The volatility in the Japanese government debt market has unnerved investors in domestic banks, with some of the country's biggest lenders alone holding an estimated 40 trillion yen ($390 billion) worth of these bonds.
A spike on Thursday in the benchmark 10-year Japanese government bond (JGB) yield to 1 percent - its highest level in a more than a year - fanned worries about the potential for massive paper losses for banks and led to heavy selling in banking stocks listed on the Nikkei.
Mitsubishi UFJ Financial, Japan's largest lender by assets, has about 48.7 trillion yen worth of JGBs, according to the bank's latest financial statement.
While at still relatively low levels, yields have jumped more than 55 basis points from a record low of 0.315 percent hit just after the Bank of Japan (BOJ) unveiled its radical monetary stimulus on April 4, undermined by uncertainty over what the BOJ's new policies mean for the debt market.
"Banks are the ones that could suffer the most from balance sheet problems because of JGB volatility," said Ben Collett, the head of Asian equities at Sunrise Brokers in Hong Kong.
"The banks will have a problem should JGBs come off and that is the trend that could continue. But bank business is not just about JGB holdings so that's an important point," he said, adding that he was looking to buy shares in "high quality" Japanese banks following Thursday's stock market sell-off.
The Nikkei dropped over 7 percent in what was its biggest one-day drop in over two years, while Japan's three biggest banks Mizuho Financial Group, Mitsubishi UFJ Financial and Sumitomo Mitsui Financial Group slumped between 7 percent and 11 percent on Thursday.
Despite the sell-off, Japanese banks have strong financials . According to ratings agency Standard & Poor's, Japan's five major banking groups achieved their strongest financial results in the fiscal year that ended in March, since 2006 on the back of positive tax effects, overseas business and increased fee income.
"We take the view that the [banking] groups' stable profits and relatively low asset risk by international standards support each group's credit quality," S&P said in a report earlier this week.
The Nikkei gave up early gains on Friday to trade more than 1.5 percent lower. Banking stocks edged down in line with the broad-market weakness to trade 0.5- 1 percent lower.
In the bond market, yields pulled back from Thursday's peaks with the 10-year JGB yield to around 0.84 percent.
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Nikkei 5-Day Chart
Analysts said one factor that could help calm bank shareholders' worries about bonds is that the market is not as volatile as it might look.
"Bond volatility may have risen, but it is not outside the normal range: 30-day volatility is just under a standard deviation above the long-term average and 60-day volatility is just over," said Nicholas Smith, Japan strategist at the brokerage CLSA in Tokyo.
Smith said the fact that Japanese yields were rising was in sync with a rise in bond yields in other major debt markets and so was not unusual.
The trigger for Thursday's spike in yields followed an overnight rise in U.S. Treasury yields as bond investors fretted about an early end to the Federal Reserve's quantitative easing program following comments from Fed Chief Ben Bernanke.
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"I'm not particularly worried about the rise in JGB yields - so what if we are at 90 basis points? Bond yields around the world are rising," Smith told CNBC's "Cash Flow."
The rise in yields also meant the bonds could become attractive to institutional investors such as pensions funds. Their buying, together with buying from the central bank, could help slowdown the rise in yields, analysts said.
Tai Hui, chief Asia-Pacific strategist at JP Morgan Funds said that he expected the 10-year JGB yield to rise to around 1.1-1.3 percent over the next 12 months – implying a rise of roughly 20 basis points from current levels.
- An earlier version of this story said that Japanese banks held 40 trillion yen ($390 billion) worth of these bonds. This version corrects that to say some of the biggest banks hold this number.