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TOKYO (Reuters) - Hedge funds and foreign investors are building up protection on Japanese government bonds in the credit default swaps market, underscoring persistent worries about Japan's poor fiscal health and suggesting that JGBs could be shaken by CDS moves in the near future.
The outstanding volume of CDS written on JGBs has doubled in the past eight months as Europe's sovereign debt crisis has made anxious banks and investors hedge their exposure to Japan, the most heavily indebted of the major economies.
Japan's public debt -- totalling nearly 200 percent of GDP -- has long been financed domestically from the country's massive pool of savings that mostly sits in the banking system and is recycled into JGBs.
But fears are growing that the ageing population will start drawing on that pool of savings, forcing Japan to rely on foreign investors to fund its debt and potentially creating market instability.
New Prime Minister Naoto Kan, who has vowed to start fixing the tattered finances, warned on Friday Japan risked default if it failed to act, and investors are not convinced it has been taking enough steps to head off a crisis down the road.
Graphic on CDS spread/volume, click link.reuters.com/xag59k
While other sovereign CDS spreads have shrunk this week along with a rebound in stock markets, Japanese sovereign CDS spreads have edged out to 99 basis points, pushing back towards a record peak of 130 basis points and up from 3 basis points just three years ago.
Some analysts are wary the big increase in volume on Japanese sovereign CDS may spark a volatile widening of spreads that could even prompt domestic investors to start shedding their JGB holdings.
"Fear is what drives CDS, big upticks take place when sentiment is weak. It is a game of increasing fear as much as possible and then getting out," said a senior credit trader at a U.S. bank.
Foreign commercial banks, which have loan business with Japanese companies and swap houses exposed to yen products, are among the buyers of protection, traders said.
"There are participants out there scared enough to buy protection. People really drive hard on fear. It is 'hedge when you can, not when you have to'."
Net notional volume of Japan's five-year sovereign CDS stood at $4.45 billion on June 4, data from the Depository Trust & Clearing Corporation (DTCC) shows, up from $2.94 billion at the end of November.
Traders said some investors have made handsome profits over the past two years thanks to extreme moves in CDS, which is the best scenario for dealers.
The Japanese government is doing little to give a sense of security to the markets in managing its public debt, and this could be used by speculators to create market volatility and opportunity for profits, the trader at a U.S. bank said.
Potential disappointment or a downgrade of the sovereign credit rating following Japan's expected medium-term outlook on fiscal restructuring due later in the month could be their trading incentives.
Volume has also grown in U.S. sovereign CDS and UK sovereign CDS in the past year, a research paper released by the Bank of Japan in April showed, reflecting market concerns over the fiscal state of major economies after a blow-up in government spending following the global credit crisis.
But the volume in Japan sovereign CDS remained about 1 percent of a total of $2.17 trillion, in which Italy's sovereign CDS had the biggest share at 10 percent.
Traders said the biggest advantage of CDS was its low cost enabling speculators to make bets. Protection against Japan's default risk was bought and sold almost entirely by overseas investors, they said.
For that reason, some analysts warned that price movements in Japan sovereign CDS may become very volatile and that in turn could sour sentiment among domestic investors towards JGBs, resulting in higher costs for Japan to finance its debt.
"A boost in trading activity may come sooner than we're now anticipating if more foreign players recognise the trend of falling domestic savings and an expected rise in foreign JGB holdings in the coming years, and find motivation to sell protection now," said Jun Ishii, chief fixed-income strategist at Mitsubishi UFJ Morgan Stanley Securities, in a client note in April.
Market experts argue that Japan's sovereign CDS market, despite the recent jump in volume, is still a drop in the bucket compared to the huge JGB market dominated by real money domestic investors who invest trillions of yen.
It will be the domestic investors, not overseas players, who would rock the JGB market if they decide to react negatively on fiscal concerns, they say.
Japan's five-year CDS spread rose to a 14-month high of 98 basis points in late May as fears escalated that the euro zone's debt crisis was spreading to its banking system.
That was a day after the benchmark 10-year JGB yield dropped to a five-month low of 1.190 percent .
"A sort of correlation between CDS spreads and JGB yields may exist but when you are talking about a hundred million on one side and a trillion on the other, it is like smoke and mirrors. I am skeptical that the CDS market can move JGBs," said the trader at a U.S. bank.
(Editing by Eric Burroughs)
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