Foreigners pile into Foreigners pile into Japanese bonds as FX swaps make yields more attractive as FX swaps make yields more attractive

TOKYO: Foreign investors have snapped up Japanese bonds at a near record pace in recent weeks, as financial alchemy through currency swaps makes their yields more attractive than those of many European bonds.

Data from Japan's Ministry of Finance published on Thursday showed they bought a net 1.03 trillion yen ($9.22 billion) last week, bringing the total over the past 13 weeks to 6.12 trillion yen ($54.77 billion).

That's the highest level since late 2014, when net buying hit 6.5 trillion yen.

Market players say investors are increasingly buying longer-dated debt, such as five-year bonds. That marks a shift from past investment trends when buyers spurned longer maturities on worries about Japan's massive public debt and mostly focused on shorter-dated notes like two-year notes.

The yield on five-year government bonds (JGB) has been stuck around minus 0.150 percent due to the Bank of Japan's aggressive easing.

However, by swapping cash flows from bonds to dollars and euros - a common strategy among institutional market participants - the investment proposition completely changes.

Because of the large premium investors can earn by swapping foreign currencies for yen, five-year JGBs yield about 3 percent when converted to the dollar, about 50 basis points more than five-year U.S. Treasuries.

When swapped out to euros, they yield more than 0.2 percent.

While euro-based JGB yields have not changed significantly from that level, recent falls in European bond yields have made euro-based JGBs attractive.

"Demand from Europe appears to be very strong. JGBs now yield more than Spanish bonds, and their volatility is very low because of the BOJ's policy, " said Koichi Sugisaki, strategist at Morgan Stanley MUFG Securities.

The yield on five-year Spanish bonds, for example, dropped to 0.10 percent on Thursday as sluggish euro zone growth prompted the European Central Bank to push out the timing of a rate hike to beyond next year.

In October last year, they yielded more than 0.75 percent.

LAST-MINUTE SALES

But the boom is likely to slow in April, analysts say, partly because a factor that has helped to enhance JGBs returns for foreign investors is likely to disappear due to Japan's new rules on bank bond investments.

In recent months, many European banks have issued yen bonds in order to increase sufficient financial buffers, the so-called Total loss absorbing capacity (TLAC).

When these banks issue yen bonds, they swap yen to dollars and euros. This demand has contributed to higher swapping costs, which benefit players who would be on the other side of the swap, such as dollar- and euro-based investors who want to buy Japanese bonds.

But European banks' yen bond issuance is likely to diminish, bringing down the extra returns foreign investors could earn on swaps, as Japan's financial watchdog imposes much higher risk weightings on TLAC bonds Japanese banks will buy from April.