Forget Hedging and Yields. The Yen Is Key to Japan Buying Abroad

(Bloomberg) -- International brokers with Japanese clients are no doubt salivating at the slide in currency hedging costs, which increases their incentive to buy overseas. But history suggests it is the yen itself that is key to a flood of investment from the east.

The cost of buying protection against an adverse move in the yen for three months has slumped over one percentage point in about a year, to 2%, according to data compiled by Bloomberg. While overseas security purchases from Japanese investors have edged higher, a look at past trends hints that the level of the yen plays a more important role in their investments rather than hedging or higher yields available abroad.

Here are a selection of charts that show the complex relationship between Japan’s overseas investments, hedging costs, foreign yield differentials and the yen -- and that the most straightforward one is currency:

Hedging Costs

Over the past decade, 3-month hedging costs for yen investors in dollar securities surged to a peak of 3.4% in 2018 from just 20 basis points at the beginning of 2010. A quick glance at the chart below shows that rise failed to dent Japanese demand for overseas bond investment. Furthermore, despite the slump in costs over the past 12 months, the pace of weekly foreign purchases has begun to slow.

Yen Strength

The relationship between the yen and overseas investment looks much clearer. Periods of strength in the Japanese currency have corresponded with increases in overseas security purchases and vice-versa. Net investment in foreign stocks and bonds rose 17% to about 20.5 trillion yen ($186 billion) in the 12-months to December, during which the yen climbed 1% against the dollar.

“The past year’s pattern shows that outbound flows emerge when the yen appreciates,” said Eiichiro Miura, general manager of the fixed income department at Nissay Asset Management Corp. At levels around 110 per dollar, where the yen fell to for the first time since May on Tuesday, “Japanese investors will be reluctant to actively buy foreign bonds without currency hedges.”

Overseas Yields

Perhaps surprisingly, the link between higher yields available abroad and the level of overseas investment also looks tenuous. Nothwithstanding the fact that the yield premium Japanese investors could obtain in the U.S. and Europe has been in overall decline since 2013, periods of rising spreads abroad counterintuitively show foreign outflows while those of falling spreads show inflows.

One prominent example is U.S. Treasuries. The Federal Reserve’s three rate cuts last year and injection of ample liquidity to markets has eased upward pressure on money rates and dollar funding costs in favor for Japanese investors. Still, Japan’s share of outstanding U.S. Treasury securities has been in steady decline, and a rise in the middle of last year was being quickly reversed in the latest U.S. data through September.

“At current levels, the return from Treasuries is still negative, making it difficult for Japanese investors to buy fully-hedged,” said Shinji Hiramatsu, a senior investment manager at Sompo Japan Nipponkoa Asset Management Co. “The alternative will be to remove some hedges to seek out positive returns or take currency risks when the yen’s appreciation accelerates.”

To contact the reporters on this story: Chikako Mogi in Tokyo at cmogi@bloomberg.net;Masaki Kondo in Tokyo at mkondo3@bloomberg.net

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

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