The high debt ratio, potential for further fiscal expansion, and fewer natural buyers all make Japan vulnerable to bond market gyrations.

But if Japanese bonds were to come under stress, there would be several tools available to authorities to stem a crisis.

In the eye of the storm of global bond market pressures

Government bond auctions typically attract minimal attention outside of a small universe of bond traders. However, last month’s failed 20-year Japanese government bond (JGB) auction played into a worrying sell-off in long-end global bond markets.

Moody’s downgrade of US government debt on May 16 had already set the stage for the sell-off by raising investor concerns over debt sustainability. But Japan’s failed auction the following day was a further catalyst. As a result, yields on long-term debt in developed markets surged to decade highs by late May, and have remained elevated since (Chart 1).

The start of the trend in higher global bond yields, of course, dates to the inflation increase in the aftermath of the pandemic and then the Russian invasion of Ukraine, and the consequent sharp tightening in monetary policy.

But, in addition, structural supply and demand imbalances at the super-long end (20–40-year tenors) of global bond yields, central banks reducing or selling bonds purchased through quantitative easing (QE) programs, and governments issuing more long-duration bonds to fund fiscal plans, have all added to these pressures.

The Bank of Japan (BoJ) was explicitly targeting 10-year bond yields during the period of yield curve control (YCC) between 2016 and the abandonment of the framework in March 2024. Longer-end JGBs were also very stable. However, the long end of the JGB curve has since become especially sensitive to sell-offs, amid volatility in global bond markets.

But while Japan may be particularly exposed to bond market pressures, policymakers also have the tools to contain excessive volatility.

High debt levels and more issuance coming

Japan has the highest government debt-to-GDP ratio among the developed economies, exceeding 200% (Chart 2).

This is a legacy of the efforts to offset the 1990s crash and the subsequent low growth of the “lost decades.” However, it is also due to demographic challenges, high social security costs, low borrowing costs, and high levels of domestic debt ownership, which make it possible to issue it in large quantities.

This high debt load is, however, what makes significant bond market volatility possible.

Moreover, the need for additional fiscal spending has continued to rise. Increased spending on defense, social security needs for an aging population, and subsidies to offset higher food and energy costs may be unavoidable against the current macro and geopolitical backdrop.

Consumption tax is an essential source of fiscal revenue for the government. But poor polling for the ruling Liberal Democratic Party (LDP) coalition may lead to pressure from opposition parties advocating for a tax cut. The latter, whether it is temporary or permanent, would require further bond issuance.

Less demand from the BoJ itself

Japan faces a significant supply-demand imbalance as natural buyers are slowly reducing their JGB purchases. Following years of QE, the BoJ is the single largest owner of JGBs, holding over 50% of outstanding stock. Life insurers and pension funds are the next biggest holders, with a combined ownership of 22% (Chart 3).

The BoJ started tapering bond purchases in July 2024. It announced a reduction of ¥400 billion in purchases each quarter, aiming to move from ¥5.7 trillion in purchases in July 2024, down to ¥2.9 trillion by January–March 2026.

The composition of tapering has been heavier in the under-25-year bucket, while long-end purchases were maintained.

At the June policy meeting, the central bank announced an interim plan for Q1 2026 and beyond. Purchases will taper at a slower pace of ¥200bn each quarter, which should leave monthly purchases at ¥2.1trn by the end of Q1 2027.

Notably, the statement also signaled that the BoJ can change the pace of purchases at any meeting. This introduces a lot of flexibility to manage bond volatility in the future. Bond market vulnerabilities seem central to the decision and technical changes.

Fading demand from private sector buyers …

The long period of zero and negative interest rates and YCC in Japan fueled the carry-trade, whereby investors borrowed in yen at a low yield to invest in higher-yielding risk assets abroad. It also encouraged life-insurers and pension funds to buy long-dated bonds to earn incremental yields and match long-term liabilities.

However, these natural buyers of the long end have been reducing demand, particularly for 20- and 30-year maturities, for several reasons.

… due to regulatory change …

Since mid-2020, Japan has been in the process of transitioning to a new economic value-based solvency regulation, as part of a global trend toward risk-based capital frameworks like Europe’s Solvency II.

Under this regime, insurers need to value assets and liabilities using market-consistent measures. Interest rate changes have a larger impact on the present value of liabilities than assets due to the longer duration and contractual cash flows.

In the past, these incentivized insurers to buy more long-dated bonds as part of their asset-liability matching strategies to reduce the duration gap.

… and a narrowing “duration gap”

But since 2022, when YCC ended, JGB yields rose, narrowing the duration gap without insurers needing to buy more long bonds.

Mark-to-market losses on existing long bond holdings made the long-end less attractive. With a small duration gap, insurers had less pressure to buy long-dated JGBs.

To mitigate risks from rising yields, insurers increased exposure to foreign bonds, equities, alternatives, and shorter-term domestic bonds, where returns were more attractive.

Moreover, insurers are shifting to dynamic asset-liability matching strategies to minimize interest rate risk from long-dated JGBs ahead of the 2025 regulatory implementation.

JGB liquidity has also deteriorated

JGB liquidity has deteriorated following the Liberation Day US tariff announcements, now stands at historic levels (Chart 4).

Liquidity is calculated as the average intraday yield error relative to fair value across Japanese bonds. During the post-financial-crisis and pre-pandemic decade, the average liquidity in JGBs was stable around 1. Liquidity began to deteriorate in 2022 with market concerns around debt sustainability, combined with exceptionally loose monetary policy, and speculation over the BoJ ending YCC.

Could the JGB sell-off accelerate from here?

Mark-to-market losses on extensive holdings of long-end JGBs for life insurers could erode capital buffers and cause self-reinforcing sales of bonds. The negative duration gap means rising yields increase the valuation of liabilities faster than asset values and so intensify capital strain. Banks holding JGBs could also face valuation losses, impacting earnings and capital adequacy.

Together, these fueled concerns of a vicious cycle where insurers or regional banks may need to sell JGBs into a falling market and create a feedback loop like the UK liability-driven investing (LDI) crisis of 2022.

Policymakers still have plenty of tools

However, the Japanese authorities have several tools at their disposal to prevent or contain a bond market crisis.

The MoF could issue shorter-term JGBs

In the immediate aftermath of the weak JGB auctions, the Ministry of Finance (MoF) surveyed primary dealers to understand the drivers of market volatility (Table 1).

Further market discussions over appropriate bond issuance plans will take place between 20 and 23 June.

These announcements, which helped stabilize the JGB market, could see the MoF shift issuance patterns away from the long end, towards the short end of the curve. Less supply at the long end would reduce upward pressure on yields.

In extremes, the MoF could announce bond buybacks to help cap yields or coordinate orderly rebalancing via industry groups to avoid everyone selling at once.

The BoJ has multiple tools

It could resume purchases of long-dated JGBs, signal temporary yield caps, or use more explicit forward guidance to cap yields and stabilize the market. This would help insurers revalue liabilities more predictably. The BoJ could also employ special repo facilities or discount windows for insurers to access funds without needing to sell long bonds at a loss. This reduces the risk of fire sales.

Could the FSA delay full enforcement?

The Financial Services Agency (FSA) could delay full enforcement of the new solvency framework. Phasing in could provide insurers time to adjust.

GPIF to step into the market?

The Government Pension Investment Fund (GPIF) could explicitly step into the market. GPIF is viewed as a leader in the domestic pension market, with its allocation shifts often followed by other managers.

During the initial stages of Abenomics, GPIF played a pivotal role in facilitating policy via the “portfolio channel” by shifting allocation toward risk assets. JGB allocation was slashed from 60% to 35% in 2014. This dropped further to 25% in 2020. The allocation was left unchanged in the latest five-year review concluded in March.

There is potential for the fund to utilize the deviation rule of +/-7% around the 25% target domestic bond allocation, and +/-6% around foreign bonds, to reallocate toward 20-year-plus JGBs on a tactical basis. With over ¥250 trillion under management, this could provide sizeable support for long-duration JGBs.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Moody's is an independent, unaffiliated research company that rates fixed income securities. Moody’s assigns ratings on the basis of risk and the borrower’s ability to make interest payments. Typically securities are assigned a rating from ‘Aaa’ to ‘C’, with ‘Aaa’ being the highest quality and ‘C’ the lowest quality.

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