Japanese 15-year floating rate notes

8 June 2009

(Extract from page 46 of BIS Quarterly Review, June 2009)

An important innovation in debt management took place in Japan in this century. Debt managers hesitate to shorten the duration of government debt because it can increase rollover risk. This risk is usually neglected for top-rated sovereigns, but prudent debt managers cannot be indifferent to large financing requirements. Fitch (2009) recently warned that "sizeable and sustained increases in governments' reliance on short-term funding would entail additional risks", recalling the downgrade of Belgium in the 1990s when financing requirements hit a third of GDP.

The Ministry of Finance (MoF) limited such rollover risks by introducing a 15-year bond (the CMT) in 2000. Its coupon, payable every half year, is set equal to half the average 10-year JGB auction yield over the prior six months less an issue-specific number of basis points (alpha). This ranged from 81 basis points in the first auction, to a peak of over 100 basis points in 2005, to 40-50 basis points in 2007. The floating rate notes reduced the supply of fixed-rate debt significantly (Graph 4, right-hand panel). Nevertheless, like the central bank purchases, issuance of floating rate notes only slowed the growth of issuance of fixed-rate debt.

Since mid-2007, market pricing of these floating rate bonds has fallen below their "theoretical" values, by as much as 10% in late 2008, and the MoF cancelled issuance for the balance of the 2008-09 fiscal year. It is said that these bonds had come to be heavily held by hedge funds speculating on a convergence between the market price and the higher theoretical price (Bank of Japan (2008, pp 58-9; 2009, p 45)). The widening of the gap between the market and theoretical price is thought to reflect the recent shrinkage and deleveraging of hedge fund positions.