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Japanese Bonds at Turning Point as Hedge Fund Fire-Sale Ends

Stephen Spratt
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Japanese Bonds at Turning Point as Hedge Fund Fire-Sale Ends

(Bloomberg) -- Japan’s out-of-favor bonds look to be turning the corner.

Demand for the beleaguered securities is starting to recover at debt sales after sinking over the previous six months. The reasons: more attractive (and stable) yield levels, and an end to the wave of foreign selling. Auctions for a combined 2.8 trillion yen ($26 billion) of 10- and 30-year bonds this week may help confirm if this rebound is for real.

JGB holders have had a wild ride over the past few months. Benchmark yields slid to an almost record-low minus 0.295% in September before jumping back to as high as minus 0.03% in the middle of last month.

The biggest outbreaks of volatility coincided with benchmark bond sales. A disappointing 10-year auction on Oct. 1 saw 10-year bond futures swing in a 97-tick range, the widest in three years. They almost matched that at the following 10-year offering on Nov. 6, with a 93-tick turnaround.

Life insurers often get the blame for big bond moves in Japan -- as they are the largest JGB holders -- but the culprits behind the latest stomach-churning moves have been foreign investors.

Quantitative hedge funds, trend-following investors that rely on computer-derived analysis to determine their trading strategies, embarked on a fire-sale of long JGB positions as prices began to slide. Ten-year bond futures -- their preferred trading vehicle -- have clocked up six straight weeks of net sales.

Foreign investors also began to unwind bullish positions in long-dated interest swaps, causing a blowout in the spread between swap rates quoted in Tokyo and London.

In the last few weeks however, the backdrop is starting to look more positive. Demand unexpectedly rose to the highest since July at a 20-year auction on Nov. 20, and also increased at a 40-year sale six days later.

Yields appear to have plateaued. Those on benchmark 10-year bonds have dropped back below minus 0.1%, while 10-year futures have picked up from a seven-month low.

The trend-following fund meltdown also appears to have abated. The level of open interest among investors in bond futures has stabilized, and the underlying securities in the seven-year part of the curve have begun to outperform. What’s more, foreigners appear to be back adding long positions in the swap market.

Which explains why interest is rising in the 2.1 trillion yen sale of 10-year bonds on Tuesday, and 700 billion yen auction of 30-year debt Thursday.

Primary dealers, who are obliged to buy at debt sales, may still be keen to hedge purchases in advance by selling bond futures, which may lead to another round of volatility. At the same time, the auctions may represent a dip-buying opportunity as local investors step in and buy due to the increasingly constructive backdrop.

To contact the reporter on this story: Stephen Spratt in Hong Kong at sspratt3@bloomberg.net

To contact the editors responsible for this story: Tan Hwee Ann at hatan@bloomberg.net, Nicholas Reynolds

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