Investors are too gloomy about Japanese government bonds

For years, investors complained that JGBs offered neither income nor capital return. Now JGB yields are at levels many investors have never seen in their careers – yet caution still abounds.

I think the pessimism is overdone.

I can see the concerns. Japan has one of the developed world’s highest debt burdens. Prime Minister Takaichi’s administration wants to spend for growth. The Bank of Japan is slowly stepping back from a bond market it dominated for years, while raising rates. On the surface, that points to higher yields.

But what if investors are looking at the wrong part of the balance sheet?

Japan isn’t just a heavily indebted country. It’s one of the world's largest net international creditors. Japanese domestic investors have accumulated an enormous stock of overseas assets, which may soon be put to better work at home. That matters more than markets appreciate. 

A shift is already underway. Policymakers are encouraging pension funds and households to invest more at home. If successful, this could support domestic assets, growth and even the embattled yen. A virtuous circle, so long as jawboning becomes action.

This isn’t financial repression

It’s merely common sense (and maybe the UK could take note!). After adjusting for currency effects, JGB yields increasingly look competitive versus many developed-market alternatives. That wasn’t true a few years ago. Can Japanese investors justify sending capital abroad in search of yield, when they could earn materially more at home?

The yield advantage matters because JGBs are now a supply-and-demand story. The Bank of Japan is buying fewer bonds, and new issuance remains significant. What matters now is who fills the gap. Domestic investors need not overhaul their portfolios. Even a modest shift back into Japanese assets could pull JGB yields lower.

What about the Takaichi administration? 

Bond investors have understandably focused on the risks: potentially unfunded spending, political pressure on the Bank of Japan, and concerns about fiscal discipline. Those risks are real. But recent comments from Takaichi, Katayama and others suggest policymakers recognise them.

Japan’s leaders know the bond market is watching. Yields have already shown what happens when investors question discipline. From here, much rests on the policy mix. Takaichi’s agenda may well be more expansionary, but it’s framed around investment, productivity and domestic capital mobilisation, rather than simply open-ended fiscal loosening. If delivered well, that could improve debt dynamics rather than undermine them.

Be under no illusion: JGB yield volatility has increased recently. This reflects both domestic policy uncertainty and the global rates backdrop. Outperformance may be uneven. Yet, investors don’t need perfection for JGBs to perform well from here. They simply need outcomes that are less alarming than markets expect.

That’s why I find the current opportunity so compelling. Consensus sees Japan as another fiscal problem waiting to happen. I think that risk is overplayed. What’s more, for the first time in a generation, investors in JGBs are being paid to wait while one of the world’s largest pools of overseas wealth is encouraged home. That’s a far more attractive backdrop for JGBs than current market pricing suggests.

More from The Witt

Short, incisive perspectives – fresh takes on the issues driving markets today.

Latest articles from The Witt