Why Japan’s Long Term Bonds Are Anything but Safe

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On the surface, investing in bonds might sound safe. Take Japanese bonds for example. Japan prints its own currency, and is hardly likely to default. But before investing in long term Japanese government bonds, there are a few warning bells you should be aware of.

First, Japan’s public debt exceeded US$10.46 trillion in 2013. As a percentage of GDP (229.2%), Japan carries more debt than any other nation on the planet.

Japan has had to aggressively borrow to keep their dreams of stoking inflation and economic growth alive. And this comes at quite a cost. Around 43% of Japan’s 2015 tax revenue was used to pay interest on its debt. And this number has been rising for years now.

But for the most part, all of this government spending has done little to improve private spending or spur growth. You may have heard this referred to as ‘Japan’s Great Stagnation’.

Where did it all go wrong?

In the aftermath of the Second World War, Japan ignored defence spending in favour of economic growth. The average growth rate of Japan’s economy was 10% in the 1960s, 5% in the 1970s, and 4% in the 1980s. From 1978–2010, Japan established itself at the second largest economy in the world.

However, when asset prices crashed in the 1990s, Japan’s economy started to falter. The country was growing at a slower rate than any other developed economy. Take a look at the graph below to see how inflation has trended sideways since the 1990s.

Source: Inflation.eu
Click to enlarge

Japan’s economic growth did outpace Europe and the US from 2001–2010. But their lost decade still lingers. Their massive public debt remains daunting. Along with massive fiscal spending, Japan has pushed interest rates into negative territory.

Japan increased efforts to encourage spending earlier this year. It was the first time the government issued bonds which cost money to hold. In February, the Bank of Japan (BOJ) issued a 10-year note with a yield of negative 0.05%.

David Blanchflower, Professor of Economics at Dartmouth, said in an interview with NPR, ‘[We] all thought that the zero lower bound was as low as things could go. That was as much stimulus as you could put into the economy.’

This might seem a little confusing if you’re not familiar with bonds. So think of bonds as just another investment property. The coupon rate you receive on that bond is just the rent you receive on your investment. Therefore, the yield of a bond is very similar to the rental yield of a property (the coupon divided by the price).

Now imagine you own multiple investment properties. But you don’t get to keep these houses forever. Instead, let’s say you own three investment properties.

Your ownership expires on the first property in five years’ time, the second in 10 years, and the third in 20 years. You can try to sell them before that time on the ‘secondary market’, in which case you may get more or less than you paid for them. Or, if you hold each house until your ownership expires, you receive the amount you initially paid.

Now all three properties also pay different rents, or yields.

Let’s say the first yields 2%, the second 4%, and the third 8%. You can see the difference between the yields, or the ‘spread’, increases the longer you own each property. The bond market works much the same way.

But why would anyone buy negatively yielding investment properties…or bonds? In Japan’s case, the investor might want to keep their capital protected, and they are willing to pay for that protection. Or investors could be speculating that the yen will strengthen in the future.

This isn’t the first time bonds like this have been issued. Countries in Europe already tried this strategy early last year. Switzerland, Germany, Denmark and several others issue bonds which trade at negative nominal yields.

Why would governments do this? Well if you had more than $10 trillion in debt, wouldn’t you want someone to pay you for the privilege of holding onto that debt? And — aside from trying to stimulate growth and your tax revenues — wouldn’t you hope that your policies stoke inflation, so your real debt reduces on its own?

Of course you would. And so does the Japanese government.

Now, as mentioned, to date all of their meddling has done little to stoke inflation. Hence many investors believe Japanese long term bonds are safe from a spike in inflation down the road.

Assume you had bought a 10-year Japanese note with a yield of negative 0.05%. You will be paying, instead of receiving coupons for 10 years if you hold until maturity.

The act of buying means you believe Japan’s inflation is going nowhere. And looking at Japan’s inflationary track record, you might be confident in this idea. At every turn inflation has been reluctant to take off. Japan’s inflationary figures for April dropped 0.3%.

Excluding 2014, Japan hasn’t been able to keep their yearly average inflation rate at 1% since 2008.  And policymakers have tried almost every economic tool to shock the economy into spending.

In 2012, Shinzo Abe, the current prime minister, employed three ‘arrows’ to kill Japan’s stagnation. The three arrows consisted of fiscal policy, monetary policy and structural reform. All too little avail…so far.

But markets move in cycles. Nothing lasts forever. Just because Japan’s struggled in the past, it doesn’t mean inflation will remain flat in the future. Buying a negatively yielding note from Japan means you assume inflation will remain constant for years to come.

It’s an enormous amount of risk to take on. Let me explain why.

Imagine that Japan’s inflation jumps above 2%, like in 2014, and remains above this level. The impact would mean huge losses for 10-year note holders. And with all the money Japan pumps into its economy, how do you know inflation won’t rise to 10%…or higher?

You don’t. You might have a strong conviction, but there’s no such thing as complete certainty. As with any investment, you have to consider how much you’re willing to lose if you are wrong.

Inflation finally taking hold in Japan could create a flow on effect. As inflation starts to rise, Japan will likely tighten monetary policy to avoid hyperinflation. Then, if rates rise, Japan will no longer continue to aggressively buy their own bonds.

Soon enough, new positively yielding bonds will be issued to investors. And you’ll be trapped with your 10-year negatively yielding note.

Now, as mentioned in the housing analogy above, you could always sell your bond on the secondary market. Like the share market, there are buyers and sellers.

But while you might wish to sell (really badly!), you won’t get back what you paid for it. Why would other investors buy your negatively yielding note, when they can easily buy a positively yielding one?

Now a one-year negatively yielding note is not nearly as risky as a 10 or 20-year bond. You might be in the same situation, having to pay to hold on to your bond. But you wouldn’t be holding on for such a long time.

But don’t be fooled. Japan’s long term debt is anything but safe. The longer you hold a low or negative interest rate bond, the higher your chances are of losing money.

It’s a trap you may live to regret.


Härje Ronngard,
Contributing Editor, Money Morning

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