Japanese bonds in a negative interest rate environment

Transcription

1 Japanese bonds in a negative interest rate environment On January 29, 2016, the Bank of Japan (BoJ) introduced "Quantitative and Qualitative Monetary Easing with Negative Interest Rate". The decision initiated a sharp decline in interest rates across the Japanese bond market. In this note, Manulife Asset Management s Keisuke Tsumoto, Managing Director, Head of Japanese Fixed Income Investment, shares his view that: What is common sense when investing in a positive interest rate environment does not necessarily apply in a negative rate environment. In particular, the potential for returns in a cash bond portfolio is limited by low and potentially uncertain compensation for interest rate and credit risk. Structural changes driven by the introduction of a negative interest rate dramatically increase the importance of employing financial instruments such as derivatives. In addition, it highlights the need to address a diverse investment universe with a flexible investment strategy. The BoJ s introduction of a negative interest rate came as a big surprise to the Japanese bond market, pushing Japanese government bond (JGB) yields into negative territory along the short end of the curve 1. Negative yields reached the 10-year tenor on 9 February as the central bank intensified its JGB purchasing amid widespread market concern over the health of emerging market economies newly issued 10-year JGBs closed the day at %. Figure 1: Historical 10-year JGB yield trend Figure 2: Comparison of 10-year JGB yield curves Source: Bloomberg, as of February 10, 2016 Source: Bloomberg, as of February 10, All market data from Bloomberg unless otherwise noted.

2 Implications of a negative interest rate environment for fixed income investment We believe that what can be considered common sense for bond investors amid positive interest rates may no longer be applicable in a negative interest rate environment. Investors may consider reassessing their investment approaches when it comes to assumptions about: Compensation for interest rate risk Although Japanese policy rates have been close to zero since 1999, they have remained positive. In this environment, investors in Japanese fixed income had a high degree of certainty that they would be compensated for interest rate risk if they held bonds until maturity (unless the bond defaulted). In addition, positive interest rates and a yield curve that effectively started at zero were relatively strong guarantees of roll-down yield. However, things are different in a world where a portion of the interest rate curve falls below zero. Carry income on bonds purchased at negative rates is obviously negative and, perhaps more importantly, there is no guarantee of roll-down yield. This significantly increases the level of uncertainty for investors in Japanese fixed income, raising the potential that they will not be compensated for interest rate risk in a negative interest rate world. Measures of credit risk In a positive interest rate world, corporate bond yields are calculated based on the following framework: Government bond yield + Spread that reflects credit risk = Non-government bond yield However, in a negative interest rate world it has yet to be seen whether this price formation mechanism will continue to apply to non-government bonds. Indeed, if JGB yields at the shorter end of the curve were to stabilise below zero or move deeper in negative territory, market participants would face some potentially disturbing questions: 1) should non-government bond yields be allowed to fall below zero as well or should they trade with a floor of zero yield? and 2) if non-government bond yields trade with a floor of zero yield and JGB yields move deeper into negative territory, should corporate credit spreads be allowed to widen irrespective of a given issuer's credit risk? These questions have potentially disruptive implications and would need to be addressed to maintain a properly functioning market for non-government bonds. Fixed income portfolio management under a negative interest rate policy As of 10 February, JGBs with maturities longer than 10 years continued to trade at positive rates while those with shorter tenors remained in negative territory. Similarly, some non-government bonds are issued or priced at negative rates in the primary and secondary markets. In such an environment, we see several strategies that could help generate positive returns for a Japanese fixed income portfolio: Increased use of derivatives 2 In a negative interest rate environment, the use of financial instruments such as derivatives becomes dramatically more important. The effective use of derivatives has the potential to stabilise or even improve returns by diversifying returns sources, increasing portfolio construction efficiency 2 The use of derivative instruments could produce disproportionate gains or losses, more than the principal amount invested. Investing in derivative instruments involves risks different from, or possibly greater than, the risks associated with investing directly in securities and other traditional investments and, in a down market, could become harder to value or sell at a fair price. Counterparty risk, liquidity risk (i.e., the inability to enter into closing transactions) and risk of disproportionate loss are the principal risks of engaging in transactions involving futures contracts, options, swaps and foreign currency forward contracts.

3 and reducing trading costs. In fact, we believe derivatives could be an essential component of bond portfolio construction in a world where positive returns cannot be taken for granted. As mentioned earlier, in a negative interest rate environment there is no guarantee of compensation for interest rate risk in either the JGB or non-government bond markets. In this environment, interest rate derivatives can be an effective means of diversifying risk exposure by creating multiple interest positions within a bond portfolio. Similarly, we previously discussed the potential for credit spreads on non-government bonds to be driven by negative base JGB yields irrespective of a given issuer's credit risk. As the pricing of credit default swaps (CDS) were determined independent of JGB interest rate movement, we believe that CDSs could emerge as effective measures of pricing credit risk in the non-government bond market 3. As we expect non-government bond issuance at maturities for which equivalent JGB yields are negative to decrease in a negative interest rate environment, CDSs could also work as a key tool for diversification and expansion of the accessible credit investment universe. Investment universe expansion In a negative interest rate environment, we believe it is crucial to address a broader investment universe than that suggested by the relevant benchmark index. For example, investment in instruments such as inflation-linked government bonds, floating-rate government bonds and hedged foreign bonds can deliver a liquidity premium due to the attractiveness of their specific product features and the potential to access a different investor base than is active in the market for generic cash bonds. This liquidity premium could improve and stabilise returns by diversifying returns sources. Putting structural bond market changes in perspective The BoJ s introduction of a negative interest rate policy obviously has significant implications for the Japanese bond market. Of particular concern is the possibility that negative interest rates will continue for the long term, potentially limiting the attractiveness of long-standing conservative bond market investment strategies such as passive investment in a benchmark index or adopting a ladder strategy. The immediate fallout from the introduction of a negative interest rate in Japan has been market turmoil that contributed to a growing global risk-off trend across asset classes, exacerbating the concurrent impact of low oil prices and uncertainty over the prospects of emerging markets and European financial markets. That being said, while low oil prices and turmoil in emerging markets are generally short-term factors, the introduction of negative interest rates has the potential to fundamentally change the Japanese bond market s interest rate structure and price formation mechanism. With this in mind, we have carefully assessed the implications of the negative interest rate for investors in the Japanese fixed income market and developed several hypothetical investment scenarios to illustrate the potential benefits of employing derivatives and addressing a more diverse investment universe. 3 A credit derivative, such as a credit default swap, is subject to risks associated with both derivatives and fixed income securities. Investments in fixed income securities are subject to varying degrees of risk that the issuers of the securities will have their credit rating downgraded or will default, potentially reducing an investment's value. The use of derivative instruments could produce disproportionate gains or losses, more than the principal amount invested. Investing in derivative instruments involves risks different from, or possibly greater than, the risks associated with investing directly in securities and other traditional investments and, in a down market, could become harder to value or sell at a fair price. Counterparty risk, liquidity risk (i.e., the inability to enter into closing transactions) and risk of disproportionate loss are the principal risks of engaging in transactions involving futures contracts, options, swaps and foreign currency forward contracts.

4 Hypothetical Scenario 1: Sample use of interest rate derivatives 4 Five- to seven-year flattener yield curve strategy to gain from tighter yield spread Derivatives employed: Short five-year interest rate swap (pay fixed rate and receive floating rate) + long JGB futures. In a cash bond portfolio, the position is created by underweighting five-year bonds and overweighting seven-year bonds. However, the five-year bonds are only to be underweighted to a small degree. This position could potentially be created using interest rate derivatives. Hypothetical Scenario 2: Sample use of credit derivatives 4 Security selection strategy to take a credit risk of company A Derivatives employed: Short a single-name CDS as an alternative to a long position of non-government bonds issued by company A. Holding the single-name CDS eliminates the uncertainty of compensation for the credit risk associated with company A or the potential for bonds issued by company A to be unavailable in the secondary market due to the impact of negative JGB base rates. This position could potentially be created using credit derivatives. To buy or not to buy bonds with negative rates? Since the BoJ announced the negative interest rate, many have expressed concerns about holding or selling existing bond positions and purchasing newly issued bonds with negative rates. We do not see a compelling reason to sell across the board simply because of negative rates, and even see the potential to profit from purchasing bonds at negative rates. This may seem counter-intuitive, as bonds with negative rates will invariably generate negative returns if held to maturity (i.e. aggregate coupon income from the time of purchase to maturity will be smaller than the capital loss at redemption, meaning the total return will be negative). However, even bonds with negative rates have the potential to generate positive returns if they are sold (or marked-to-market) prior to maturity. For example, if interest rates fall (or move deeper into negative territory) following the time of purchase, capital gains (or mark-to-market gains) could exceed the negative carry income, generating a positive total return. This scenario can be illustrated clearly via the performance of short-term (one- to three-year) JGBs following the BoJ s introduction of a negative interest rate. While the average yield on short-term JGBs within the NOMURA-BPI stood at -0.08% as of 29 January 2016, the investment return on these securities reached January to 10 February Although carry income remained negative during this period due to negative rates, the mark-to-market gain resulting from the interest rate falling deeper into negative territory during the same period significantly outweighed the carry loss, generating a positive total return. Thus, while carry income on bonds with negative rates is inevitably negative, we do not believe this is the only factor to consider. Rather, we believe all buckets of returns potential are worth considering, which includes the potential for capital gains. 4 This is a sample illustration, was prepared solely for informational purposes and does not constitute an offer or an invitation by or on behalf of Manulife Asset Management to buy or sell any security. This material should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any investment products or to adopt any investment strategy. It should not be assumed that an investment in these strategies was or will be profitable. 5 NOMURA-BPI, Nomura Securities Co., Ltd. Information as of February 10, NOMURA-BPI is an index published by Nomura Securities Co., Ltd. Copyright Nomura Securities Co., Ltd. All rights reserved. Nomura Securities Co., Ltd. shall not guarantee correctness, completeness, reliability and usefulness of the subject index, and shall not be liable for any business activities and services conducted by Manulife Asset Management Ltd. by using the subject index.

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