The ‘widow maker’ trade is becoming a world beater as Japanese bonds sink

Global bond funds have been attracted – and repeatedly burned – for decades by a trade known in Japan as the “widow maker.”

The idea is simple: Borrow and sell Japanese government bonds in anticipation of falling prices, before buying them back and pocketing the difference. The strategy takes its name from piling up losses for debt investors during the country’s long years of ultra-loose monetary policy. Now it has become one of the most lucrative investments in the global bond market.

Japanese bonds have lost more than 4% this year in terms of total returns that exclude currency movements, making them by far the worst performers in global government bond markets, according to Bloomberg calculations. The market has been roiled by continued bets on rate hikes and fears that the country’s next prime minister will unleash a spending spree that could push up long-term interest rates.

“Forget government bonds or government bonds, one of the cleanest ways is to sell JGBs,” says Mark Nash, money manager at Jupiter Asset Management, about short bets on bonds. “The widow maker trade is one of the most profitable compared to other markets.”

Yields on 30-year Japanese government bonds reached a record high this month. An S&P gauge of futures tied to the bonds is down about 2% this year. The selloff has gotten so bad that Goldman Sachs Group Inc. Japan has been labeled “a net exporter of bearish shocks” in the global debt market.

There are a few main reasons behind the trade. Japan’s core inflation has been above the central bank’s 2% target for most of the past three years. Interest rates remain exceptionally low globally, despite a series of rate hikes that started last year. Trading was also fueled by broad concerns about fiscal policy, which have weighed on bonds from New York to London this year. Hiroyuki Kimura, portfolio manager at the $230 billion-plus Western Asset Management, said his fund has long been short-dated in the Japanese bond market and plans to stick with that strategy. The trading is mainly done through a large short position in five-year bonds, he said. RBC BlueBay Asset Management, which has faced bond bulls amid previous bets on the widowmaker, recently positioned itself for a decline in Japanese 10-year bond prices and is now short-dated in the country, Mark Dowding, chief investment officer for fixed income, said in an Oct. 10 note. He still sees value in long-term rates.

There are risks to trading. Local life insurers could return by year-end, boosting demand, while improving finances give the government some room to reduce issuance in the next fiscal year. US rate cuts could provide further support as Japanese bonds have historically been correlated with government bonds.

But for now, many bond funds remain convinced that Japan’s widowmaker trade will remain a rainmaker.

Political unrest

A key question for traders is what impact Japan’s next prime minister will have on the country’s $7.7 trillion debt market.

Sanae Takaichi, who won Tuesday’s parliamentary election to become Japan’s prime minister, has promised cash handouts and tax cuts, but traders also think her rise will delay interest rate hikes. That has fueled fears that longer-dated bonds will ultimately bear the brunt of the selling pressure, as investors worry that future generations will pay the price of the current budget glut.

Just days after Takaichi won the leadership vote in the Liberal Democratic Party, the governing coalition collapsed, plunging the country into its biggest political crisis in decades. She had struck a new partnership to form an alliance, but the risk of political headlines weighing on the bonds is far from over.

Yields on Japanese five-year bonds fell two basis points to 1.22% on Tuesday, after Bloomberg reported that Bank of Japan officials see no urgency to raise rates next week.

“We expect a deal to be struck on fiscal stimulus, although the scale of any spending is unclear,” Lauren van Biljon, senior portfolio manager at Allspring Global Investments UK Ltd., said before the new coalition was agreed. “It suggests caution is needed when it comes to maturity in Japan. The yield curve is steep, but that doesn’t mean it can’t be steeper.”

Some investors are optimistic. Japanese bond yields are attractive on a hedged basis, making them attractive to many foreign investors, said Kathy Jones, chief fixed income strategist at Charles Schwab & Co. The country’s fiscal position appeared to be improving ahead of the elections, making the outlook for public debt more favorable, she said.

The bears may also be overstating Takaichi’s ability to unleash large-scale stimulus, given the risk of an uprising by so-called union vigilantes – who were partly credited with toppling the short government of former British Prime Minister Liz Truss three years ago.

“If Takaichi has any doubts, she should ask Britain what happens if you defy the bond markets,” said Alex Everett, a fund manager at Aberdeen.