【MACRO Alert】Japanese CLO giant faces financial crisis! Government seeks short-term bond issuance as new trend!

Japan Agricultural Central Bank, dubbed the “whale” of Japanese CLOs, is currently grappling with severe financial issues. According to Nikkei News, the bank plans to sell over ¥10 trillion (approximately $630 billion) in US Treasuries and European government bonds by March 2025. This move aims to prevent losses from its investments in low-yield foreign bonds, a primary cause of its deteriorating balance sheet, while reducing risks associated with holding foreign government debt.

Japan Agricultural Central Bank, the fifth largest bank in Japan with total assets of $840 billion, was renowned as one of the most aggressive CLO investors globally, focusing on securities from pension funds invested in agriculture, forestry, and fisheries enterprises. However, the Bank of Japan's first interest rate hike in decades in March this year, though modest, has already led to substantial losses for domestic Japanese banks holding overseas bonds.

According to Nikkei News, Japan Agricultural Central Bank expects its net losses to exceed ¥500 billion by March 2025, potentially escalating to ¥1.5 trillion with bond sales. CEO Kazuhito Okuda acknowledges the urgent need for substantial portfolio management changes to mitigate unrealized bond losses, currently totaling around ¥22 trillion. He explained that the bank aims to reduce sovereign rate risks and diversify investments into assets carrying corporate and individual credit risks.

With rising yields in the US and Europe depressing bond prices, the bank faces inflated mark-to-market losses on its previous high-cost (low-yield) foreign bond purchases. Consequently, Japan Agricultural Central Bank is methodically liquidating bonds worth hundreds of billions of dollars to avoid disorderly liquidation and potentially worse scenarios in the future.

The bank holds approximately ¥23 trillion in foreign bonds, constituting 42% of its total managed assets. As a major institutional investor in Japan, it accounts for 20% of the total bond market. Once it begins selling, other investors may follow suit. The bank anticipates a longer-than-expected timeframe for interest rate cuts in the US and Europe, hence plans to sell foreign bonds in the 2024 fiscal year to reduce unrealized losses.

Large-scale sales could significantly impact the U.S. bond market. Once selling begins, other banks and investors may join, including retail investors in Japan, who hold the largest proportion of U.S. Treasuries among foreign investors. Financial performance would deteriorate sharply due to substantial withdrawals from foreign bonds, turning notional losses into actual ones. It is projected that by March 2025, the final losses for the Bank of Japan will reach ¥15 trillion.

In this environment, Japan's Ministry of Finance is considering a new plan that would alter its traditional strategy of issuing long-term bonds in favor of issuing more short-term bonds. This shift aligns with the recent decision by the Bank of Japan to reduce bond purchases, signaling a significant adjustment in Japan's fund-raising methods. Currently, the Bank of Japan holds approximately ¥590 trillion (around $3.7 trillion) in Japanese government bonds, accounting for more than half of the outstanding national debt.

The Bank of Japan raised interest rates for the first time in 17 years in March and announced last Friday that it would disclose details of its reduced bond-buying plan after the policy meeting on July 31. This decision has prompted the Japanese government to seek new sources of funding. The Ministry of Finance has prepared a draft proposing an increase in the proportion of short-term bond issuance and considering floating rates as a possible option. The adjustment in this strategy aims to mitigate yield risks from market supply. Despite Japan's policy interest rates being kept near zero for an extended period and the Bank of Japan limiting long-term yields through Yield Curve Control (YCC), the Ministry of Finance has previously favored extending bond maturities.

The Ministry of Finance's draft also points out that shortening bond durations could increase the government's refinancing and interest rate risks, thus suggesting broadening the base of Japanese government bond holders. To better understand market participants' views, the Ministry of Finance distributed a questionnaire at a group meeting in May to potential bond buyers, including insurance companies, banks, and foreign investors. They plan to release the survey results and proposals for future bond issuance this Friday. Some respondents indicated that banks could become the main new clients for the Bank of Japan following its reduction in bond purchases.