The huge carry trade plays made by Japanese investors are beginning to lose their lustre, figures published this week confirm.

The first few months of Japan’s fiscal year, which begins in April, are often a time when investors stock up again on foreign bonds on a massive scale, having run down these investments ahead of their March book closings.

In the first two months of last year, Japanese investors purchased a mammoth net Y6,629bn in foreign bonds. They were propelled out of Japan by the extremely low yields on domestic bonds compared with considerably more exciting yields on US and eurozone bonds. The still more adventurous sought returns on bonds issued in Australian or New Zealand dollars, and other countries whose exposure to the commodities boom had given birth to a high interest rate environment.

But last month Japanese investors were net buyers of little more than Y1,000bn in foreign bonds, figures from the Ministry of Finance reveal. The total for both April and May was only Y2,327bn.

Demand is even beginning to wane for Kokusai Asset Management’s famous Global Sovereign Open fund, which had enjoyed runaway success as retail investors sought higher returns on foreign government bonds than the low returns in Japan. Its net fund inflow slowed to Y50bn in May, less than a third of the peak hit last June.

The yield differential between US and Japanese 10-year government bonds still remains high, at about 3 percentage points. But investors have become concerned about the value of US dollar which has slid from about Y120 at the beginning of the year to little more than Y115 now, despite its bounce this week. For those who invested at the wrong time, the fall has wiped out the gains they made from the interest rate differential.

Previously, many had hedged the currency risk. When the US Fed funds rate was languishing at 1 per cent that was lucrative. But as US short term rates have risen to 5 per cent and the US yield curve has flattened, hedging costs have become prohibitive. Hedging a US dollar bond holding one year ahead would now cost a Japanese investor nearly 5 per cent, more than offsetting the extra yield gained from investing in US rather than Japanese government bonds.

Japan’s life insurers have recently said they are no longer willing to buy US dollar bonds on a hedged basis because the hedging costs are too high.

But global turmoil in markets has also made institutional investors pessimistic about the dollar’s future trend. This makes them reluctant to make “naked”, or unhedged, investments in dollar assets.

“Japanese investors, especially banks, have changed their long-term view of the dollar”, says Akihiko Yokoyama, bond strategist at JPMorgan.

The same reasoning holds true – only more so – for the once thriving uridashi market in Australian and New Zealand bonds. These are bonds issued in Australian and New Zealand dollars and intended for Japanese retail investors.

Buyers have earned high yields, but the fall in the currencies has erased these gains.

“Retail investors have been burnt by the currency side of uridashi ownership”, says Ray Attrill, director at 4Cast, the consultancy, in Sydney.

Foreign investment in Japanese government bonds, on the other hand, is booming. The Ministry of Finance figures show a record Y2,623bn in May in net purchases of Japanese bonds and notes by foreigners.

Foreigners were attracted in part by the prospect of wrong-footing the Japanese bond market.

Some investors think the markets have taken it too much for granted the Bank of Japan is about to end its zero interest rate policy. They say if the Bank fails to raise interest rates during the next few months, bond prices could rise sharply, presenting bond investors with a windfall.

Even if the BoJ does start to normalise policy in coming months it may still pay foreign investors to hold Japanese bonds and to hedge their foreign exchange exposure, says Mr Attrill.

With US one-year interest rates near 5 per cent and Japanese one-year rates still only about 0.5 per cent, a US investor buying 10-year JGBs currently yielding a little less than 2 per cent and hedging their dollar-yen exposure one year out, can lock in a total return of about 6.5 per cent. That is more than one per cent greater than what they would earn from keeping their money at home and investing in local bonds.

So perhaps Japanese government bonds, long considered one of the dullest markets in the world, may provide some of the more exciting returns on offer in the future.

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