Another Hedge Fund Casualty: Japanese Banks via "Floaters"

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.”

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  1. Richard Kline

    ” . . . [E]quities included in Tier 2 capital . . .” Oh, dear Godddd! But that’s the Nipponese way. Did anybody every tell those U. of Toy business types that EQUITY MARKETS CAN GO DOWN!?? Why do I think that hunter-gatherers, as well as being happier, are considerably smarter than the rest of us? It’s been [mostly] downhill since the Neolithic. : (

  2. wintermute

    The Japanese are masters of NOT marking-to-market and have proven it for decades. So they will take this in their stride and grimly hold on waiting for their assets to “come good”.
    Watch this space because the complaints against mark-to-market (like the witchhunt against shortsellers) may result in the West copying the Japanese experience to a T. Doh!

  3. Timothy

    Hi Yves, strangely enough my partner & I were talking about this on Friday night. She believes ( and is in a position to have a good idea) that hedge fund hold around 90% of these issues. All the selling flow is hedge funds & as yet so is the buying.

  4. Sergei

    Marking to market in this case might not make a whole lot of sense, though, if you consider that that bonds are issued by the sovereign and supposedly risk-free. If there is no default risk, is it absolutely necessary to mark the floaters to market? In this case, marking to market is just a timing adjustment, ie. you book losses today, but make up for the losses in future years through higher interest income. If there is no risk of default, does it make sense for the bank to mark down their regulatory capital?

  5. CarlJung

    A late night post about “floaters” which goes on to describe various “dumping” mechanisms, “downdrafts”, liquidity issues “wiping them out”….

    Freud would have a field day with this.

  6. FairEconomist

    Seems like a staggering arbitrage opportunity for the Japanese government. Can’t they issue other bonds to buy these floating bonds back en masse? I thought I saw they were selling for 88% of book value, which means they could make 50 billion dollars buying that 432 billion back. That would justify some fairly steep bond premiums.

  7. Sitting-Bull

    Japan is Zombie-land regarding bonds and derivatives:

    "As with many derivatives deals, Morgan Stanley employees debate who gets credit for the complex idea that allowed Japanese institutions to recognize billions of dollars of false profits. I certainly don't claim any credit for it, nor do I want credit. The idea predated my arrival at the firm, anyway, so it can't be blamed on me. Whoever invented the trade, one thing is clear: They gave it a horrible acronym."

  8. future value

    The floaters are related to my latest fantasy:

    Re: “Clearly, if the level of the spot yield is significantly different from the defined notional coupon, or if the slope of the yield curve differs significantly from zero, the conversion factors defined by the exchange will not equate the net delivery costs of all eligible deliverable issues.”

  9. Anonymous

    floaters trade as distressed assets though they are govt bonds. there are other examples in Japan (inflation bonds) or elsewhere. everybody knows theyre cheap, and way under fair value, but some people just need to sell, and nobody has ammo to buy. it just shows also how Japanese banks have been hurt in their capital ratios (otherwise theyd just accumulate those), and that (domestic) demand for JGBs is weak: there is only “short term trading” demand: banks want to buy when there is momentum for a short term profit and be able to get out, but its notpossible with floaters now.
    Japan has a huge debt problem. now supply / demand is obviously getting worse, and long term yields might jump a lot now despite worsening economic prospects. Japan’s cycle is 15years in advance of whats going in other Western countries, and any sovereign debt problem now could give an idea of the panic awaiting us, or even spread it immediately.

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