Analysis: Futures in Japan Face Hangover from BOJ’s Bond-Buying Binge by Reuters

By Junko Fujita and Tom Westbrook

TOKYO/SINGAPORE – Japan’s $9 trillion bond market is facing potential upheaval as a shortage of bonds, stemming from the central bank’s extensive purchasing activities, could disrupt the settlement of derivatives utilized by investors and dealers managing the country’s debt sales.

The Bank of Japan (BOJ) has engaged in aggressive asset purchases for decades in an effort to combat deflation, resulting in the central bank becoming a dominant holder of Japan’s national debt. Its balance sheet now surpasses the size of Japan’s economy, and it is significantly larger compared to the U.S. Federal Reserve when measured against gross domestic product.

This situation has suppressed yields and led to a lack of attractiveness for investors, rendering Japanese bonds illiquid and ineffective as a benchmark for interest rates. As the BOJ moves to reduce its balance sheet in a bid to normalize the markets, the anticipated recovery in trading volume remains slow and uneven.

A pressing challenge arises in December when 10-year futures contracts will be tied to a government bond tranche that is predominantly owned (95%) by the BOJ. Market participants anticipate that the scarcity of this bond will complicate the purchasing of ‘cheapest-to-deliver’ bonds necessary for settling derivatives contracts at maturity, which is crucial for smooth market operations and accurate pricing.

"The absence of the cheapest-to-deliver bonds complicates risk hedging related to rising interest rates," stated Keisuke Tsuruta, a senior fixed income strategist. "This creates broader trading difficulties."

According to Tsuruta, these issues may not only disrupt trading and speculation but could also adversely impact government bond auctions, as primary dealers typically rely on futures to mitigate their auction-related risks. With the BOJ beginning a path of rate increases, investors are on the lookout for the most cost-effective bonds to settle short positions in futures, making any distortions in the derivatives market particularly harmful.

"There will be significant implications if hedging through futures doesn’t operate effectively," remarked Masayuki Koguchi, a chief fund manager at Mitsubishi UFJ Asset Management.

Japanese government bond (JGB) futures are traded on the Osaka Stock Exchange, and the benchmark 10-year futures, which have a three-month duration, are utilized for speculating on future yields while being linked to an underlying cash bond. This segment of the market is crucial for a variety of participants including hedge funds and corporations, who employ it for betting on interest rate movements or to balance exposures.

Unlike stock futures, JGB futures require sellers to deliver the actual bonds upon contract completion, rather than simply settling the price differences. The regulations currently allow the delivery of bonds with maturities between seven to eleven years against 10-year JGB futures, and under the exchange’s conversion factor, the government bond tranche will become the cheapest-to-deliver option in late December for contracts maturing in March.

This specific tranche served as the 10-year benchmark in 2022 when the BOJ was purchasing substantial quantities of bonds to uphold a 0.25% yield cap against speculative short selling. Consequently, the BOJ now holds over 95% of this bond, potentially leading futures sellers to scramble for it or settle for more expensive alternatives to fulfill their obligations.

The current scenario mirrors the disruptions experienced in JGB futures in June 2022, when an unexpected BOJ intervention regarding the cheapest-to-deliver bond caught dealers off balance. That resulted in a major collapse in futures along with a significant decline in bidding during government bond auctions, yielding some of the weakest results in decades.

While the BOJ previously adjusted rules to facilitate bond borrowing in similar situations, a repeat of such measures would alleviate some market pressure but also underscore its precarious nature. "This illustrates the negative impact of the BOJ’s prolonged loose monetary policy," noted Miki Den, a senior rate strategist.

The challenges appear likely to persist into the following year, as other bond tranches are also mostly owned by the BOJ. A generally bearish outlook for bonds is deterring many large JGB traders from participating in the cash market, indicating that normalcy in Japan’s debt markets may take a considerable amount of time to establish.

"They’re essentially attempting to unwind a decade and a half of policy," stated Norman Villamin, chief strategist at Union Bancaire Privée. "In light of timelines spanning over a decade, the ongoing normalization process over the last two years is not particularly out of sync."