Japanese Government Urged to Halt 30+ Year Bonds Amid Yield Surge

UBS Asset Management's Kevin Zhao has advised the Japanese government to halt the issuance of long-term bonds exceeding 30 years in duration. This recommendation comes as the 40-year Japanese government bond yield surged to 3.675% last month, the highest since the bond's inception in 2007. The primary concern is the diminishing demand for such long-term bonds, driven by demographic shifts in Japan's aging population. Insurance companies and pension funds, traditionally major buyers of these bonds, are facing reduced demand due to the changing population structure.

The rationale behind Zhao's advice is to stabilize the Japanese government bond market, which has been experiencing heightened fluctuations. The aging population in Japan is leading to a decrease in the demand for long-term bonds, as insurance companies and pension funds, which are significant investors in these securities, are adjusting their portfolios to accommodate the demographic changes. The high yield on the 40-year bond reflects the market's response to these structural shifts, making it increasingly difficult for the government to manage its debt issuance effectively.

Zhao's proposal to halt the issuance of bonds with maturities exceeding 30 years is aimed at mitigating the risk of further sell-offs in the bond market. By reducing the supply of long-term bonds, the government can help stabilize yields and prevent further market disruptions. This strategy would also allow the government to focus on shorter-term debt instruments, which may be more aligned with the current investment preferences of institutional investors.

The Japanese government faces a delicate balancing act as it navigates these challenges. On one hand, it needs to address the fiscal implications of an aging population, which includes managing a growing debt burden. On the other hand, it must ensure that its bond issuance policies do not exacerbate market volatility, which could have broader economic repercussions. Zhao's recommendation provides a potential solution to this dilemma, offering a path forward that prioritizes market stability while acknowledging the demographic realities facing Japan.

Zhao also suggested that the Bank of Japan should raise interest rates again in July, following the January increase. This move would signal to the market that rate hikes could occur every six months, providing clarity and potentially smoothing the yield curve. He noted that the primary driver of the recent rise in short-term Japanese government bond yields is the Bank of Japan's cautious approach to rate hikes. A July rate hike could help flatten the yield curve, with the 30-year bond yield potentially falling to around 2.25% to 2.5%, and the 40-year bond yield dropping to around 3%.

To further stabilize the bond market, the Bank of Japan should normalize the duration of its bond portfolio, which was primarily composed of 5-10 year bonds under its quantitative easing policy. Zhao recommended that any reinvestment should focus on 20, 30, 40, and 50-year bonds. This strategy would align the central bank's portfolio with market conditions over the next five to seven years, achieving market neutrality. Additionally, such purchases would increase demand for these longer-term bonds, further stabilizing the market.

Zhao acknowledged that he had purchased some ultra-long-term Japanese government bonds during the recent yield surge but is waiting for signs that Japan is seriously considering market normalization and large-scale bond purchases. He expressed optimism that if there are early indications of such a shift, these long-term bonds, including the 40-year bonds, could become attractive investments again.