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Why JGB yields won't keep falling deeper into negative yield

Japanese yen
John Phillips | Digital Editor for CNBC.com
Japanese yen

Japanese government bonds (JGBs) may look like a good bet with a ready buyer in the form of the Bank of Japan (BOJ) waiting in the wings, but there are signs prices could top out.

Finding profit in trading JGBs is a bit counterintuitive. Bond yields, which move inversely to prices, have plunged to record lows in the wake of the Bank of Japan's (BOJ) surprise move in late January to implement a negative interest rate policy.

Yields on the benchmark 10-year JGB have turned negative, which essentially means that bondholders are paying for the privilege of lending money to the Japanese government.

Even the 15-year JGB is skating close to the zero line, with the yield around 0.139 percent on Friday. The 30-year bond yield also touched fresh record lows of around 0.415 percent Friday.

One reason for the plunge in yields is that JGBs are becoming scarce on the ground. As a result of the BOJ's asset purchases through its planned 80 trillion yen ($712.16 billion) worth of quantitative easing annually, the central bank now owns more than a third of all outstanding JGBs. Other entities, such as pension funds, insurers and banks, must hold some JGBs as part of regulatory capital requirements.

Analysts told CNBC that while the possibility that the BOJ could fail to find enough JGBs to buy is rising, the central bank can always increase the price it's offering.

That has made buying JGBs a buy high, sell higher trade. But that's not a trade likely to be available for too much longer, analysts said.

For one, more supply may be on the way.

"If supply constraints reveal themselves to be a problem, that problem can easily be fixed by fiscal stimulus and by accelerated bond issuance," Gareth Berry, a fixed income strategist at Macquarie, told CNBC last week. "We expect a future period of cooperation between the BOJ and the Ministry of Finance to alleviate any future supply (issues)."

Last week, Japan's parliament approved a record budget of 96.72 trillion yen for fiscal 2016 and a debate for more spending of as much as an additional 10 trillion yen is likely ahead, Reuters reported.

Analysts are also doubtful that Prime Minister Shinzo Abe will proceed with a promised consumption tax hike next year. That would likely create the need for more debt issuance to make up for any budget shortfall.

There's another reason to be skeptical that the BOJ's purchases of JGBs will continually push the prices higher: The central bank sometimes buys fewer bonds than expected.

Last week, the BOJ reduced its purchases in the super-long segment of the JGB market, Nomura said in a research note, adding that the super-long segment, which still has positive yields, looks overheated.

The investment bank notes that the BOJ could decide to keep its buying of those bonds at lower levels in April, which may signal that it doesn't want the yield curve to flatten excessively. The BOJ may be concerned that declines in super-long JGB yields may impact other markets and the economy as well as potentially spur volatility in the JGB market, Nomura said.

Nomura also expects profit-taking in JGBs dated over 10 years as the BOJ's April meeting approaches.

Some large bondholders may be sitting on more bonds than they need for regulatory purposes.

"There's still a lot of scope to sell by banks, pension funds and insurance companies," Marcel Thieliant, a Japan economist at Capital Economics, said last week. He noted that pension funds and insurers are still holding anywhere from 20-40 percent of their funds in JGBs.

At the same time, he noted that there's a sign of an uptick in funds from Japan buying foreign bonds.

Over the four weeks to March 25, Japanese investors bought a record 5.875 trillion yen worth of foreign bonds, while selling 1.827 trillion yen worth of Japanese bonds in the week to March 25 alone, according to data from CIBC.

"We don't know who bought these foreign bonds, but obviously, the most likely candidates are insurance and pension funds," Thieliant said. "The negative rates have pushed them out of Japan."

So far, selling of government bonds varies across different types of institutions. Investment trusts and insurance companies have been net sellers of government bonds for at least 20 months through February, the latest month with available data, according to the Japan Securities Dealers Association.

There are already signs that some investors are looking to diversify away from Japan's government bond market.

A Reuters survey of Japanese fund managers, published Thursday, found they reduced their Japanese debt holdings in their model portfolios to 39.9 percent in March from 45.7 percent in February.

It's hard to find an excuse to buy the bonds, noted Takuji Okubo, chief economist at Japan Macro Advisors.

"It's an asset with volatility risk with no return, or even a negative return," he said, although he noted some "flow traders" might want to buy and hold until they have a chance to sell to the BOJ.

Okubo also noted that expectations the BOJ would cut interest rates further into negative territory are fading. That suggests the yields won't keep falling.

"People are starting to feel the BOJ realized that lowering interest rates further doesn't really help the economy and there's significant international opposition to such a move," Okubo said. "There's a mindset in the market that the BOJ is done with lowering the policy rate further. If the policy rate is unlikely to go deeper into negative (territory), there's no reason to hold JGBs."

The BOJ's foray into negative rates doesn't appear to have had the desired impact on markets, with the yen strengthening, rather than weakening. Additionally, on Friday, the BOJ's Tankan survey of big manufacturers showed confidence worsened more than expected in the first quarter, with the decline in part due to the negative-rate policy.

But while some banks are continuing to buy, institutions' interest in owning JGBs may wane.

"The only reason they would hold JGBs is you want to ensure you have Japanese yen in 10 years," Steve Goldman, managing director at fixed income manager Kapstream Capital, said last week.

Nyshka Chandran contributed to this article

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