Login

Japanese Interest Rates CMS CAPS
December 17, 2011 - 4:57am EST by
thistle933
2011 2012
Price: 1.00 EPS $0.00 $0.00
Shares Out. (in M): 1 P/E 0.0x 0.0x
Market Cap (in $M): 14M P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT 0.0x 0.0x

Sign up for free guest access to view investment idea with a 45 days delay.

 

Description

Macro trading is not our bag, and we would rather be buying cheap stocks than worrying about sovereign debt.  But that is not the world we live in.  Moreover, the Black-Scholes model is exceptionally stupid at times, especially when valuing a bi-polar situation with low historical volatility.  Maybe this means that this idea is really cheap insurance.  Or maybe it means that macro trading, and the mysterious powers of central bankers, should be left to Kovner and Soros.

In any case, read on, and tell me where I am wrong.

Japanese government borrowing has risen to 1,090 trillion yen, or 228% of GDP, the highest in the world.  Despite this massive amount of debt, yields on JGBs have remained depressed, with the five year bond currently yielding 0.35%.  The average maturity on JGBs is five years, and the average interest rate paid by the Japanese government is 1.3%.  Total interest/GDP paid by the government is thus 3%, and total annual funding need is 50-55% of GDP (~40% roll-over of existing debt plus 3% interest plus 10% deficit), or $3 trillion at current exchange rates.

Japan’s ability to pay such low interest rates has depended on high rates of domestic savings channeled into purchases of JGBs.  As a result, just 5% of JGBs are owned by foreigners, compared with 32% of US Treasuries (or 47% of publicly-held US Treasuries, which excludes those owned by Social Security and other federal entities).  ButJapan’s personal savings rate has declined from 15% in 1990 to 2% currently, and is likely to continue to decline givenJapan’s demographics.

Japan’s population is the oldest and most rapidly aging in the developed world.  Fertility rate is 1.4 children per woman (second-lowest in the G-10 – Italy is at 1.3, and the US is at the “steady-state” level of 2.1), and the population began shrinking in 2005.  There are currently 2.6 working age adults per pensioner, compared with 4.0 at the average OECD country.

While 95% of outstanding JGBs are owned domestically, it is unlikely that ongoing domestic demand will be able to absorb future issuance.  A study of the supply/demand balance for JGBs by the Bank of Tokyo concluded that declining household savings would force Japan by 2015 to sell up to 55% of new JGBs to foreigners. 

People have lost money betting against Japanese government bonds for at least a decade.  And we are stock-pickers with zero experience investing in macro trends.  But if you look at bubbles, they are always fueled by a truth that is true until it isn’t.  “Japan funds its deficit internally” seems like a pretty good candidate.

After talking to several JGB traders, and hearing that truth repeatedly expressed, and no knowledge of basic math about funding needs, I decided to model the cash flows of the Japanese government as though it were a company.  This has the advantage of isolating the government (which is astonishingly cash poor) from Mrs. Watanabe, who is cash-rich, and happy with the 20 year run she has had with JGBs.  But she is getting older, and may not react well if she learns that she will not get paid back at par.

Developing a model is tricky because disclosure about Japan’s finances is not great.  Japan has three government budgets:  General Account, Special Accounts, and Government-Affiliated Entities.  Disclosure for the General Account is good, but is virtually non-existent for the other two.  Japan has long used Special Accounts and Government-Affiliated Entities to spend money on public infrastructure with little accountability for return on investment.  Anecdotal evidence suggests that much of this money has been wasted (I remember standing in a tall building in Tokyo at 8pm looking down at a river crossed by three bridges, all of which were empty).  And my favorite part of This Time Is Different is this sentence:  “Historical data on domestically issued government debt is remarkably difficult to obtain for most countries, which have often been little more transparent than modern-day banks with their off-balance sheet transactions and other accounting shenanigans.”

In the end, I used IMF estimates for total government spending and revenues, and ran a simple set of cash flow projections starting with a 1.3% interest rate and 228% debt/GDP.  The model is too big to include, but the gist is simple.  It is unlikely that the IMF’s estimates hide happy surprises, and the question is how to finance the 228% of debt/GDP that we can see.

Key conclusions:

-   A rise in the interest rate paid by the government from the current 1.3% to 5% would increase 2015 interest / GDP to 14%. 
-   Japan is often described as under taxed.  But even if Japan raised taxes from the current 17% of GDP to 30% of GDP, 5% interest would increase 2015 interest / GDP to 12%.
-   Japan paid a 7% interest rate during the 1980s, when the economy was far healthier.  And the yield on five year Greek bonds is 54%.
-   It is highly unlikely that any democracy would tolerate interest/GDP of 12-14%.  Default through inflation or restructuring is likely.
-   If inflation or restructuring begin to dawn as possibilities, 5 year JGBs will no longer trade at a 0.35% yield.
-   The situation is unstable, and is vulnerable to what Soros would call the laws of reflexivity, or what a civilian might call a run on the bank.

 

Arguments for continuing low JGB yields:

-   Japan’s high level of domestic savings.  But this rate has fallen to near zero, and demographic trends are not promising.
-   Japan’s gross debt is balanced by assets, and on a “net debt” basis, the situation is manageable.  It is true that Japan has $1 trillion of foreign exchange reserves, equal to approximately 19% of GDP.  But published figures that show Japan’s net debt at 114% of GDP are including assets of Japan’s social security plan, which include JGBs and numerous public works projects of dubious value.  My own calculation of net debt including foreign exchange and social security assets arrives at 179%.  And if you include social security assets, you should also include social security liabilities, which are hard to value, but must be considerable given the aging population.
-   Japanese corporations will buy JGBs that Japanese households are no longer able to buy.  This implies that investment alternatives for Japanese corporations are inferior to a 130 bps yield, which seems either unlikely or an indication of further economic contraction, which would be bad for tax revenues.
-   Japan’s tax burden is low as a percent of GDP, and leaves room to raise taxes.  But a loss of market confidence in JGBs that resulted in higher JGB yields would overwhelm an increase in tax rates, even without the reduction of economic activity likely from higher taxes.

 

Japan’s alternatives:

-   Increase taxes, which are low by international standards, especially the 5% consumption tax.  But an increase of the consumption tax to 10% in 1997 caused a contraction in the economy, and was repealed.  Japan’s political system seems unable to make hard choices.  There have been 14 prime ministers in the last 20 years.  Japanese history suggests that an external shock is necessary to prompt internal change.
-   Cut spending.  The point above about hard choices applies.  Also, Japanese spending is low by international standards, and social security spending increases are being driven by the aging population.
-   Sell foreign reserves.  These total 19% of GDP.  At 5.2 years maturity, gross debt of 228% of GDP requires roll-over borrowing of 44% of GDP, plus a deficit of 10%, plus interest.  In a bond market crisis, the foreign exchange reserves would not last more than a year.
-   Promote immigration.  Japan needs 600,000 immigrants per year to keep the population from aging.  There are currently 2 million foreigners in Japan, so this would require a 30% annual growth in immigrants, which seems unlikely.
-   Monetize the debt through inflation.  Probably the most attractive solution, as JGBs are denominated in yen.  But the yield on the 5 year JGB is not likely to stay at 35 basis points in an inflation large enough to impact the debt.
-   Default.  Japan’s primary balance (new borrowing less interest expense) is basically break-even.  This tempts the current government to default, and lay the blame on prior governments.  That 95% of the debt is owned by the Japanese, and not foreigners, makes this less likely.  If it did happen, it’s hard to imagine JGB yields staying low.

 

How to make money from this:

At the very least, think through who is holding the bag on $14 trillion of Japanese sovereign debt.  A crisis here could make Europe look like a walk in the park.  Think long and hard about exposure to Japanese banks and insurance companies, whether in your portfolio or counter-parties.

Humkae848 posted the good idea of buying puts on the yen.  That certainly is cheap insurance, and it makes sense that massive monetization of JGBs by the Japanese Central Bank would drive down the value of the yen.

Cheaper still are put options on Japanese yields.  Some of the most effective that we have found are CMS caps, which give the buyer the right to the difference between a strike interest rate and the fixed swap rate to receive six month Japanese LIBOR over a given period.  If you look at the history of the spread between JGB yields and swap rates of similar durations, you see high correlation, and usually a premium of the swap rate over JGB yield.

Below is recent pricing for caps with one year and three year terms referencing the five year swap rate, which has been highly correlated to the five year JGB:

Term    Strike               Price                Return at 3%   Return at 5%   Return at 7%

1 yr      1.5%                8.0 bps             17.8x               42.8x               67.8x

1 yr      2.0%                5.0 bps             19.0x               59.0x               99.0x

1 yr      3.0%                2.8 bps             loss                  71.7x               144.5x

 

3 yr      1.5%                44.0 bps           5.8x                 14.9x               24.0x

3 yr      2.0%                36.0 bps           6.1x                 20.4x               34.7x

3 yr      3.0%                27.0 bps           loss                  25.7x               52.3x

 

There is no magic to choosing the five year rate, other than a feeling that shorter term rates might be more susceptible to central banking meddling, and longer term rates might not be as subject to near-term default risk. And pairing this investment with Humkae848’s yen put is a good idea, as the central bank will likely monetize heavily to avoid default.  

 

Risks:

-   Mrs. Watanabe keeps buying JGBs for another decade.  Insert your own generalization about Japanese social solidarity.
-   The caps are OTC derivatives, and your counter-party may not be solvent when you go to collect.
-   Central banks and governments under stress can do a lot to rig rates, especially in the short term.

           

 

 

Catalyst

    show   sort by    
      Back to top