Japan’s benchmark 10-year bond flirts with negative yields

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Japan is teetering on the brink of a becoming the only country to have both a major government bond market and a negative yield on its benchmark 10-year bond, but analysts aren't necessarily worried.

The yield on the 10-year Japan government bond (JGB) dropped to as low as 0.045 percent, a record, on Wednesday, just a few basis points from negative land. On Thursday, the 10-year bond was yielding around 0.072 percent in early Asia trade.

Analysts already expect positive yields may not last long. Deutsche Bank is forecasting 10-year JGB to trade in a range of negative 0.05 to positive 0.15 percent for the time being. Capital Economics tips the bond yield to fall to negative 0.25 percent by the end of this year. Bond prices move inversely to yields.

Yields on shorter-dated bonds are already negative in Japan, as well as in many countries in the euro zone, where the European Central Bank has flooded financial markets with cash.

However, a yield below zero on 10-year bonds is rare. Switzerland 10-year bonds currently yield negative 0.28 percent although the country's bond market is smaller than Japan's.

A negative yield on a bond--which means investors are effectively paying for the privilege of lending Japan's government money -- would suggest continued strong demand for JGBs.

Bank of Japan adopts negative interest rate policy

The latest driver for the rally in bond prices (and the decline in yields) was last week's move by the Bank of Japan to adopt negative interest rates for the first time, saying it will apply a rate of negative 0.1 percent to excess reserves that financial institutional place at the central bank, effective February 16. A decline in assets perceived to be risky such as stocks and commodities has also sent investors scurrying into JGBs, which are considered safer.

But persistently low yields come with their own risks. At yields below zero, investors are effectively paying more for an asset than what they will get in return when the bonds mature. Demand could take a hit as investors become fearful of running losses.

There are already signs of nervousness. A sale of government bonds to retail investors was scrapped Wednesday amid expectations that yields will turn negative, Nikkei Asian Review reported Wednesday. Nearly 70 percent of the JGBs in the market already have negative yields, the report said.

Weaning banks away from JGBs is not inconsistent with the central bank's objectives though. The BOJ would prefer if some of the funds parked in the bond market were instead lent out to companies or consumers, helping drive economic growth.

The amounts sitting around gathering dust are certainly large: Three Japanese megabanks have seen their cash and balances parked at the central bank grow by 87 trillion yen ($730 billion) between March 2013 and September 2015, even as domestic loans only rose by 5 trillion yen over the same period, Moody's said in a note Tuesday.

A security guard stands outside the Bank of Japan headquarters in Tokyo, Japan.
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Analysts aren't necessarily holding out too much hope that Japan's investors will shift to riskier assets.

"The BOJ has hopes that negative yields will impact savings and investment behavior. And that's the big question mark here. The textbook theory says it will. There should be more willingness of businesses to invest for yields," Christian de Guzman, senior analyst for the sovereign risk group at Moody's, said Wednesday. "But this is Japan. In many ways, as in the past, they've defied a lot of the textbook."

Current global market volatility may also throw a spanner in the works.

"Japanese investors are very sensitive to global risks," he said. "When there is a risk off environment, they come right back into Japan."

The government is also likely to be able to continue selling bonds, even at negative yields.

While the BOJ is cutting out retail investors, traditional buyers of JGBs will be able to expect some profit on their purchases because the central bank will still be buying the bonds for its quantitative easing program, noted Marcel Thieliant, a Japan economist at Capital Economics.

While holding JGBs, even at negative yields, may look more attractive for banks than parking funds at the BOJ where rates are deeper in negative territory, the BOJ can always just raise its offering prices until selling the JGB looks attractive, Thieliant noted.

Any losses for the BOJ -- when the government pays back the bond at a lower price than the central bank paid for it -- likely wouldn't be felt for several years as the BOJ doesn't mark its JGBs to market, he said. Additionally, the BOJ already owns more than 50 percent of already-issued JGBs, meaning it's sitting on profitable trades to cushion any losses.

But some analysts are concerned that banks may just hold on to their JGBs as the returns are slightly more attractive than letting the funds sit at the BOJ at negative rates.

"Given that the bulk of institutional investors' remaining JGB holdings are for regulatory and ALM (asset liablity management) purposes, there will likely come a point where these holders will be unwilling to sell their JGB holdings, no matter what price the BOJ offers," HSBC said in a note Monday.

There was no sign of that Wednesday, when the BOJ's regular debt-buying operation avoided negative surprises, Reuters reported.

But HSBC said negative yields might eventually derail the BOJ's efforts at 80 trillion yen worth of quantitative easing annually, possibly as early as this year, adding that may push the central bank to cut rates deeper into negative territory.

On Thursday, BOJ Governor Haruhiko Kuroda said the risks it would face difficulties buying JGBs because of negative interest rates was likely small, according to a Reuters report.

-Nyshka Chandran contributed to this article

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1