Japan’s developed status, though an economic achievement, has increasingly emphasised the differences between its economy and the rest of Asia’s vibrant financial activity. Numerous ‘Asia ex-Japan’ indices have flourished for investors eyeing fixed income and equities in the region. But the line dividing Japan from the rest of Asia is starting to blur as economic gaps narrow between the country and its neighbours. And for the first time in decades, Japanese bond issuers have joined a benchmark Asia Pacific US dollar index, a historic development for the region’s $1tn-plus US dollar bond market.

This accession to Asian US dollar bonds adds to other catalysts for change, such as Japan’s exit from negative interest rates, breathing new life into the world’s third-biggest fixed income market. Over the next few years, Japan’s USD $10tn-plus bond market, including both yen and US dollar securities, is likely to attract greater global investor interest as it provides diversification, quality, and decent risk-adjusted returns. 

Say hello to a new benchmark

Global asset managers are preparing fund products to track the JACI Asia Pacific index, which is compiled by JPMorgan and came into effect last year. The index marks an expansion from a previous ‘Asia ex-Japan’version and upsizes the Asian US dollar bond investable universe by more than 20 per cent. The regional market, where Chinese bonds still make up the biggest share with about $600bn outstanding, now includes over $500bn of Japanese credit - around one fifth of the total index. Australian US dollar bonds have also been added for a market share of about one tenth.

As well as the benefit of a larger investable universe, the inclusion of Japan brings a higher degree of country-level diversification for investors, because Japanese bonds have relatively low correlations with those of other Asian countries. This should translate into lower volatility for portfolios that include them.

A brighter future for yen-denominated bonds

As for yen-denominated bonds, the Bank of Japan’s yield curve control (YCC) used to suppress interest rates and leave little room for investors to seek income or speculative profit. The central bank’s decision in March to abandon YCC and end its negative interest rate policy has changed that. Trading volumes have spiked in response, especially for Japanese government bonds (JGBs) and interest rate derivatives.

The value of over-the-counter trading in JGBs has jumped to a daily average of about ¥249tn ($1.6tn) this year, up from ¥228tn in 2023 and ¥196tn in 2022¹. Meanwhile, the notional value of interest rate swaps cleared by the Japan Securities Clearing Corporation surged to a record ¥626tn in the first quarter, up 24 per cent from the same period of 2023.

Higher rates could combine with improving fundamentals and potential inflows to drive a fixed income boom in Japan. The country’s macroeconomic outlook is brightening, with mild consumer price gains and wage hikes sustaining a cycle of reflation. Meanwhile, market reforms have strengthened corporate governance and sustainable practices. With higher return expectations, Japanese assets are likely to attract more repatriating funds as well as foreign capital.

At the time of writing, foreign investors in yen-denominated bonds can achieve relatively high yields after hedging their currency exposure. For example, a US dollar-based investor can harvest a 1 per cent bond yield plus a 6 per cent hedging gain due to the wide interest rate gap between the US and Japan.

Despite the uplift, the pace of monetary tightening represents a significant risk. Interest rates rising too fast could cause large mark-to-market losses. Inflationary risks should also be closely monitored, although price rises have been mild so far in Japan. If inflation takes off as it did in Europe and the US over the last few years, Japanese bond yields could surge and trigger significant volatility. In the near term, durations should be kept at modest lengths to minimise the risk of a steepening yield curve. A quality tilt would also help investors navigate economic uncertainties.

Phasing out of the ‘ex-Japan’ moniker marks a new chapter for Japanese bonds and heralds the emergence of a China-Japan duopoly in Asia’s dollar credit space. Good research and sophisticated positioning should help early birds gain a competitive advantage in this new market.

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Why adding Japan boosts Asia credit quality

More than 90 per cent of Japanese bonds in the JACI Asia Pacific index are investment grade, with nearly 80 per cent rated A- or above, giving a boost to the overall quality of Asian dollar credit. With relatively high Sharpe ratios, these bonds can also help enhance the risk- adjusted return of Asian portfolios.

Financial companies dominate Japanese US dollar bonds, with banks and non-bank financials accounting for more than half of the market value of Japanese issuance in the JACI Asia Pacific index. External quasi-sovereign is another key sector with over 20 per cent.

In addition, nearly two thirds of Japanese US dollar bonds in the index have time to maturity below five years, implying relatively low duration risks.

Previously, as an off-benchmark bet, Japanese firms had to compete with issuers from other developed countries for investor attention, with $500m being a common issuance threshold for ensuring sufficient secondary market liquidity. The new index has a market value requirement of $300m which should effectively lower the threshold for Japanese companies to issue US dollar bonds.

Supply in Asian US dollar bonds has diminished over recent quarters, due to relatively low domestic funding costs in countries like China, which previously dominated Asia’s new issuance pipeline. The inclusion of Japanese credit helps fill the gap left by Chinese issuers.

An earlier version of this article appeared online in December, 2023.

[1] Japan Securities Clearing Corporation