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Wednesday, Jan 25, 2006


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JGBs: The world's most expensive financial asset?

S. Balakrishnan

JGBs — short for Japanese Government Bonds — are among the most widely-traded debt papers. They also happen to be the most expensive bonds in the world.

As Japan embarked on its rate-cutting spree in the 90s, JGB yields followed. From the range of 4-5 per cent, they fell below 1 per cent, touching (for any bond) unheard of levels of 0.5 per cent.

The reasons are not hard to find. Short-term interest rates in Japan were cut to zero and have stayed there for quite some time now. Naturally, bond yields moved in tandem.

Secondly, in sharp contrast to every other country, deflation became an almost endemic Japanese disease. Prices have been falling for years and there seemed to be no end in sight. Thirdly, the stock market crash dating to the early 90s, pushed the Nikkei down to sub-10,000 levels, from its peak of 40,000. Bonds tend to become preferred investments when stocks are weak. The confluence of these factors and the Government's and Bank of Japan's oft-repeated commitments to the zero-interest rate policy till the country's economic woes are over combined to drive the prices of Japanese bonds to stratospheric levels.

What is unique about the Japanese story is the persistence of low yields of 1-1.5 per cent for several years now. True, the US saw Fed Funds at 1 per cent, but 10-year bonds maintained a 2 per cent spread on short-term rates even in those times and never breached 3 per cent.

In October 2003, the Bank of Japan set three conditions to end its zero interest rate policy: sustainable year - on - year growth in consumer prices, an assessment that deflation is over and a sanguine outlook for the economy. These look like getting fulfilled in the course of 2006.

The phenomenon of falling prices is probably over in Japan. Recent data show price changes moving into the positive zone. Whether this will "sustain," as the BoJ wants, is the issue.

Japan's growth prospects depend not only on its much-vaunted export machine, but also on a revival of domestic demand from business and consumers. Both are now recovering. Besides, China's solid performance and prospects can only improve Japan's position, considering that the two countries have become major trading partners.

Further evidence that the worst may be over for Japan comes from the rise of about 60 per cent in the Nikkei from below 10,000 to over 16,000 in the course of the last year.

Everything points to a gross overvaluation of JGBs. This year should see 10-year yields pushing to the range of 2-2.5 per cent from the (current) region of 1.5 per cent.

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