Aozora Delivers Grim Reminder Of Japan Carry-Trade Risk

By Masaki Kondo, Bloomberg Markets Live reporter and strategist

Aozora Bank’s shock loss projection serves as a reminder of just how little room the Bank of Japan has to tighten its policy and for the nation’s bond yields to rise.

Carry trade isn’t just about buying and selling currencies in the spot or forward market (see "The $20 Trillion Carry Trade That Will Destroy Japan"). When investors in a country where interest rates are low raise funds domestically and invest the proceeds in higher-yielding assets abroad, it’s a form of carry trade. Banks in Japan can do this by gathering deposits at an average rate on ordinary deposits at 0.001% and buying higher-yielding overseas securities, such as five-year Treasuries with a yield of 3.8%.

It looks like Aozora has been doing just that.

The bank sold foreign securities to cut losses that were mainly caused by a rise in US interest rates. Nearly 40% of Aozora’s securities portfolio consists of foreign bonds but a share of foreign-currency assets is probably higher considering other asset classes such as ETFs include overseas securities. Japanese government bonds made up just 2% of the total portfolio.

This isn’t to say other Japanese banks are facing similar risks. But Japanese investors as a whole have boosted their overseas investment since the BOJ expanded monetary easing in 2013. Even if overseas assets have positive returns, a substantial rise in yen borrowing costs could risk triggering unwinding of this big Japan carry trade.

This suggests a first rate hike since 2007 will be a balancing act for the BOJ. It will probably settle for only small increases to avoid wreaking havoc. This outlook also argues for low bond yields in Japan.

More here.