Quake costs may shake faith of JGB investors at home

The Japanese government bond market may finally be reaching a tipping point, with the issuance needs for post-quake reconstruction prompting domestic investors to demand higher yields to absorb yet more debt. Abroad, Japan's massive and growing debt load has stirred worries, driving the cost of default insurance to historic peaks and prompting credit rating cuts to below Spain. At home, benchmark yields have not budged much from near 1 percent.
In a country with public debt twice the size of its $5 trillion economy, many fund managers here are reluctant to talk on the record about any fears about the bond market - in part because they have to justify holding bonds in their super conservative portfolios.
But the direct damage from the March 11 quake and tsunami - now seen as high as $310 billion, or about 6 percent of the economy - is raising some doubts about whether already overloaded investors can absorb much more debt at such low yields. Big Japanese banks - a key pillar of support - may cut back on JGB holdings for reconstruction lending, while insurers may need to sell to raise funds to pay claims. Household investors have traditionally shifted funds into higher-yielding foreign assets and prefer JGBs only at yields well above current levels.
"Yields are not going to rise in the short term but it does raise medium to long-term risks for the JGB market," Hidenori Suezawa, chief strategist at Nikko Cordial Securities. Economists at Credit Suisse said the government may face a 12 trillion yen ($148 billion) funding shortfall in the fiscal year beginning in April. Even if the Ministry of Finance takes measures to limit the increase in bond issuance, such as postponing planned corporate tax cuts, Credit Suisse warned it may not be enough to prevent a "significant deterioration" in the JGB market.
Before the quake and ensuing crisis at a nuclear power plant, the medium-term risks about bonds were being reflected in the JGB market via a steep yield curve, with investors gradually demanding a higher yield to hold long-term bonds relative to short-term paper. Since the quake, the yield curve between 5-year and 20-year JGBs has steepened to 158 basis points and is holding close to last year's decade high of 167 bps.
Benchmark 10-year yields even rose slightly last week as the Nikkei share average plunged more than 10 percent, showing the need among insurers to sell. Yields are now at 1.220 percent, 40 basis points above seven-year lows touched last year. Foreign players have gradually built up positions betting on debt troubles for Japan via credit rating cuts.
The five-year credit default spread for JGBs is now 95 bps, about 15 bps wider than pre-quake levels after briefly hitting a record above 120 bps last week - above the spread of South Korea which has a lower credit rating. PIMCO warned earlier this year that there was little value in longer dated JGBs around current yield levels. Mitsubishi UFJ Securities estimates that, in a worst case scenario, the impact on net government debt outstanding, compared to where this would otherwise have been, could be as much as 5-10 percent of GDP by 2014 as a result of the quake.