Japan's Fiscal Tightrope: Bond Strategy and Childcare Spending Test Debt Sustainability

The Japanese government's recent decision to slash issuance of super-long government bonds while ramping up childcare spending marks a pivotal moment in its long-running fiscal balancing act. With public debt at 265% of GDP—the highest among major economies—the twin moves aim to stabilize yields and address demographic decline. Yet they also highlight the fragility of Japan's debt dynamics and the precarious path ahead for investors.

### The Super-Long Bond Retreat: A Tactical Win, But Structural Risks Remain
The Ministry of Finance's (MOF) reduction of super-long bond sales (30- to 50-year maturities) by 25% since 2020 has been a tactical response to collapsing demand. Domestic insurers and pension funds, once key buyers, now face regulatory constraints and low yields, while foreign investors have fled amid yen volatility. By shifting issuance toward 1- to 5-year bonds, the MOF has successfully lowered 30-year yields from 3.185% in May 2025 to 2.91%, while 2-year yields have risen to 1.455%—a stark inversion of the yield curve.



This strategy has created opportunities in short-term bonds, which now offer higher yields with better liquidity. However, risks loom in the long end: trading volumes for 30-year bonds have dropped 40% since 2020, and bid-ask spreads have widened, signaling liquidity traps. The Bank of Japan's (BoJ) tapering of quantitative easing—from ¥6 trillion to ¥3 trillion in monthly JGB purchases by March 2026—exacerbates this, as its exit from bond buying reduces market support.



### Childcare Spending: A Demographic Lifeline or Fiscal Time Bomb?
To combat a birthrate at record lows (758,631 births in 2023), Japan is pouring funds into childcare. The FY2025 budget allocates ¥160.7 billion to improve worker-to-child ratios and raise childcare worker pay, while plans to double childcare spending to ¥9.6 trillion by the early 2030s require an additional ¥3.5 trillion annually by 2027.

This spending is funded by debt issuance and tax hikes on health insurance premiums, but the IMF warns that rising interest rates could double debt-servicing costs by 2030. With social security expenses already accounting for 33% of the budget, Japan's fiscal math grows more precarious: every 1% rise in yields adds ¥1.7 trillion to annual interest payments.



### The Investment Conundrum: Short-Term Gains vs. Long-Term Pain
Investors face a clear dilemma. Short-term JGBs (1-2 years) now offer compelling yields (1.455% for 2-year bonds) with lower risk due to stable supply and BoJ liquidity support. Tactical overweighting here makes sense, particularly as global carry trades unwind and yen volatility rises.

But long-term JGBs (30+ years) remain risky. Their liquidity has eroded, and yields could spike if the BoJ's tapering triggers a bond market sell-off or if childcare spending pressures force more borrowing. Until yields hit 3.5%—a level that might attract foreign buyers—the segment should be underweighted.

### Navigating the Crosscurrents
- Short-Term Bonds: Favor 1- to 5-year maturities for yield and liquidity. Monitor the BoJ's tapering timeline—any delay could ease near-term pressures.
- Currency Hedging: Pair short-term exposure with yen-hedged ETFs to mitigate volatility.
- Inflation-Linked Bonds: Consider JGB inflation swaps if core inflation stays above 2%, as wage growth (now at 5.1%) fuels a wage-price spiral.
- Equity Exposure: Look to sectors benefiting from fiscal spending, such as construction (for childcare facilities) and healthcare, but avoid overvalued tech stocks vulnerable to yen carry-trade unwinds.

### The Bottom Line
Japan's fiscal strategy is a high-wire act: reducing super-long bond issuance buys short-term stability, but rising childcare and aging-related costs threaten long-term sustainability. Investors should focus on the front end of the curve while hedging yen risks—and brace for turbulence if yields breach critical thresholds. As the MOF's “shorten the curve” plan shows, Japan's debt problem isn't solved—it's merely delayed.