Analysis-Futures in Japan are experiencing a hangover from the BOJ’s bond-buying glut

By Junko Fujita and Tom Westbrook

TOKYO/SINGAPORE (Reuters) – Japan’s $9 trillion bond market is bracing for disruption as a paper shortage caused by massive purchases by the central bank is expected to affect the settlement of derivatives used by investors and underwriting dealers sales of the nation’s debt.

Decades of fighting deflation have prompted the Bank of Japan (BOJ) to buy assets and made it the majority owner of the country’s national debt, with a balance sheet larger than the $4 trillion economy and five times that of the Federal Reserve of the US compared to gross domestic product.

This has kept yields low and made the Japanese market unattractive to investors, leaving its bonds illiquid and unreliable as a benchmark for interest rates.

Now, as the BOJ pulls its balance sheet toward a normalization of markets, the long-awaited renewal of debt fund trading is proving to be a slow and bumpy process.

A test looms in the futures market in December, when the 10-year contracts will be linked to the #366 government bond tranche, which is 95% owned by the BOJ.

Participants say the bond shortage in the open market will interfere with the buying of so-called “cheapest to deliver” bonds to settle derivatives contracts at maturity, crucial for the market to trade smoothly and price accurately.

“The lack of the cheapest bonds to deliver makes it difficult for investors to hedge their exposure to rising rates,” said Keisuke Tsuruta, senior fixed income strategist at Mitsubishi UFJ Morgan Stanley Securities. “This makes general trading difficult.”

Tsuruta said this will affect not only trading and speculation, but also government bond auctions, as primary dealers bidding at these auctions largely use futures to hedge their exposure.

As the BOJ has embarked on a rate-hike path, investors are also looking for the cheapest bonds to settle short futures positions, and distortions in the derivatives market would hurt them.

The lack of such bonds will mean “futures hedging doesn’t work,” said Masayuki Koguchi, chief fund officer at Mitsubishi UFJ Asset Management.

DYSFUNCTIONING DERIVATIVES

Japanese government bond (JGB) futures are listed on the Osaka Stock Exchange. Benchmark 10-year futures, which are contracts that last three months, are used to speculate where yields will be in the future and are tied to an underlying cash bond.

They are the deepest part of the market and vital to participants, from hedge funds to corporates, who want to bet on interest rate movements or use the market to offset an exposure.

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Unlike stock futures, sellers of JGB futures must physically deliver bonds at the end of a contract, rather than just paying the price difference.

The rules allow sellers to deliver bonds with maturities between seven and 11 years against 10-year JGB futures, and under the exchange’s conversion factor, the #366 government bond will become the cheapest to deliver at the end of December for contracts which mature in March.

That tranche was the 10-year benchmark through 2022, when Japan’s central bank was buying billions of bonds to defend a 0.25 percent yield ceiling against speculative short sellers.

The result is that the BOJ owns more than 95% of #366, which will leave futures sellers scrambling to grab it or look for more expensive bonds to settle their trades.

The situation is reminiscent of the distortion in JGB futures in June 2022, when a surprise BOJ intervention at the cheapest delivery tenor surprised dealers. Futures tumbled with bidding at the JGB auctions, which produced some of the weakest auction results in more than 30 years.

Then the BOJ eased the rules to make it easier to borrow bonds, and surely a similar move – or if the finance ministry reopened the tranche to sell more debt – would ease pressure on the market. But that would also highlight his fragility.

“This situation reflects the negative effect of the BOJ’s easy monetary policy,” said Miki Den, a senior Japan rates strategist at SMBC Nikko Securities.

It is also likely to persist next year as subsequent tranches are also heavily owned by the BOJ. A bearish outlook for bonds is also keeping big JGB traders out of the cash market, making it likely that normalcy will only come to Japan’s debt markets over an extended time frame.

“It’s basically trying to unwind, let’s call it the last decade, a decade and a half of politics,” said Norman Villamin, chief strategist at Union Bancaire Privée.

“When you put it in the context of these kinds of ten-year-plus time horizons … the normalization that’s been going on for about two years (isn’t) particularly out of step with those timelines.”

(Reporting by Junko Fujita and Tom Westbrook; Editing by Vidya Ranganathan and Muralikumar Anantharaman)