Japan corporate pensions bullish on bonds as rates rise

Japanese corporate pension funds are once again favoring domestic fixed income after years of waning interest, as the Bank of Japan (BOJ) embarks on an unconventional path of interest rate hikes.

A decreasing trend in domestic bond allocation appears to be bottoming out, according to JP Morgan Asset Management’s (JPM AM) annual survey of Japanese defined benefits (DB) corporate pension funds. This year’s edition of the survey marks the first year-on-year increase in expected domestic bond allocation in 14 years.

Kaguya Komatsu

JPM AM

“With the assumed interest rate for DB pensions set at 2.3%, DB pensions are seeking low-risk assets with relatively high expected returns. Domestic bonds can be expected to provide stable yields (returns) with limited risk,” Kaguya Komatsu, head of Japan funds business and institutional business at JPM AM, told AsianInvestor.

On July 31, BOJ unexpectedly raised interest rates to 0.25%, marking the second rate increase this year. This follows the initial hike on March 19, when the central bank ended its long-standing negative interest rate policy.

According to Komatsu, BOJ's rate hike is likely to bolster domestic bond investments by DB pension plans in the long term. Nevertheless, she notes that in the short term, interest rate increases typically lead to declining bond prices, which could temporarily reduce returns for DB pensions.

“However, since the exposure is already limited, the impact is minimal. Rather, it is important to note that in the long term, the increase in yields through the interest rate hike will raise the expected returns,” she said.

NEW SCENARIO

The survey, which began in fiscal year 2009 (FY2009), shows that the average portfolio share of domestic fixed income had steadily declined from 38.2% to 15% by FY2022. However, last year saw a slight uptick to 15.1%, and the recent rate hikes by the BOJ are expected to further stimulate demand.

“Domestic bonds will provide stable yields with limited risk as rates steadily rise, which is critical characteristic in asset allocation,” Komatsu said.

On August 7, BOJ deputy governor Shinichi Uchida stated that the central bank would refrain from raising interest rates during periods of market instability, dampening expectations of an imminent increase in borrowing costs.

"As we're seeing sharp volatility in domestic and overseas financial markets, it's necessary to maintain current levels of monetary easing for the time being," Uchida said in a speech to business leaders in the northern Japanese city of Hakodate.

The remarks contrasted with BOJ governor Kazuo Ueda's hawkish signals from the hike announcement last week that more rate hikes could be forthcoming.

"The policy rate is still very low even after a hike to 0.25%. It is still negative after inflation is taken into consideration. We do not view this as a strong brake on the economy," Ueda said on July 31, not ruling out another hike rate by the end of the year.

"I do not necessarily view 0.5% as a barrier,” she said.

Japan's return to a positive interest rate environment for the first time in 17 years is reinvigorating investment in Japanese Government Bonds (JGBs). The yield on 10-year government bonds, which DB pensions are eyeing for increased allocation, has climbed to 1.25% and is projected to surpass 1.5%. This upward trend is expected to persist as future yields continue to rise.

HEDGING OVERSEAS

The JPM AM survey was conducted among 80 DB pension funds in Japan and took place between April 2024 and June 2024.

The survey revealed that approximately 30% of DB pensions had reviewed their policy asset mix. These funds not only reduced risk but also decreased their allocation to foreign bonds with currency hedges. This trend suggests a potential shift in strategy in response to the positive interest rate environment, indicating a willingness to forgo the premium associated with high currency hedging costs.

“The characteristic of currency-hedged foreign bonds is that they offer higher yields than domestic bonds even after deducting hedging costs, making their returns more predictable,” Komatsu said.

Over the past year, the Japanese yen has exhibited unusual weakness against the US dollar.

In contrast, unhedged foreign bonds can produce widely varying returns due to currency fluctuations, potentially yielding substantial gains or losses. This volatility introduces significant currency risk to investment portfolios.

“Comparing the two, the former can be considered an asset that aims for stable returns, while the latter is an asset with the potential for large gains but also large losses,” Komatsu argued.

As DB pensions aim to "reliably" exceed the guaranteed interest rate, and their target return, and do not seek excessively high returns, they prefer low volatility as long as they can achieve a certain level of return.

“From this perspective, DB pensions have focused on allocating to hedged foreign bonds. In other words, it can be said that DB pensions prefer hedged foreign bonds due to the predictability of returns,” Komatsu said.