Description

Find negative interest rates baffling? Want to benefit from rising rates in Japan but worry about the cost, ease and difficulty of implementing the trade?  Shorting JGB Future allows investors to profit from rising rates, involves no initial outlay of capital besides the maintenance margin, and can be implemented easily through IB.    

Why Short Interest Rates?

In the past 5,000 years, nominal interest rates have never been negative.  Negative nominal rates fail the common sense test as investors are paying the government to borrow money.  Instead, investors have the ability to put cash under the mattress or hold it in a vault, which involves a nominal cost to cover insurance and storage costs.  Based on our analysis of the cost of storing precious metals, we estimate that the cost to hold paper in a vault would be between .15% (based on $ value and insurance rates) and 1.35% per annum (based on volume of the notes vs. equivalent dollar value of gold).  Additionally, although there are trillions of dollars of negative yielding debt, many of the current holders purchased the debt at a positive yield and are content to hold the securities to maturity.  When these bonds mature, investors will have to face the choice of whether to invest their money elsewhere or purchase new bonds at negative yields.

Why Short Japanese Bonds?

Around the world there are numerous sovereign debts that are yielding negative rates, however we believe Japan has the least serviceable debt load and will struggle to pay back the borrowed without deflating the currency which will lead to increased interest rates. As the Japanese Ministry of Finance states in very simple terms, “Japan’s government bonds outstanding has been increasing year after year. The government bonds outstanding is estimated to rise to ¥838 trillion at the end of FY2016, which is 15 times as large as Japan’s annual tax revenue and will surely impose heavy burdens on future generations.”

Japan Credit Quality Concerns

Japan has the highest credit to GDP ratio in the world, the highest ratio of gross debt to GDP, the second highest ratio of net debt to GDP (behind Greece) and the highest deficit in the developed world. Japan’s debt to revenue and net debt to revenue are 12.2x and 18.8x, respectively.   The country runs a deficit and will continue to run a deficit for the foreseeable future in the most optimistic case.  The government has not balanced its budget since the 1970s.  If we were to compare Japan to a hypothetical household, Japan would earn $5,200 per month, borrow $2,900 per month and its total debt would be $870,000.  

Difficulty of cutting Spending or Increasing Taxes

While Japan has increased government spending / GDP from 36.1% to 42.2%, it still ranks as the 8th lowest among OECD countries.   This expansion stems entirely from increased social security spending.   In fact, Japan has the lowest ratio of government spending ex Social Security of any OECD country.   On the “positive” front, Japan has the lowest ratio of tax revenue to GDP and has a relatively low social security contributions ratio, which leaves room to expand both ratios.  Japan needs to grow the economy, so implementing a higher tax on income or corporations would be difficult and politically dangerous as it would represent a significant inter-generational transfer of wealth.  

Japan has a budget deficit of 20bn Yen or ~4% of GDP.  More specifically, Japan raises 9.8% of GDP in taxes on income and profits, which is below the OECD average of 11.7%.  Japan’s corporate tax rate of 32.26% in 2016 compares to the OECD average of 24.85% (Source: KPMG).  Japan recently dropped its tax rate, as have most countries, so this seems like an unlikely revenue source.  Nonetheless, a meaningful drop in the rate may actually increase tax collection.   Japan has a 22.1% capital gains tax, which compares to an average of 18.23% in OECD (as of 2014 per the Tax Foundation).  This does not seem like a good place to raise taxes, since the government needs to incentivize savings and investment to grow GDP.  The last large source of potential revenue would be through increased income taxes.  Japan has a high top marginal tax rate of 45%, but there may be an opportunity to broaden the tax base.  Again, this would be difficult as it would be a significant transfer of inter-generational wealth transfer.

Instead, Japan has turned to a consumption tax.  Japan raised its consumption tax in 2014 to 8%, which caused a recession, but the increase did raise the total revenue collected.  Abe planned to raise the rate to 10% in 2016, but put off the raise due to political considerations.  Should Japan increase its consumption collection from 5.3% of GDP to the OECD average of 11.0% of GDP, it would be able to plug its budget deficit and stop the increase in debt.  

However, this assumes that interest payments will stay at 1.2% per annum.  Any meaningful increase in rates will lead to a vicious cycle and most likely hyperinflation.  2016 interest payments remain below levels seen from 1986-1998, despite a significant increase in debt outstanding.  Higher rates will make the budget more unsustainable, which will call into question the value of the Yen, which will increase the discount rate applied to government bonds, which will increase the yield that investors demand etc.  While the BOJ manipulates the market through purchases, it may lose control of the market quickly if the markets lose confidence in Japan’s ability to repay its debt in real terms (it will always repay in nominal terms).   

Liquidity Needs

More than 75% of Japan’s debt comes due within the five years, including 121T (~25% of GDP) in 2016.  While the BOJ has the ability to print money to satisfy maturing debt, concerns about the real value of the Yen may cause a sharp revaluation of borrowing costs due to the significant amount of annual maturities.  Should yields rise, the government’s balance sheet will quickly become unsustainable.  Currently, Japan pays ~1% on its outstanding debt.  If rates were to rise above 6.3%, where rates were from 1975 to 1987, Japan’s interest burden would exceed tax revenue.

Imminent Inflation

In the past 3 years, the Bank of Japan has printed enough Yen to increase the total money supply in Japan by approximately 8%. However, this increase in money supply has not fully translated into inflation yet (approximately 4% inflation over the same period). The Bank of Japan has stated it will continue to pump money into the economy to create inflation. Eventually, inflation should match increases in money supply and when inflation begins, interest rates should rise as well.

Difficult Growth Outlook
Japan’s working age population will continue to shrink in absolute terms, while the proportion of the population aged 65 and older will continue to increase until 2060. This is not a recipe for GDP growth or reduced government spending.  In addition, the country has shown no tolerance for increased immigration to replace the declining population.   Increased spending on social security has been the main driver of Japan’s debt expansion.   Japan raised the same amount of tax in 1990 and 2016, but spent 20 trillion more on social security and 10T more on debt service in 2016 as compared to 1990.  Given the aging population and shrinking workforce, this pattern will likely continue going forward.

Return Profile

Shorting futures presents a very different return profile than a typical value investment.  Shorting futures involves no initial outlay of capital.   For funds with long time horizons that believe that rates will eventually rise into positive territory, the trade will produce a high ROI even if it takes 10 years to play out.  The futures need to be rolled on a quarterly basis, but no there’s no cost other than transaction fees to implement the trade.   It goes without saying the JGBs are a large and liquid market.  

One JGB contract currently represents a notional value of ¥152,010,000 (approximately $1.494M). If interest rates rise 1% from -0.07% (on the 10 year JGB) to 0.93%, then the notional value will fall to ¥140,800,000 ($1.384M) and you will profit from the difference. The table below shows different profit and losses for different changes in future interest rates.

The Mechanics of the Trade

When one enters into a futures contract, no capital is outlaid, but margin is posted. Each day, money exchanges hands based on the change in the futures price contract. If the price goes up, the seller pays the buyer the difference. And if the price goes down, the buyer payers the seller. This is settled daily through the Japan Securities Clearing Corporation through which the margin must be posted daily.

What is a 10-Year Japanese Government Bond Future? It is the right to receive or deliver a notional amount of 7 to 11 Year Japanese Government Bonds at the end of the quarter. There are several issues of JGBs within that 7 to 11 year range and at they represent several different coupon rates. A conversion factor unique to each bond issue is used to put all these bonds with different coupons and different dates of maturity on comparable terms. What’s important to know is that at any time one specific issue will be the “cheapest to deliver” and that will be the one which the futures price will be based on. The JGB Futures market is a very large and active market. The price of the futures and bonds are constantly being arbitraged, so one can be confident that the future price that they are transacting at represents the bond price and vice versa.

Futures contracts themselves are quarterly contracts that close at the end of each quarter. At the end of each quarter there is about a 2-week period where futures in both the old quarter and new quarter are active and one can “roll” their future to make it a continuous trade. To make this a continuous trade, if you are shorting the future, then you buy a futures contract in the current quarter and simultaneously sell a futures contract in the next quarter. This will close out the current quarter and open the next quarter effectively “rolling” your contract into the next period.

Lastly, because these are rolled over quarterly, as long as you continue to roll, you will always be effectively short a 7 to 11 year JGB. Whereas if you shorted an actually Japanese government bond, the bond would become shorter and shorter in duration, the longer the trade stays open.

Risks

Outlawed Physical Cash – If physical cash were obsolete and all money was electronic, then there would be no way to avoid negative interest rates by moving to physical cash and the reasoning for negative interests being illogical would no longer be valid.

New Normal – Economists are puzzled by negative interest rates and they were previously thought of as impossible, so one must be wary of other “impossible” realities.

Currency Swaps – Investors holding USD can currently buy JGBs and do a currency swap of the USD and Yen to synthetically create positive yields on negative yielding Japanese debt, since the demand for dollars has positively influenced the USD Yen swap for investors holding USD.  Further USD strength may exacerbate this problem.

BOJ Corners the Market – The Bank of Japan currently owns 35% of JGBs. They have effectively already cornered the market. However, if they wish to reduce this percentage, the selling could put tremendous upwards pressure on rates or if they wish to continue to own 35% as the debt burden grows, more money will have to be printed which will accelerate inflation.

Catalysts

The BOJ’s steadfast commitment to printing money, which will eventually turn into inflation.  

Interest rates rise in other countries, leading to capital outflows from Japan.

USD weakness, for some reason as above.   

Should rates rise in Japan, Japan may become stuck in a “negative flywheel,” where rising rates make the debt less sustainable in real terms, which forces investors to demand higher rates, which makes the debt more unsustainable etc.

Yen weakening leads to lower real yields and therefore necessitates higher nominal yields.  

Catalyst

The BOJ’s steadfast commitment to printing money, which will eventually turn into inflation.  

Interest rates rise in other countries, leading to capital outflows from Japan.

USD weakness, for some reason as above.   

Should rates rise in Japan, Japan may become stuck in a “negative flywheel,” where rising rates make the debt less sustainable in real terms, which forces investors to demand higher rates, which makes the debt more unsustainable etc.

Yen weakening leads to lower real yields and therefore necessitates higher nominal yields.