Say sayonara to the yen and Japanese Government Bonds

Investors’ diversified portfolios of worries include: the potential demise of the Euro; EU’s sovereign debt problems; China’s slowing growth; and a U.S. fiscal cliff. Though silent as to its debt problems, Japan has potential to become an investment nightmare.

Japan has more government debt as a percent of GDP than any developed country and Japan has more total debt as a percent of GDP than any developed country. (“Total Debt” is defined as the sum of: households, non-financial corporations, financial corporations and Japanese government debt or “JGB.”)

So, if Japan is really in bad straits far beyond the problem of more “lost” economic years, why isn’t it the topic of conversation?

There are two reasons. First, as part of its culture, its problems are not discussed in a public forum; they are kept internally (e.g., post tsunami, critical help from international, nuclear power experts was initially declined.) But “going public” on the problem are several U.S. funds (later mentioned) that could make a windfall if JGB prices crash and/or the yen falls.

Second, Japan might have reached the tipping point in funding its debt eat expansion. Japanese pension and insurance funds, which have historically been the biggest buyers of JGBs, now face demographicd wot reality that Japan’s retiring work force will cause net liquidations of JGB investment positions as opposed to prior years’ net funding/ additions to JGB investment holdings.

Japan’s problems are long in the making.

In the 1980s, Japan was heralded as the industrial whiz kid taking over the world. During the decade ending 1990, GDP growth averaged 3.95 percent and Japanese real estate boomed and equities bubbled. With that euphoric expansion, corporate, financial and household debt surged from 197 percent of GDP to 328 percent. (McKinsey & Company, January 2012, Debt and deleveraging: Uneven progress on the path to growth”.)

Though real estate and equities burst in 1990, GDP growth collapsed from prior lofty levels; for the decades ended 2000 and 2010, GDP grew, respectively, 1.2 percent and 0.75 percent. Stock market rebounds had no “stick” and the banks remained riddled with private sector bad loans. Despite these problems and non-growth begging for structural changes, political inability or cultural denials allowed few changes.

In lieu of a bona fide solution, government responded with stimulus financed by JGB issuance; alas, nothing stimulated. (Sound familiar?) Japan’s government debt as a percent of GDP grew from 59 percent in 1990 to 226 percent by second quarter 2011; Total Debt to GDP grew from 387 percent to 512 percent. (McKinsey & Company)

So how can Japan’s ratio of government debt to GDP (a barometer of solvency) be several times greater than many EU debt challenged countries and JGBs still be issued? How can the yield on 10-year JGBs be 2 percent or lower since 1997?

Unlike U.S. Treasuries, which are approximately 40 percent foreign funded, JGBs are 90 percent financed internally with the two largest owners and “net” buyers being: Japanese banks ($5 trillion) and Japanese insurance/pension funds ($4.5 trillion). Japan now faces a demographic tipping point as, “… baby boomers born in the wake of World War II are beginning to reach 65 and eligible for pensions. That’s putting… the Japanese Government Pension Investment Fund under pressure to sell JGBs so it can cover the increase in payouts.” (zerohedge.com, July 25, 2012)

Though amongst others playing the demise of Japan, two professional money managers have fashioned strategies that could make a bundle if JGB prices precipitously fall (yields rise) and/or the yen falls from its safe haven valuation. Kyle Bass, a famed hedge fund manager, and Tres Knippa, a wellknown commodity trading adviser and CNBC guest, believe that Japan is the “next big short,” but timing of demise is subject to vagaries of central bank manipulations. Bass requires a very large minimum and has so far experienced high costs to carry the position (kylebassblog.blogspot.com). Knippa allows much smaller minimums and uses an option strategy which attempts to self-fund a large volume of puts skewed toward a full-fledged Japanese crisis. www.shortjapandebt.com/wwfs1/

There is no reason to think 23 years of Japan’s fruitless government spending will suddenly be reversed or retirees will forego their pensions. Even if the Japanese central bank prints yen and replaces loss of pension funding of the JGB, the magnitude of yen printing would mean depreciation in the value of the Yen and a rise in yields.

The manager websites and the McKinsey report are excellent reads. Seek counsel of multiple advisers, especially those in areas of specialization, as to the suitability of the aforementioned. ¦

— There is a substantial risk of loss in trading futures and options on futures contracts. Past performance is not indicative of future results. This article is provided for informational purposes only. No statement in this article should be construed as a recommendation to buy/ sell a futures/ options contract or to provide investment advice.

— Jeannette Showalter, CFA is a commodities broker with Worldwide Futures Systems, 571- 8896. For mid- week commentaries, write to showalter@wwfsystems.com.