Why Do Investors Still Buy Japanese Bonds with Negative Yields When U.S. Bonds Offer Higher Yields and Better Credit Ratings?

While U.S. Treasury bonds offer higher yields and a better credit rating, many investors still find themselves drawn to the Japanese government bonds (JGBs) even at negative yields. This article explores several factors that can explain this seemingly paradoxical behaviour.

Market Factors Influencing Investment Decisions

Flight to Safety: JGBs are considered a safe haven, especially during periods of global uncertainty. The Japanese government's fiscal and monetary stability can provide a sense of security to investors who may be willing to accept lower yields to mitigate risk.

Currency Considerations: Some investors may look to hedge against currency fluctuations. Expectations of the Japanese yen appreciating against their home currency can partially offset the negative yield on JGBs, making these bonds potentially more attractive.

Market Expectations: There is a belief among investors that yields will decline further, making current negative yields more attractive. If prices of bonds continue to rise, even negative yields might be seen as a worthwhile trade-off.

Regulatory and Institutional Constraints: Certain institutional investors, such as pension funds and insurance companies, may be mandated to invest in government bonds regardless of yield. They may face limitations in investing in foreign assets or higher-yielding, riskier assets.

Financial Mechanisms Underpinning JGBs

Quantitative Easing (QE) and Bond Market Dynamics: The Bank of Japan's (BoJ) aggressive QE program is a key factor. The BoJ purchases a significant amount of bonds each month, keeping the 10-year yield around zero under its "Yield Curve Control" program.

According to statistics, the BoJ purchases net Y6.67 trillion, or approximately 61 billion U.S. dollars, worth of bonds every month. This intervention effectively creates a jiujitsu effect on bond yields:

You purchase the bond at a price above par (often above 100). Eventually, you hold the bond to maturity and receive 100 back at par value. However, if you plan to sell the bond before maturity, you can always sell it back to the BoJ, likely at or near the price you originally paid. The critical element is whether your cost of financing the bond through short-term interest rates is lower than the bond's coupon rate. If it is, you can achieve a low-risk carry trade.

Economic Outlook and Investment Decisions

Economic Outlook: If investors have a positive outlook on Japan's economy, they may prefer the security of JGBs over riskier U.S. bonds. This outlook can outweigh the initial attractiveness of higher yields offered by U.S. bonds.

Diversification: Including a variety of asset classes in a portfolio can reduce overall risk. Investors may choose to buy JGBs to diversify their holdings, even if it means accepting a negative yield.

Conclusion

While negative yields may seem unattractive at first glance, a combination of safety, currency dynamics, regulatory constraints, and market expectations can make JGBs a preferred investment choice for some investors. Whether the U.S. bonds still represent better value depends on the prevailing economic conditions, investor sentiment, and the specific investment strategies in place.