Blunting the Samurais' Blade?

It is not as if financial markets are short on action at the moment, and financial pundits and analysts are certainly being served an ample amount of ammunition from which to draw inspiration. In this light, I am sorry to report that your author here at Alpha.Sources is still crippled by a lack of stable access to the internet. Not unlike the issue in financial markets and the global economy the problem with the apartment in which he is housed has appeared to run deeper than first assumed As such, the attempts to secure stable access to the World Wide Web have so far been futile. Here is to hoping that I am will be up and running some time this week.

Another thing which does not seem to be running at the moment (apart from the entire global financial edifice that is) is the market for samurai bonds which are yen denominated bonds issued by foreign entities in Japan. Or more specifically, after Lehman’s default many observers have voiced concern that this might effectively blunt what has hitherto been a very sharp business for both issuers and investors.

I have been writing about the samurais before not least because the market for these instruments has been growing tremendously [1] , but also because the capital flows epitomized by the samurais represent an important example of how an ageing economy such as Japan is a net provider of global credit. Coupled with the thesis of decline in Japanese investor’s home bias, the increase in issue of samurai bonds represent an important case study of the symbiotic relationship between old capital intensive and most importantly yield hungry economies and young economies in need of capital. Obviously, the distinction between old and young here is rather crude and as such, one big theme for the samurais in the past year has simply been the manner in which foreign financial institutions have sought Japanese capital due to the relative calm of capital markets in the kingdom of the rising sun. However, from a fundamental supply and demand perspective, I have also shown how the Samurais can be seen in a wider perspective of the necessity of Japan’s savings to go for yield.

In this way, I think that the structural driving forces for the continuing build up of samurai bond assets are quite strong. However, this does not mean that the collateral from the credit crunch will go unnoticed.  

The sudden questioning of the future of the market for samurais is thus not surprisingly closely tied to the almost cataclysmic events in the US financial sector. More specifically, the dramatic demise of Lehman Brothers marked the first spectacular default on a major portion of samurai bonds. As for the actual figure it seems that even Bloomberg has some difficulties delivering a feasible point estimate, but in the region of USD 2 bill worth of samurai bonds outstanding seem a reasonable guess. Given the fact that Lehman is defaulting entirely on its outstanding debt, it has naturally cooled the sentiment of its Japanese creditors somewhat. Tetsuo Ishihara from Mizuho Securities Co. pinpointed it well when he said that; (courtesy of Bloomberg) 

``It will be difficult for independent investment banks to sell samurai bonds after this,''

Of course, with investment banks out of the picture entirely there may not be much need to worry, but the underlying point should indeed be taken seriously. Aozora Bank Ltd., Mizuho Financial Group Inc. and Shinsei Bank Ltd were the biggest of Lehman’s Japanese creditors and in terms of the last of the three, credit default swaps rose 150 basis points as the Lehman bust became reality. Initial reports from the Japanese lender furtthermore suggest that the exposure has cost dearly. So far, the butcher’s bill indicate that net income may decline as much as 80% on the back of the exposure to Lehman.

``These figures leave a very bad impression,'' said Hiromichi Tsuyukubo, a hedge-fund manager in Tokyo at Myojo Asset Management Japan Co., which oversees about $150 million. ``The 38 billion yen to Lehman was already announced but the size of the downward revision is much bigger than expected.''

The sentiment in the wake of the collateral damage has not gone without notice on the supply side either with Deutsche Bank recently shelving plans to issue samurais until markets, or in this case required yield premiums, have found a more calm level.

Once Bitten Twice Shy?

Japanese savers may need yield, but they are not stupid and in general, I would presume a pretty careful bunch (in relative terms). As such, and while it seemed at some point that Japan’s savings not unlike Chinese, Middle Eastern and other SWF money rollers together would bail out the entire US financial system Japanese bond investors may adopt a once bitten twice shy mantle on the back on Lehman’s collapse. This need not however increase Japanese investors’ risk aversion in general and the decline in their home bias in particular. Or as Bloomberg’s William Pesek notes in one of his recent columns;

One reason Japanese banks bet on foreign names like Lehman has been their inability to get domestic consumers to borrow more. It's a key dynamic restraining growth. Fixing it will require hard work from all facets of Japanese society -- including samurai.

This is a point will made, but what if the inability of banks to get Japanese consumers to borrow more is an inbuilt function of the country’s demographic profile? In that case, I would submit that while Lehman may have dented Japanese investors’ appetite for samurais, they will soon head for the trough again. As such, I maintain my thesis grounded in a structural assessment of Japanese savers’ need for foreign yield. Given the low domestic interest rates and the low level of domestically generated growth, foreign debt instruments still look very attractive from the point of view of Japanese savers. Moreover, and given the fact that the unfolding credit crunch is not about to fade in any given sense of the word, the supply side [2] is not going to dwindle as companies will continue to have problems raising capital. This year’s bumper issues from giants such as Wal-Mart and Citigroup suggest as much, although the latter of course was a quite necessary attempt to shore up a credit turmoil struck balance sheet.

Conclusively, I think that structural forces will keep capital flowing from Japan into foreign asset markets and while the distinct market for samurai bonds may have been dented, I still see this market as an integral part of the bigger picture.

[1] Data compiled by Bloomberg suggests that the market grew 61% to 2.6 trillion yen over the past year.

[2] i.e. supply of bonds