Bond Investors Bet on Japan's Day of Reckoning

By GREGORY ZUCKERMAN And JOANNA SLATER Some hedge funds are starting to wager on painful times ahead for Japan, the world's second-largest economy. These investors, including some who made successful bets against risky mortgages and financial companies in recent years, anticipate trouble for Japan's financial system. Their concern: Government borrowing continues to climb while demand for the nation's debt could taper off. View Full Image Agence France-Presse/Getty Images A currency dealer in Tokyo waits for an order in November. Some bets on derivatives by bearish traders could pay off handsomely if the yen lost a quarter or more of its value. A collapse of the Japanese government-bond market "is going to happen; it's a question of when," said Kyle Bass, head of Hayman Advisors LP, a Dallas hedge fund, who has placed wagers on that outcome. He and others, such as David Einhorn's Greenlight Capital Inc. and a fund run by Daniel Arbess of Perella Weinberg Partners LP, have been buying a variety of investments that could pay off if the Japanese bond market crumbles. Betting against the debt of various nations such as Greece and Ireland has proved a popular move during the past several months as worries have mounted over deteriorating government finances in the aftermath of the financial crisis. But a selloff in Japan's bonds would be much more worrisome than woes in some other countries, because of the size of Japan's bond market, 694.3 trillion yen, or about $7.543 trillion, and the role Japan plays in the global economy. "In Japan, the mist has subsided and you see this huge mountain of debt," said Tom Byrne, a sovereign-credit analyst for Asia for Moody's Investors Service. That has raised concerns among some that "this could blow," although Mr. Byrne doesn't believe that will happen. A spokesman for Japan's Ministry of Finance declined to comment. Not everyone is worried. For starters, the wager against the country's debt has a long and unprofitable history, saddling investors with big losses. And even those with deep convictions about Japan's troubles are hedging themselves. Mr. Bass has placed only a small portion of his $650 million fund in bearish Japanese bond investments. Despite an increasing debt burden and long-standing predictions that demand for government bonds would flag, the market has held up. The biggest buyers remain domestic investors that hold almost all of the nation's debt, such as Japanese banks, pension funds and insurance companies. That has kept yields, which move in the opposite direction of prices, low. The yield on Japan's 10-year government bond hasn't gone above 2% in more than a decade. The presence of domestic, rather than foreign, investors also reduces the possibility of a mass exit from the market. Moreover, Japan has been plagued by bouts of deflation-falling consumer prices since the late 1990s. In November, consumer prices fell for the ninth month in a row. If that persists, bonds may continue to have allure, because even slender yields can look good amid deflation. Even some who believe yields will rise don't expect the big increase envisioned by the hedge-fund pessimists. "I just don't think it's the blowout trade some funds think it is," said George Papamarkakis of North Asset Management LLP, a London hedge fund. But bears maintain there are reasons to bet against Japan. They note that government debt as a percentage of gross domestic product is expected to hit 219% in 2009, up from 120% in 1998, according to the International Monetary Fund. By way of comparison, debt will total 85% of the U.S.'s GDP, and 69% of the U.K.'s, the IMF said. Even net government debt, which subtracts government assets, is high in Japan; the IMF puts it at 105% of GDP in 2009, compared with 58% for the U.S. Some predict that as Japan ages, more people retire and savings rates dip, some purchasers will start pulling back on buying or even turn into sellers. Japan's public pension fund, the world's largest, has said it could become a net seller of holdings in 2010. About three-quarters of the fund's holdings have been in Japanese bonds. "The biggest buyer is now a seller. That's the biggest difference today," said Mr. Bass of Hayman Advisors. To attract buyers, particularly from overseas, yields will have to rise significantly, the bears assert, making it painful for Japan to service its debt. The election of new government leadership in August also has ramped up anxieties of investors, who fear less-experienced officials will spend too freely in an effort to put money in the hands of ordinary Japanese. On Wednesday, the government unveiled a plan to try to spur the economy and cut employment. Japan's government recently stopped short of setting a firm limit on new debt sales in the next fiscal year, a sign for bears that the country isn't committed to fiscal discipline. Bloomberg News Perella Weinberg's Daniel Arbess anticipates trouble for Japan. Some investors burned in the past now find the trade hard to ignore. Back in 1995, David Roche, head of investment consultancy Independent Strategy, predicted that Japanese yields would rocket higher. He went so far as to call the country's debt "junk bonds in drag." That turned out to be "dead wrong," he acknowledged this year, because Japanese investors kept on depositing their savings in banks. The banks funneled the savings, together with cheap money from the central bank, back into government bonds, keeping prices buoyant and yields low. But that arithmetic can't be repeated now, Mr. Roche wrote in a recent report. Although Japan's stock of savings remains large, the savings rate has dropped below 3%, from more than 10% in the 1990s. Traders are betting against Japan's debt in myriad ways. Some bearish traders are entering into option contracts betting on "forward rates," or the direction of Japanese yields. These options are among the most heavily traded of the commonly used bearish tools, so some beginners to the game are embracing them. The downside is investors can find themselves exposed to big losses if yields fall further. Others buy credit-default swaps, derivative contracts that serve as insurance to protect against a default of Japan's debt. The cost to insure $10 million of Japanese bonds is about $70,000 a year for five years. That price has climbed from less than $50,000 since October. Still others are buying more exotic instruments, such as "CMS caps," also called constant-maturity-swap caps, and "swaptions." These interest-rate options reward a buyer if Japanese rates climb over the next few years, but limit downside because there is only a one-time upfront payment. Mr. Bass has purchased protection on about $12 billion of Japanese bonds, according to a person close to his firm, a move that is costing him about $6 million, a skimpy price because most investors still doubt the trade will succeed. If 10-year yields, currently at 1.3%, rise to 3% or so, Mr. Bass won't make that much; but if they hit 4%, he would make about $125 million on his $6 million investment. He will make at least $125 million for each subsequent percentage-point rise, according to people close to the firm. Still, such bets are on the rise. Traders said they can see increased interest in derivatives that would pay handsomely in extreme outcomes, such as if interest rates on Japanese government bonds multiplied several times, or if the yen lost a quarter or more of its value. Write to Gregory Zuckerman at gregory.zuckerman@wsj.com and Joanna Slater at joanna.slater@wsj.com