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Dollar swap alchemy gives unloved JGBs a high yield allure
March 24, 2017 / 3:35 AM / 8 months ago

Dollar swap alchemy gives unloved JGBs a high yield allure

* Negative-yielding JGB offer decent return when swapped to dlr

* Dollarised JGBs yield 30 bps over LIBOR, was above 70 bps

* Sovereign investors among main buyers of dollarised JGBs

* Asian investors buy JGBs at record level in January

By Hideyuki Sano

TOKYO, March 24 (Reuters) - Negative interest rates on Japan’s government bonds make them among the world’s least attractive but financial alchemy has allowed investors to turn this debt into high-yielding dollar bonds that cut exposure to Federal Reserve policy risks.

While short-term JGBs, whose yields are still below zero percent, are spurned by domestic investors, a quirk in the currency swap market makes them attractive to foreign investors.

“There remains fairly strong interest from foreign investors on JGBs, including banks and sovereign players,” said Naoya Oshikubo, yen rates strategist at Barclays.

Two-year JGBs now yield minus 0.26 percent. Using a technique called asset swaps, however, they can be repackaged into two-year floating-rate dollar bonds that yield about 0.30 percent, or 30 basis points, above the benchmark London InterBank Offered Rate (LIBOR).

That is a hefty yield enhancement compared with two-year U.S. Treasuries notes, which would yield about 35 basis points less -- not more -- than the LIBOR if investors swap their fixed coupon into floating rates.

Earlier this year, the dollarised JGBs yielded about 70 basis points more than LIBOR.

Yields on dollarised JGBs are elevated because of the imbalances in the currency basis swap market, where players swap two currencies for a certain period of time.

For instance, an investor can borrow yen, paying yen interest rates, in exchange for lending dollars and receiving interest on them. In other words, a bank effectively borrows one currency while using the other currency as collateral.

So this swap should theoretically have no additional costs involved. But in reality because there is far greater demand for dollar from Japanese investors, dollar borrowers have to pay extra costs to yen borrowers.

That premium, called dollar/yen currency basis spread, rose sharply last year, with three-month spread hitting almost one percent in December.

While the premium has since shrunk to around 31 basis points, partly because foreign investors’ appetite for JGBs has grown, it still remains large enough to keep dollarised JGBs attractive.

According to data from Japan’s Ministry of Finance, in January, the latest month for which data is available, Asian investors bought 1.379 trillion yen ($12.36 billion) of Japanese bonds, their largest net buying in almost six years.

Among them, Chinese investors bought 890 billion yen of Japanese bonds, their biggest since August. A large part of Asian buying is considered to have come from state-backed investors - such as sovereign wealth and pension funds - who tend to park their funds in fixed income rather than bank deposits.

The shift to JGBs comes as institutions reduce their U.S. Treasuries holdings amid the spectre of rising interest rates.

Data from the U.S. Treasury shows foreign official investors sold $44.9 billion in U.S. Treasuries in January this year after a record $338.0 billion selling last year.

China bought a small amount of U.S. Treasuries in January but that came only after seven straight months of net selling, the longest such spell on record, as Beijing sells U.S. bonds and dollar to prop up the yuan.

Analysts say while the pace of buying of dollarised JGBs could slow, they’re likely to continue to attract foreign investors.

“It also depends on what other alternatives investors have in dollar investments,” said Makoto Noji, senior strategist at SMBC Nikko Securities.

“But as long as there are decent yields, JGBs appear to remain a place to go for them.”

$1 = 111.60 yen Reporting by Hideyuki Sano; Editing by Sam Holmes

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