Shorting Japanese Bonds: Betting Against The Italy Of Asia

by: Nicholas Pardini

Europe may be dominating the press now, but the same factors that have driven up the yields in sovereign debt in Europe are just as prevalent in Japan. Unlike Europe, however, Japanese bonds and the Yen have remained strong. Due to an oncoming demographic catastrophe, near zero percent yields, an overvalued currency, and unsustainable debt levels, I am extremely bearish on the prospects of Japanese government bonds.

Historically, Japanese bonds have remained high because the country's investors' low risk appetite and wealthy baby boomer generation. Unlike the US, nearly all of Japan's debt is financed by its own citizens. Unfortunately, Japan's wealth and savings is heavily concentrated among the older citizens of the country. Japan's largest generation is currently beginning to retire. As more of them leave the workforce, they will change from net savers to net consumers and sell their bond holdings (or not renew them upon maturity) to pay for living expenses.

With one of the world's most homogeneous societies, Japan has been restrictive toward immigration. The younger generations in Japan are fewer in numbers than their parents and also much poorer ecomically. Estimates from Japanese government surveys indicate that the population of NEETs and freeters (those who either live with their parents unemployed or bounce between low paying jobs) range anywhere between 25% to 60% of Japanese youth. Whether this is due to a lack of economic opportunities since the 1990s or the laziness of young people to do anything but watch anime, the NEET problem has caused fertility rates to plummet and leaves the younger generations lacking capital to invest. As a result, younger workers will not be able to buy enough Japanese debt to replace the older sellers.

Foreigners will not buy Japanese debts at such low yields (10-year currently 1.06%). With the world's highest debt-to-GDP ratio at 220%, any significant rise in yields would put the country at the risk of default. Japan's economy has been sluggish since the early 1990s, so its unlikely it can grow its way out of the problem. The Bank of Japan already sets rates at zero, so that leaves limited monetary policy options to hold down a spike in sovereign borrowing rates. With debt servicing already amounting to 14% of the Japanese budget, a 200 basis point rise will make the Japanese government insolvent.

The main ways for individual and small institutional investors to short Japanese bonds is through either options on JGB futures or ETNs. JGBS-OLD is the government bond inverse ETF and the JGBD is the triple levered inverse ETN. Since these ETNs are relatively new and unheralded, the volume and liquidity for both securities is quite low. However, this should improve over time as more investors catch on to the structural problems in Japan and its crippling debt.

An indirect way to profit off a Japanese debt crisis is through shorting the Yen. Over the past five years, the Yen index (NYSEARCA:FXY) has appreciated by over 50%. The reason for this is not because the Yen is fundamentally strong, but that financial crises have triggered global central banks to lower their interest rates to match Japan's near-zero interest rate policy. Since the Yen had already priced in zero percent interest rates, the rest of world's currency's just fell. The implosion of the Japanese bond market will be catastrophic for the Yen as investors will lose confidence in the currency and/or the Bank of Japan will resort to printing money to finance its budgetary shortfalls.

Within the next few years, I believe that the Japanese bond market to break down like the PIIGS currently are in Europe. Similar to the PIIGs, Japan has an aging population, with wealth concentrated among the elderly, smaller and poorer succeeding generations, an overly strong currency, and an unsustainable government debt/GDP level. Now is the time to enter a short position into Japanese debt, before these issues get priced in.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in JGBD, JGBS-OLD over the next 72 hours.