Japan's JGB Ownership Shift: Can Banks Fill the BOJ's Void?

The Bank of Japan's (BOJ) aggressive quantitative tightening (QT) has drastically reduced its holdings of Japanese government bonds (JGBs), creating a critical vacuum in the bond market. As the central bank exits its accommodative stance, the onus has fallen on domestic banks to absorb the slack—a task they appear ill-equipped to handle amid rising interest rates and regulatory constraints. For fixed income investors, this transition presents both opportunities and perils. Here's how to navigate it.

The Challenges Facing Domestic Banks

1. Rising Yields and Capital Losses
The BOJ's retreat has pushed long-term JGB yields to record highs. The 40-year yield, for instance, surged to 3.3% in Q2 2025, up from 1.5% in early 2023 (). This creates a stark dilemma: banks holding long-dated bonds face steep capital losses as yields rise. Major institutions like Mitsubishi UFJ Financial Group (MUFG) have already shortened their JGB portfolios' average duration to just 1.1 years, down from 1.5 years in 2023, to mitigate exposure.

2. Regulatory Constraints on Interest Rate Risk
Banks are legally required to keep interest rate risk within strict limits. The Financial Services Agency mandates that banks' duration gaps (the difference between asset and liability durations) remain below 2 years. With the BOJ's QT pushing yields higher, banks are reluctant to stretch durations further. Mizuho Financial Group, for example, cut its JGB holdings to ¥13.5 trillion by mid-2024—a 19% reduction from a year earlier—as it prioritized liquidity over yield-chasing.

3. Strategic Priorities: Trading vs. Holding
Banks are split between trading short-term JGBs for capital gains or holding shorter-dated bonds to maturity. Regional lenders favor the latter, but even this strategy faces headwinds. As yields rise, the carry (interest income) on short-term bonds improves, but the risk of further hikes keeps investors on edge. The BOJ's plan to reduce its balance sheet by 6–7% over two years adds uncertainty, as abrupt QT could trigger volatility.

The Opportunity in Short-Term and Floating-Rate Instruments

1. Short-Term JGBs: A Safer Bet
Investors should focus on JGBs with 1–3 year maturities, which offer better risk-adjusted returns. These bonds are less sensitive to yield fluctuations and benefit from the BOJ's implicit support for short-term rates. For example, the 2-year JGB yield remains anchored near 0.5%, far below the 3.1% for 30-year bonds.

2. Floating-Rate Notes: Navigating Rate Hikes
Floating-rate JGBs, which reset their coupons quarterly or semi-annually, are poised to outperform. The Ministry of Finance plans to issue ¥10 trillion in such notes annually, capitalizing on investor demand for yield stability. These instruments directly benefit from rising rates, making them ideal for portfolios.

The Risks of a Failed Transition

1. Liquidity Crunch and Yield Volatility
If banks cannot absorb the BOJ's reduced purchases, the JGB market could face a liquidity crisis. Recent auctions, such as the May 2025 20-year JGB offering with a bid-to-cover ratio of just 2.5—its lowest since 2012—highlight deteriorating demand. A sustained shortfall in buyers could push yields higher, destabilizing global bond markets and triggering capital flight from Japan.

2. Macro Risks for Japan's Debt Sustainability
Japan's debt-to-GDP ratio exceeds 260%, and its fiscal health hinges on low borrowing costs. A prolonged JGB selloff would force the government to pay more on new issuances, exacerbating deficits. The yen's strength—a byproduct of rising JGB yields—could also hurt exports, deepening economic fragility.

Investment Recommendations

• Act Now: Shift allocations to short-term JGBs (e.g., 1–3 year maturities) and floating-rate notes.
• Avoid Long-Dated Bonds: The 10–40 year sector faces structural headwinds from rising yields and bank aversion.
• Monitor Bank Stocks: MUFG and SMFG's JGB holdings () signal broader market sentiment.

Final Take

The BOJ's exit from JGB markets has set off a high-stakes game of musical chairs. Banks lack the capacity to fully replace the central bank's demand, leaving fixed income investors to navigate a treacherous yield environment. The solution? Focus on duration control and liquidity. Without swift action, portfolios risk being crushed by the weight of Japan's debt—and the banks' inability to carry it.

The clock is ticking. Position portfolios for shorter durations—or risk being left behind when the music stops.