naked capitalism

Hedge funds continue to create considerable dislocation as they dump positions to meet redemption requirements. For instnace, a major downdraft in gold this week occurred in a very short time frame and is almost certain to have resulted from an investor selling some large holdings. With even larger redemptions expected this quarter, all sorts of unexpected corners of the financial markers can get whacked.

Consider the latest example: Japanese government floating rate bonds, now selling at distressed prices. That in turn is bad news for Japanese banks, who have also have large holdings.

From the Financial Times:

Panic selling by hedge funds has hit the Y44,000bn ($432bn) Japanese floating-rate government bond market. Some issues are trading at levels usually seen in countries at risk of default.

The plunging value of so-called “floaters” could hurt Japanese banks, which are estimated to hold at least Y10,000bn to Y15,000bn of the bonds. They may have to take mark-to-market losses on them, on top of big losses on their equity holdings.

All such bonds are trading well below their par value, say analysts, in some cases as cheap as 88 per cent of par, as hedge funds and other highly-geared investors dump holdings to repay debt.

The banks were encouraged to buy floaters earlier this decade, analysts and hedge funds say, because this was said to lower the riskiness of their portfolios.

“There’s no subprime mortgages in Japan, but the government basically made subprime for their own banks,” said one large London hedge fund.

The market for floaters, which pay interest based on the market yield of 10-year fixed-rate bonds, minus a spread, had problems two years ago when banks began selling, but stabilised thanks to buying by hedge funds. It took another hit in March, when problems at several funds, including the collapse of London’s Peloton Partners and big losses at Endeavour, spilled over into fixed-income markets.

“After the Lehman shock [last month] the situation started getting more serious,” said Koji Shimamoto, chief fixed-income strategist at BNP Paribas in Tokyo. “Liquidity is miserable as there are almost no buyers.”

The Ministry of Finance in August halved planned annual issuance to Y1,200bn. It plans to raise substantially the amount it buys back to Y1,400bn.

But Mr Shimamoto points out the speed of the market deterioration is faster than the increase in the buy-back operation…The government is considering adopting temporary measures to help banks by easing mark-to-market accounting rules…

“If they have to mark-to-market the [floater] bonds, it will be bad for banks, but it isn’t going to take them down,” said Stefan Liiceanu, a senior fixed-income strategist at Barclays Capital. “It certainly won’t hurt them as much as the decline in the Nikkei, which virtually wiped out trillions of yen worth of unrealised gains on equities included in Tier 2 capital.”

The falling prices of the bonds means that the yields are rising, forcing the government to pay more to issue new floaters.

“If the market remains broken, it increases the cost of financing,” said Mr Shimamoto. “If the market normalises, they can finance at a lower interest rate.”