It's hard to find a gutsier bond investor than Dan Fuss. The Loomis Sayles & Co money manager, armed...
It's hard to find a gutsier bond investor than Dan Fuss. The Loomis Sayles & Co money manager, armed with some $15bn of fixed income assets, has made a career of buying debt others wouldn't dream of owning.
There he was in the late 1980s, buying up the Latin American securities others were desperate to unload. In 1998, he was dabbling in volatile New Zealand debt and binging on crisis-plagued South Korean and Malaysian bonds while the herd was charging the other way. In late 2000, Fuss nibbled on the US corporate bonds that gave most investors indigestion. The credit crunch others feared was a buying opportunity for Fuss.
In each case, Fuss's iron stomach investment style paid off when the bonds he'd bought at bargain basement prices came back into vogue. Yet there's one market Fuss is avoiding like the plague. It's not Russia or Turkey, the homes of two of the developing world's most volatile currencies. It's not Brazil or Argentina, economies cursed with massive budget deficits and a history of financial panics. And it's not Indonesia or the Philippines, countries haunted by political uncertainty.
The subject of Fuss's aversion? Japan, a Group of Seven nation and home to the world's largest government bond market. "The yields are low, the credit trends are negative, the prime minister's about to step down and the currency looks vulnerable," said Fuss, who's based in Boston. "I'd prefer to avoid the whole mess."
He's not alone. Japan's hardly been a magnet for foreign capital in recent years. On the equity side, slowing economic growth has spooked investors. News that industrial production fell 3.9% in January dashed hopes Japanese growth would recover from the 0.6% drop in gross domestic in the July - September quarter.
The report helped send the Nikkei 225 average to its lowest level in 15 years and fed into the Bank of Japan's move to cut its overnight call rate target to 0.15% from 0.25%.
It was a clear indication of the precariousness of Japan's economic outlook.
Nor does it help that Prime Minister Yoshiro Mori is expected to step down soon. Even after the BOJ's surprise cut, Japan's debt isn't looking very attractive to the outside world.
The recent decision by Standard & Poor's to strip Japan of its AAA credit rating reminded investors of the nation's crushing debt load. Its debt to GDP ratio is approaching 130%.
What that means to many investors is that Japanese government bonds are vulnerable to a major sell-off. Yields are at their lowest level for more than two years, the rate on the No 229 10-year bond is 1.21%, the lowest since 14 December 1998.
Yield-hungry investors aren't looking to Japan, where yields are by far the lowest among industrialised nations. Ten-year bonds in Germany and France are yielding 4.74% and 4.88% respectively. Canada's 10-year issue offers a rate of 5.31%, while Italy's yield 5.16%. The UK offers a 4.83% yield, the US 4.86%.
Those looking to profit on a capital-appreciation basis aren't too interested either. The spectre of another BOJ rate cut, which may return short-term rates to zero, might be a positive in the near term.
The same is true of the seasonal repatriation of funds to Japan before the fiscal year-end on 31 March. Neale Vincent, head of fixed income research for Credit Suisse First Boston in Tokyo, thinks Japanese debt will do well into May, thanks to slowing global growth and expectations for further BOJ easing.
Clearly, investors who've shunned Japanese bonds in recent years regretted it. In 1999, for example, Japanese debt returned 15% as the yen appreciated in global markets. Last year, Japanese government bonds returned 3.64%. While a far cry from the 16% offered by the US 10-year issue and the 21% by the US 30-year in 2000, Japanese bonds did well considering the meltdown in US corporate debt and in some emerging markets.
Yet investors such as Fuss wonder how much potential Japanese debt has to gain. That's a logistical problem for global fund managers, since Japan is the largest issuer of government debt in the world. Its massive bond-issuance campaign has come at a time when just about every other major economy, the US and eurozone included, is reducing debt.
Since investors often configure their portfolios to reflect the complexion of the global market, many are grappling with whether to own as many Japanese government bonds as the market's size dictates. For Fuss, the answer is a resounding no. The biggest reason is credit risk. S&P's cut of Japan's long-term debt rating to AA+ from AAA may not convince many western buyers to increase their Japanese exposure. Moody's Investors Service downgraded Japan in November 1998. But S&P's move to strip Japan of a top credit rating for the first time since 1975 hurt investors who'd bought yen-denominated assets betting the economy was on the mend.
With interest rates near zero and global growth slowing, markets fear Japan will have little choice but to enact new fiscal stimulus measures. "Looking at Japan's economy, I don't know how the Government can avoid a major response," Fuss said. "That means more [Japanese Government bonds]. I can see them printing these things like wallpaper."
Of course, Japanese bonds enjoy plenty of demand domestically. Foreigners own less than 10% of Japan's outstanding debt, which leaves the market less vulnerable to overseas selling than the US or European bond markets. Problems may arise, however, if Japanese investors turn sour on the low returns being offered on their bonds. A study by Greenwich Associates in Stamford, Connecticut, found that competition from overseas assets rose in 2000 as buyers searched for higher yields. That's why average annual trading volume last year was 56% higher than in 1999.
According to Lara Rhame, an economist with Brown Brothers Harriman & Co in New York, Western investors are digesting the "dismal economic news out of Japan, which is even more dismal, if that's possible, than what we are seeing in the US." Given that US stocks are swooning and analysts are buzzing about a global recession, one would expect Japanese debt to attract buyers from around the globe.
News that Japan in January posted its first trade deficit in four years indicated that slowing global growth is already taking its toll on Japan. A key reason buyers aren't stepping up is concern about the yen. It's losing ground against the dollar along with Japan's economic prospects. The dollar is changing hands at 117.46 yen today, compared with 114.50 at the start of the year.
Mansoor Mohi-Uddin, a Singapore-based strategist with UBS Warburg, believes fundamentals point toward a weaker yen in the months ahead because growth isn't likely to rebound anytime soon and the BOJ will probably print more yen in the months ahead.
Dan Fuss says: "The way Japan's looking now, it defies reason that the yen could rise against the dollar, or even the euro. That's why I'm keeping clear."
William Pesek Jr in Bloomberg Washington newsroom
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