the market.
    • Peaks in JGB yields in recent years have all coincided with economic recoveries and, so far, failed exits from deflation.
    • Such recoveries led to a trinity of increased demand for loans, higher inflationary expectations and interest rate tightening. They all also happened amid fiscal consolidation.
    • Unsurprisingly, these meant that most of the action happened between 2y and 10y while super-long end rates have been on the whole unchanged.
    A long(ish) history of JGB yields Typical shapes of JGB curve Source: Bloomberg and SG Fixed Income Research
  • The 10y JGB Futures
    • The 10-year JGB futures is the most important and active instrument for hedging and trading interest rate risk. A large proportion of foreign investors will only trade using this futures contract and its derivatives. There is trading in the JGB roll (inter-month JGB futures spread) and JGB futures’ options.
    • The main relative value measure the market would look at would be the implied spread to JPY IRS (the futures ASW.) Also the relative deviation of implied volatility compared to JPY IRS swaptions as well as the magnitude of the JGB roll relative to historical experience.
    Source: TSE and SG Fixed Income Research
  • JPY Over-the Counter Interest Rate Derivatives Description
    • The most usual way of foreign access to the JPY rates market, other than JGB futures, is JPY/JPY IRS. This is one of the most liquid IRD contracts in the world and is easily accessible to most internationals investors.
    • There is active corporate issuance and investment hedging through the USD/JPY CCS basis as well as relative value trading around such hedging activity.
  • Typical Trades: 5y-7y-10y IRS
    • Why: This would be the alternative to being long/short futures for investors preferring IRS or needing a futures offset. It relates to the fact that under close to zero rates mid-sector butterfly spreads become highly directional.
    • How: Given the low level of JPY rates and design of the JGB futures contract, risk always falls on 7y. Thus the pay/receive the belly of a 5y-7y-10y IRS DV01 neutral butterfly is a natural hedge/offset to JGB futures positions.
    • Alternatives: A popular alternative among hedge funds seeking more volatility is to pay/receive the 5y2y-7y3y slope. The basic idea is the same only with about 4-times volatility on the quoted spread.
    • Risks: 5y-7y-10y IRS can de-correlate from direction which can happen if/when banks aggressively buy the 5y sector in case of sharp deflationary expectations.
    Source: Bloomberg and SG Fixed Income Research 5y-7y-10y a directional trade 5y2y-7y3y same idea, just more leveraged
  • Typical Trades: Short-Term Forward Steepener/Flattener
    • Why: This is the classic bet on an exit from zero interest rates/deflation and is based on the observation that front-end IRS would steepen in anticipation of a BoJ rate normalization process. The attraction of this trade increases as forward starting dates are sometimes positive roll-down.
    • How: The idea is that the investor enters early enough (or the BoJ is late) so that most re-pricing occurs on the paid leg. Also this assumes banks would liquidate JGBs around 3y-5y sectors as rates move higher. Trade usually implemented as a 6m to 1y forward start 1y-3y IRS spread.
    • Alternatives: Can be implemented through outright or spreads on Euroyen futures contracts as well using OIS/Tonar swaps.
    • Risks: This trade has rarely been successful for long. This is partly because we have not observed a full normalization of short rates but also because the BoJ has been always an early hiker relative to macro conditions. As such long rates were stable and expected steepening never materialized.
    Source: Bloomberg and SG Fixed Income Research Short-end forward steepeners a bet on BoJ exit
  • Typical Trades: Medium-Long Term Steepener/Flattener
    • Why: Under close to zero-rates the directionality of slope spreads are very segmented. There is bull (bear) / flattening (steepening) in the short to mid sectors. However, the reverse is true between mid to super-long segments.
    • How: As the super-long end is perceived as more likely to price equilibrium rates/default risk while excess liquidity spreads through the 2y sector, the preferred trade is a 5y-20y JGB or IRS spread.
    • Alternatives: This view can be implemented as a 5y-10y-20y fly or outright received/paid position on 10y10y IRS. Also since much of volatility in 15y floaters relates to this segment, long JF positions are advised on a steepening view if the bond is theoretically cheap.
    • Risks: This trade has been relatively safe except with the exception when rapid withdrawals of exposure from banks on the 5y sector or de-risking of Lifer portfolios occurred. Positions expressed in 15y floaters can be riskier given their relative illiquidity as often MoF buybacks are the only available bid.
    Source: Bloomberg and SG Fixed Income Research Medium-term slope is segmented from front-end Medium-term slope is highly correlated to JF performance
  • Typical Trades: The JGB Inflation-Linked Bond
    • Why: This comes from the notion that, at some point, the BoJ will generate (good or bad) inflation result of its balance -sheet expansion. Also low potential growth versus increased inflation expectations should mean linker out-performance.
    • How: This would be done by simply going long the “cheap” JGBi against its corresponding nominal bond. On occasion the investor hedges “effective” duration of the JGBi using an empirical beta and selling a shorter nominal JGBs. Seasonality in CPI means some issues are structurally rich/cheap to others.
    • Alternatives: There is some activity in JPY inflation swaps but trading in that market is rare.
    • Risks: Contradictions on the instrument’s design as MoF purposefully chose not to provide a floor on the principal of the JGBi. Unlike JFs there is no obvious domestic buyer for JGBis thus market dislocations can occur depending on foreign positioning or repo difficulties.
    Source: Bloomberg and SG Fixed Income Research JGB linkers not floored, CPI behavior is a risk Current valuations show significant stress
  • Basis You Need To Know: Cross-Currency Swap Basis
    • The cross currency swap basis is a critical risk transfer mechanism for any economy with large balance of payments imbalances. Japan is an extreme case of this.
    • Historically, large negative basis reflected differential credit risk assessments between Japanese and foreign banks and corresponding access to USD funding. The normalisation of this basis in 2005-07 coincided with the consolidation of the Japanese banking sector.
    • Receive side key flows: hedging issuance of foreign yen bonds and of Japanese investments overseas. Pay side: FX asset swapping of super-long JGBs or expressions of the carry-trade such as PRDC issuance. The latter are leveraged pay JPY against receive FX fixed structures with a digital option on FX/JPY.
    • The turmoil of 2008 destabilized the USD/JPY CCS basis market. The most obvious example was re-hedging of PRDC notes exposure related to USD/JPY breaking lower. This situation is now slowly normalizing.
    Source: Bloomberg and SG Fixed Income Research USD/JPY CCS basis have long history of volatility Some normalisation already taken place
  • Typical Trades: JGB Swap Spreads
    • Why: Investors can trade the notion of equilibrium level of implied repo-Libor spreads through JGB-IRS spread. This can be done by outright ASW for more macro views (supply, curve considerations) or relative value as ASW boxes.
    • How: Typically done through a long or short JGB position against matched maturity swaps (ASW or reverse ASW). Normally quoted on a yield-yield basis.
    • Alternatives: The most usual alternative is an ASW or reverse ASW using the 10y JGB futures thus bucketing risk around 7y. Most ASW box spreads or flies center around 7y to take advantage of the liquidity in that sector.
    • Risks: There is significant segmentation on the ASW curve from directionality of 7y sector, to Lifer demand around 15y-20y (in JGBs not IRS), to structural cheapness on 30y owing to lack of stable domestic demand and FX ASW interest. ASW can dislocate very severely in times of market stress.
    Source: Bloomberg and SG Fixed Income Research JGB ASW also highlight market segmentation Also can show strong dislocations in time of stress
  • Typical Trades: Super-Long Curvature
    • Why: Play on the segmentation of the JPY market with banks dominating up to 10y against a super-long sector led by lifers and pensions with more stable investment targets. Foreigners are opportunistic players in relative value space.
    • How: The easiest expression is long/short 10y-20y-30y JGB fly. The key issue is whether onshore Lifers can achieve investment targets via long 20y JGBs or through a barbell combinations of 10y and 30y, and more recently 40y.
    • Alternatives: Can be expressed in IRS spot flies or forwards steepeners such as 10y10y-20y10y IRS. Also in swaption space through payer spreads on 10yx10y.
    • Risks: Key factor is Lifers asset allocation decisions. Also risks related to USD/JPY CCS basis as un-hedging of PDRC exposure extends duration of the notes thus cheapens flies and flattens forwards. Hedging of FX JGB ASW exposure also can impact this sector.
    JPY curvature behaves very differently in super-long end Influenced by exogenous factors such as FX and equities
  • Basis You Need To Know: JPY Tibor-Libor Basis
    • This basis reflects the existence of two different interbank fixings used for standard IRS contracts. The Tibor panel is dominated by Japanese megabanks thus there is a differential in access to liquidity and credit risk assessment.
    • Historically, large positive basis reflected concerns about Japanese banks’ creditworthiness relative to the (more international) Libor panel. The normalisation of such basis into 2005-07 coincided with the consolidation of the Japanese banking sector.
    • The turmoil of 2008 destabilized the Tibor-Libor basis as the credit assessment and liquidity access of foreign banks sharply deteriorated relative to megabanks. There was a segmentation of the Tibor-libor curve with the long-end remaining positive, probably owing to USD/JPY CCS basis receiving dominating flows.
    • It appears the enormous supply of liquidity globally by overseas central banks helped restoring balance in this market.
    Tibor-Libor basis volaitlity an expression of relative liquidity Tibor-Libor correlation to FX and CCS basis has changed
  • Basis You Need To Know: JPY 3mx6m Libor Basis
  • Your partner in… Euro Capital Markets Derivatives Structured Finance