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The Bank of Japan’s latest relaxation of its cap on bond yields will enhance the returns on offer on the country’s debt, leading some investors to forecast that a “great repatriation” of Japanese investment flows is set to accelerate. 

The policy shift comes at a time when overseas debt has become an increasingly unappealing prospect for many Japanese investors because of the soaring cost of hedging against swings in the value of the yen.

Many big Japanese investors, such as insurers, routinely hedge their currency exposure when they buy foreign bonds. Rising interest rates in the rest of the developed world have sharply driven up the cost of doing so, more than cancelling out the growing yield gap between Japan and other economies, making Japan’s low-yielding bond market appear relatively attractive.

The currency-hedged yield on a 10-year Treasury fell below the equivalent Japanese bond yield late last year, according to data from Apollo, and a gulf has opened between the two markets since then.

“It hasn’t made sense for Japanese investors to own Treasuries and [German] Bunds, they would rather buy Japanese government bonds — which is what everyone was doing,” said Mohit Kumar, managing director at Jefferies.

Line chart of Yield (%) showing Hedging costs make foreign bonds unappealing for Japanese investors

Japanese investors are some of the biggest owners of bonds in the US and Europe, after years of a strong currency and higher returns elsewhere had made foreign assets more attractive to own. According to Commerzbank research, Japanese investors owned more than $2tn in foreign long-term debt securities at the end of 2022, with large holdings in the US, France, the Netherlands and Germany.

But Japanese investors have been net sellers of foreign assets over the past 18 months, said Kumar, despite soaring yields in the US and Europe and a domestic bond market where the BoJ has kept borrowing costs at very low levels.

On Friday, the BoJ took a step towards ending its ultra-loose monetary policy by saying it would tolerate yields on 10-year government bonds of up to 1 per cent, from a previous level of 0.5 per cent. The policy shift sent jitters through US and European bond markets, as traders bet that it would encourage Japanese investors to bring their cash home by further burnishing the appeal of the domestic market.

“Global yields have risen in response to the tweak in yield curve control based on the fear that higher yields in Japan may lead local investors there to invest more in Japanese government bonds and therefore sell some of their holdings of Treasuries or bunds,” said Michael Metcalfe, head of macro strategy at State Street Global Markets. 

Investors also said that a relatively strong economy and diminishing threat of deflation would tempt more investors back to Japan, including Tokyo’s high-flying stock market, where the Topix index is up more than 20 per cent this year.

The “great repatriation” of Japanese assets is just getting underway, said Luca Paolini, chief strategist at Pictet. “People always talk about bonds, but it will also cause a re-rating of Japanese equities.”

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