Foreign investors threaten JGB stability Who would want to own a claim on a government that has collected less money in tax than through selling bonds in each of the past four years? And who would want to hold a piece of a country's debt pile well over twice the size of its economy? Plenty of people, it turns out. Foreign investors have been flocking to Japan's government bond market as never before. At the end of the fiscal year to March, the Bank of Japan reported this week, non-Japanese investors owned a record 8.3 per cent of outstanding JGBs. The foreign-held share has almost certainly risen since, as global funds have been spooked into Japanese bills and bonds by renewed fears over Greece and Spain. There is no safer haven than Japan, argues Naohiko Baba, a Tokyo-based economist at Goldman Sachs, pointing out that the risk-adjusted return of a 30-year JGB, as measured by its Sharpe ratio, is about three times higher than equivalent US Treasuries, and four times German Bunds. "The market has sufficient scale and liquidity to be a viable temporary refuge," he says. But the increased foreign interest in JGBs poses two big questions, say analysts. Will the newcomers start to demand higher yields? And will it hurt the market if they beat a retreat? On the first, the answer is probably no, at least for now. As yield curves in other developed markets converge on that of Japan's, investors are becoming less choosy. When set against negative-yielding Bunds, for example, a 9 basis-point yield on a one-year JGB is "good enough," says Hideki Nagai, head of rates trading at Barclays. Furthermore, the worldwide dollar crunch arising from the eurozone sovereign debt crisis has boosted returns on yen bills and bonds when using currency swaps. The pick-up for currency-hedged JGBs over Treasuries currently ranges from 47 basis points for three-month paper, to 55bp for one-year. As long as the euro crisis lasts, "cash-rich, real-money investors should be exploiting negative currency basis spreads for yield enhancement in their dollar portfolios," says Yuya Yamashita, rates strategist at JPMorgan. As to whether a big foreign retreat will hurt JGBs, the answer is, probably, yes. For much of the past year and a half, increased foreign JGB purchases have been concentrated in short-dated bonds, where their share reached 18.5 per cent at the end of March, from 10.6 per cent two years earlier. That is an area of the market where the BoJ holds greatest sway, committed to buying trillions in debt with maturities up to three years. But recently foreigners have begun to creep up the yield curve, buying from domestic institutions as they, in turn, extend durations in search of better returns. In the past two months, for example, foreigners were net buyers of about Y900bn ($11.3bn) of longer-term bonds, and in April super-long JGBs (with a residual maturity of more than 10 years) saw a sudden, Y600bn wave of net buying - the first since 2007. For all the stability of the JGB market, it has not been immune to foreigner-led sell-offs. In spring 2008, for example, overseas hedge funds were hit hard by leveraged bets on yen swap spreads, causing 10-year bond yields to soar almost 50 per cent in three months, before domestic insurers stepped in. In March this year, cash yields blipped higher as trend-following speculators sold big blocks of JGB futures. Analysts also recall the so-called "Ozawa shock" of autumn 2010, when investors took fright at a leadership challenge to Naoto Kan, then prime minister, as he pursued a fiscal reform programme. Now that foreigners have a more powerful influence on prices, they may act as a more aggressive "check" to fiscal lapses, says Shuichi Ohsaki, rates strategist at Bank of America Merrill Lynch in Tokyo. While new sources of demand are a good thing in theory, they carry risks too, admits Kohei Noda, an official in the finance ministry's debt management policy division. "We don't deny that higher foreign participation raises the risk of the transmission of exogenous factors to the JGB market," he says. The market has plenty of stabilisers, of course. Aside from the increasingly supportive BoJ, banks have to keep buying bonds to close huge gaps between deposits and loans. But if foreigners have driven up prices - JGB yields should be 20-30bp higher than they are now on economic fundamentals alone, according to Nomura - they could just as easily drive them down again.