Disruption in Japan’s Bond Market

By Junko Fujita and Tom Westbrook
TOKYO/SINGAPORE (Reuters) – Japan’s $9 trillion bond market faces disruption as a shortage of paper due to the central bank’s massive buying affects derivative settlements used by investors and dealers in debt sales.

Decades of combating deflation have led the Bank of Japan (BOJ) to large asset purchases, making it the primary owner of the national debt, with a balance sheet larger than the $4 trillion economy—five times that of the U.S. Federal Reserve relative to GDP. This has kept yields low, rendering Japanese bonds unattractive and illiquid as interest rate benchmarks.

As the BOJ begins to normalize its balance sheet, the anticipated revival of trading is challenging. A critical test occurs in December with the futures market—10-year contracts tied to government bond #366, predominantly owned by the BOJ.

Market participants warn that the bond’s scarcity will hinder purchasing ‘cheapest-to-deliver’ bonds needed for settling derivatives, impacting risk hedging and overall market functionality. Senior strategist Keisuke Tsuruta from Mitsubishi UFJ emphasizes this could also disrupt government bond auctions.

With the BOJ on a rate hike trajectory, the quest for these bonds intensifies, risking distortions in the derivatives market.

Dysfunction in the Derivatives Market
JGB futures, vital for speculating on interest rates, require physical bond delivery unlike stock futures. The rules permit sellers to deliver bonds maturing in seven to eleven years against 10-year JGB futures.

Due to the BOJ’s significant ownership, sellers may struggle to acquire bond #366, leading to reliance on pricier alternatives. This scenario echoes June 2022’s market turmoil following BOJ interventions which significantly impacted futures prices and bond auction outcomes.

While the BOJ previously relaxed borrowing rules, tightening conditions may reflect the fragility of the market. Senior strategist Miki Den notes this situation illustrates the unintended consequences of the BOJ’s prolonged easy monetary policy.

This imbalance is expected to continue, as the BOJ holds substantial portions of subsequent tranches, driving larger traders away from the cash market. Expert Norman Villamin cautions that unwinding over a decade of policy is a lengthy endeavor, indicating a slow path to normalcy in Japan’s debt markets.