What do you do if you are a major Japanese investor, whose mandate is to invest in safe assets, yet the yield on Japanese govvies is too low to cover the cost of your liabilities?
That's the question that Japan Post Bank Co., the banking unit of Japan Post Holdings, has been grappling with. Its answer: buy and hold over half a trillion dollars, or $577 billion to be precise, worth of foreign corporate bonds. That, as Bloomberg notes, is "more than the investment-grade portfolio at Fidelity Investments or the fixed-income holdings at Britain’s Standard Life Aberdeen Plc." And since Japan Post is a public company, majority-owned by the government, it means that one Japanese bank (really, Japan, due to its state-ownership) is directly funding countless US-based corporations, resulting in hundreds of billions in stock buybacks , and this bank is also indirectly funding the hiring of thousands of US workers. In this "new normal" era of super low rates, this represents a major change from just a decade ago, when the foreign bond portfolio at Japan Post Bank was virtually nil.
This new global bond market "whale" did not emerge voluntarily: as a result of decades of ZIRP and NIRP, Japan Post was effectively pushed out Japan's bond market and forced to look for investment opportunities elsewhere. Long-term yields in Japan are around 0%, far below even the exceptionally slim rates in the U.S, crippling the business model the postal bank used for more than a century.
Some background: as Bloomberg details, Japan’s postal system set up savings accounts in 1875, which at one point grew to become the world’s largest deposit-taking institution. However, to maintain an especially safe risk profile, the bank was barred from making loans like those of a normal commercial bank, and so the banking unit plowed those deposits into government bonds. Which, when yields were well north of 1%, that made for a boring, yet profitable, enterprise, and helped the bank grow its deposits to a whopping $1.7 trillion, comprising the savings of millions of Japanese households in big cities and remote villages. And, being a bank, it has to invest this money somewhere. But with Japan’s bond yields too low to cover the cost of servicing the bank’s funds, which according to S&P is 0.57%, the bank had to look to other assets.
“It’s a road to insolvency” for the postal bank to invest in Japanese government bonds now, says David Threadgold, a Keefe, Bruyette & Woods analyst in Tokyo who’s followed banks there for more than three decades. And with no other domestic asset class big enough to pour deposits into other than equities, which would require the bank to keep higher capital reserves, “they have to turn themselves into an overseas investment vehicle,” he says.
Such as corporate bonds.
To be sure, the majority of the bank’s investments are still boring enough: Instead of buying supersafe Japanese government bonds paying essentially nothing, it buys supersafe U.S. Treasuries yielding about 2%, which should be sufficient to leave the bank comfortably profitable; the main risk is currency fluctuation, although investors can hedge that risk, even as the cost of doing so has climbed in recent years due to rate differentials between the US and Japan.
Still, its profit margins remain razor thin, and so to boost its profits, the Postal bank has been on the hunt for new kinds of assets. However, with $539 billion of domestic government bonds still on the books and set to mature over time, and deposits continuing to grow, "that’s no simple task."
To broaden its universe of possible investments, the bank aims to direct some funds to private equity and real estate. It’s also gone into credit investments, including U.S. collateralized loan obligations—which bundle together loans made to riskier companies. Of course, it isn’t the only Japanese savings institution diving into CLOs in search of better yield. Norinchukin Bank, a cooperative that invests the deposits of millions of Japanese farmers and fishermen - and which has recently emerged as a CLO whale - is too. Norinchukin bought $10 billion of CLOs in the U.S. and Europe in the last three months of 2018, accounting for almost half of the top-rated issuance for the period, according to estimates compiled by Bloomberg (more on this later).
So are Japanese savers and pensioners going to be the next financial crisis' German "widows and orphans", i.e., bagholders of the trillions in fallen angel corporate bonds and "safe" CLO tranches?
While Bloomberg notes that observers are confident Japan Post doesn’t have major time bombs on its balance sheet, the sad record of Japanese investment overseas is replete with missteps; just two examples:
- In March, Japan’s No. 3 bank, Mizuho Financial Group Inc., surprised investors by booking 150 billion yen ($1.4 billion) of losses on its foreign bond holdings.
- Norinchukin posted a $6 billion loss during the financial crisis because of its purchases of toxic assets in the U.S.
“You are asking if we are comfortable with this? I don’t think everything is fine. There are risks," a resigned Japan Post Holdings CEO Masatsugu Nagato said about the need to invest abroad at a June press briefing. He also said: “We are very careful, but foreign bond investment will increase” for one simple reason: he is forced to buy the next generation of "toxic assets" because the BOJ assures the bank's insolvency, as Keefe, Bruyette said, if it sticks with Japanese assets.
To be sure, this is not the first time questions have been asked about Japan seemingly price-insensitive investments around the world, and mostly in US corporate bonds and CLOs (see "A Japanese Tsunami Out Of US CLOs Is Coming"). Aware of the growing concerns about its massively levered financial system, financial regulators say they are keeping an eye on lenders’ investments in CLOs and other loans, so the postal bank’s freedom to pile into particularly risky assets may be limited (although who can forget that according to none other than Ben Bernanke, "subprime was contained").
Yet even so, another risk is on the horizon: what if even more Japanese investors scramble for the "high yield" of US Treasurys and corporate bonds? If U.S. Treasury yields fall? "The scary thing really is that they are all depending on the U.S. market," Michael Makdad, a Morningstar analyst said of Japan Post Bank and its peers.
Indeed, prompting speculation that US Treasuries have become a Giffen Good, 10Y Treasury yields have tumbled by more than a percentage point over the past nine months, as investors have bought up government debt expecting central banks to become even more dovish as economic growth slows; and yet foreign demand appears to be stable, if not rising. On the other hand, with the Fed set to cut rates, Treasury yields are expected to slide well below 2%. Of course, the euro region hardly offers a better option, with much of the area’s debt trading with negative yields. “If you turn the rest of the world into Japan, then there’s no escape,” Threadgold says.
Meanwhile, as the scramble for yield comes back with a vengeance now that all global central banks have turned dovish again, Japanese mega-buyer Norinchukin Bank - better known as Nochu - and lender to Japan’s farmers and fisherman, has re-started purchasing CLOs after dramatically cutting back around April amid heightened market scrutiny, Bloomberg reported separately.
How big is Nochu in the US CLO market? Let's just say there is no single bigger player, because until very recently it was a massive presence in the $600 billion CLO market, buying as much as half of the highest-rated bonds in the fourth quarter in Europe and the U.S.
That helped sustain record growth which in turn sparked regulatory scrutiny and diverted attention to the bank’s outsized role in the market, prompting its recent retrenchment. And after taking a brief sabbatical, the bank is back yet even in its absence, CLO sales held near record pace, underscoring their popularity with investors starved of yield; indeed, even with a largely absent Nochu, sales hit $35.9 billion in the second quarter of 2019, compared with $29.5 billion in the first three months of the year.
“We aim to build a portfolio of bonds, equities and credit with healthy risk balances by exercising necessary checks,” a representative for Nochu told Bloomberg. “CLOs are credit assets that we will invest in based on this concept.”
The silver lining is that Japanese banks invest mostly in the super-senior, AAA-tranches. Yet even so, it is only a matter of time before they too are forced to buy riskier tranches. Consider that even with Nochu's brief absence, average spreads on the triple-A rated bonds sold by top-tier managers tightened to roughly 130 basis points across May and June, compared with about 138 basis points in the first quarter, according to data compiled by Bloomberg. Market participants point to the tightening as proof of the CLO market’s resilience. Of course, the other, more correct explanation, is that with central banks herding investors into increasingly riskier assets, CLOs had nowhere to go but up.
On the other hand, CLO risk premia have been more resistant to tightening than other asset classes in 2019, so the increase in Japanese buyers will likely result in a spike in demand for the bundled loans. That would lower borrowing costs for junk-rated companies and help increase the volume of leveraged buyouts, but could also add air to a market that regulators worry is already over-inflated.
Meanwhile, as Japanese banks seek to allocate trillions in local savings, they have emerged as some of the world's largest bond, and CLO, investors: Nochu alone held more than 18% of all triple A-rated CLO bonds outstanding at the end of March 31, according to research by Citigroup. Wells Fargo held around 9.5% while Japan Post Bank Co. owned approximately 2.9%, the Citi research showed (of course, Japan Post appears far more interested in buying corporate bonds outright).
“The basic concept of Norinchukin Bank’s investment is global diversification,” the bank’s representative said in its email, written in response to questions from Bloomberg News. As a reminder "diversification" is how you try to justify a reckless investment just after the crash.
And speaking of growing concentration risk, Japanese regulators - and millions of Japanese savers - appear to have no choice but to see more investments into increasingly risky fixed income.
One option to mitigate such risk, according to Bloomberg, would be to wind down balance sheets of banks such as Post Bank and make it smaller. But Japan Post is sometimes the only provider of financial services in areas where the population is shrinking. And the banking unit subsidizes the postal business, so it is a monopolistic Catch 22. Furthermore, the idea of turning customers away or discouraging deposits by adding fees is difficult for any national policymaker to embrace. Japan Post Bank is “a national brand,” says Rie Nishihara, a senior analyst at JPMorgan Chase & Co. in Tokyo. “They face a more challenging yield cycle and credit challenges, and that’s very difficult while also supporting 24,000 branches” across the postal system, she says.
So, as Bloomberg concludes, "the fortunes of this mammoth institution may rely on the U.S. avoiding the same low-rates-forever dynamic that has driven the bank overseas." Yes, but that's just half the story, because if instead of dreaded low-rates, yields on the US investments in which Japan has invested trillions suddenly were to suddenly soar, then neither Post Bank nor Nochu would survive absent full-blown nationalization. While it is unclear if such an option is amenable to Japan's taxpayers, the alternative is for tens of millions of pensioners and savers in the demographically crippled country to one day wake up and upon checking their retirement account finding that it's gone... it's all gone.
Or, as Threadgold said earlier, for Japan "there’s truly no escape."