Description

I'm not a macro investor and put most macro opportunities in the "too hard" bucket.  Most asset classes are not only widely followed by market participants but are also far more complex and harder to predict than a single company's future cash flows or asset value.  Even if you are right on the ultimate outcome, timing a macro bet is even more difficult.  With all that said, I believe macro trades are attractive additions on the margins of a portfolio when: they appear egregiously mispriced on a fundamental basis, have a limited and defined downside, offer many multiples of upside if you are right, can be implemented with a multi-year view, and can be expected to hedge your core portfolio if certain adverse macro environments play out.  I believe this opportunity affords all of those characteristics.        

Since the early 1990's Japan has run a chronic budget deficit in order to stimulate its stagnating economy and in the 1990's completed several large fiscal stimulus packages that were financed by bond issuances.  From 1995 to 2009 Japan's GDP has actually fallen slightly, leading to a fall in tax revenues, so the government has had to borrow more and more to fund its increasing expenditures.  Domestic savers and institutions have funded around 95% of Japan's debt issuance historically, and those buyers have been rewarded with far superior returns than were achieved in other Japanese assets (equities and real estate remain well below their peak).  With a large pool of happy lenders the government has continued to borrow, and now has significantly more debt than even Greece:

"Japan may already be past the point of no return. When a country cannot reduce its ratio of debt to GDP over any time horizon, it means it can only refinance, but can never repay its debts... Should the market re-price Japanese credit risk, it is hard to see how Japan could avoid a government default or hyperinflationary currency death spiral." - David Einhorn, 10/19/2009, http://www.foolingsomepeople.com/main/VIC_2009_Speech.pdf

Why Now?

This trade hasn't worked for so long that it has been dubbed "The Widow Maker" by some investors.  One could have made the case that Japan had too much debt years ago and yet rates have continued to go down.  In fact a typical retort for why this won't work is simply that it hasn't worked in the past (which to me echoes those saying in 2006 that real estate in the US wouldn't go down for the same reason). 

Fortunately the future is different than the past and there are a few reasons why the timing seems to have improved.  In particular, the household savings rate in Japan has been steadily declining over the years from 15% to 2% and many expect it to head into negative territory in the near future.  The demographic profile of Japan is awful - the population is actually now shrinking, continues to age rapidly, and is quite averse to immigration.  As Japanese citizens retire they will need to increasingly tap into their savings (JGBs) and will also become a larger burden to the government because of rising healthcare costs.

Japanese institutions that have historically bought JGBs may not be so reliable in the future either.  In July 2010 the Government Pension Investment Fund, which owns 12% of all JGBs outstanding, announced it had been a net seller for the first time in 9 years because of a decrease in pension reserves and rising benefit payouts.  Many other pensions and insurance companies already have the majority of their assets in JGBs as well - I have heard anecdotes that some pensions have recently sold all of their equities and are currently 80% in JGBs and 20% in foreign government bonds, for example.  Commercial banks are one group that has apparently been buying JGBs, and could continue to for a while, but some of them are becoming quite exposed to JGBs which in itself could cause issues from a mark to market standpoint if the market turns the other way.

While it is impossible to time precisely, I believe 5 year swaptions provide plenty of time for this to play out.  As we've seen in Europe, these things can take a while and the government will likely step in to try and calm the market when the first cracks begin to appear.  The Japanese government's best option will be to print money, hence the recommendation to also own out of the money puts on the Yen.  Taxes are already quite high in Japan, and while the government could sell assets to support itself for a while, this would likely be seen by the market as a sign of weakness and could create other issues depending on what it sold (if it sold foreign currency holdings, for example, it could create undesired upward pressure on the Yen).  The bottom line is that if Japan ever has to fund itself externally, rates are likely going higher, particularly given the market's heightened sensitivity to sovereign debt issues that we've seen in the past year. 

Perhaps the scariest part is what could happen if rates begin to rise.  Japan already spends over 40% of its revenues to pay the interest on its debt, and it's estimated that this number would rise 20-25% for each 1% increase in Japan's borrowing costs.  So for example a 3% increase in rates could mean that effectively all of Japan's revenues would go to paying off the interest on its debt.  In this scenario rates would likely not stop at a 3% increase, and it is possible that significantly higher rates could be seen. 

Risk/Reward of Payer Swaptions

Strike: 3.32%, At the money forward: 2.32%

Premium: $1.0 mm, Notional: $33.1 mm, Price: 302 bps

I believe this is a very attractive risk/reward profile, although various different strikes and tenures are available to fit your particular view.  Rates only have to reach 4% in 5 years in order to make money, and there is significant upside from there.  If things got really ugly you could make 10x or more. 

"Men who hold JGBs are popular with women!!" - Actual Government Advertisement in Japan

According to Bloomberg Japan's Ministry of Finance has been running advertisements with the quote above and other pleas for Japanese citizens to purchase government bonds:

http://www.bloomberg.com/news/2010-06-09/women-prefer-men-holding-government-bonds-japan-finance-ministry-ad-says.html

http://msnbcmedia.msn.com/i/CNBC/Sections/News_And_Analysis/__Story_Inserts/pdf/Japan_govtbond_ad.pdf

While at first I thought this was a joke, it appears to be real and suggests that the Japanese government realizes that it has a significant problem on its hands.  Betting on such a problem taking place appears to be both attractive on a standalone basis and a prudent hedge for a larger portfolio which may be adversely affected if the problem occurs.     

Risks

• Counterparty risk - these are purchased from a bank so choose wisely
• Yen risk - you will get re-paid in Yen, which will likely go down (potentially a lot) if the thesis plays out. I believe out of the money puts on the Yen are an attractive complement to this position as a result
• Timing/time decay - there is just no way to be certain of the timing
• Government actions - I don't see any easy answer but the Japanese government will pull out all the stops to avoid a hyperinflationary spiral or default. Part of me hopes they find the magic cure since the US could be facing awfully similar problems in the future

Catalyst