Japan: The teacher who invested $15 billion

Last year the international capital markets were heavily influenced by the arrival of a new investor: Mrs Watanabe, the mythical Japanese housewife. Japanese retail investors like Mrs Watanabe bought about $20 billion of Eurobonds in the second half of 1995. The pace has slowed but Japanese individuals still put about $16 billion into foreign securities in the first six months of 1996.

And now for this year's big new investor: Mr Watanabe. But Mr Watanabe is no myth. Hiroshi Watanabe is deputy manager of the investment department of the Public Teachers' Pension Fund. Watanabe has invested, according to market estimates, $15 billion in Euro medium-term notes (EMTNs) in the 12 months since mid-1995 when the institution ­ Japan's third-largest public pension fund, with assets of ¥61.9 trillion ($590 billion) ­ decided to bring the management of a portion of its funds in-house. Watanabe invests mainly in highly structured securities such as reverse dual-currency bonds (where the principal is in yen, but the coupon is paid in a foreign currency).

Buying is on an enormous scale. Watanabe has been known to invest as much as $1 billion in a single week. The whole EMTN market (excluding public, syndicated deals) was worth $134 billion in 1995 and $97 billion in January to August 1996, according to MTNWare, a new database produced by Euromoney affiliate Capital Net. In other words, Watanabe buys about 10% of all EMTNS. Some bankers in Japan have taken to calling him "Mr 10%" ­ after the infamous Yasuo Hamanaka of Sumitomo Corporation, the "Mr 5%" of the copper market.

Because of these large volumes, and because the credits he is allowed to buy are severely restricted (mainly double A or triple A sovereigns and supranationals), Watanabe has often been forced to take securities at almost any price. After swapping the proceeds into floating-rate dollars, issuers can usually obtain funds at Libor minus 40 basis points or lower. In the most extreme case, bankers say, the International Finance Corporation earlier this year achieved Libor minus 60bp on a private placement it sold to the Public Teachers' Pension Fund.

And Watanabe is not the only Japanese investor buying EMTNs in large sums. London-based MTN specialists reckon that 70% or 80% of private placements issued off MTN programmes are sold into Japan ­ in other words, between $90 billion and $100 billion during the whole of 1996. The Japanese institutions which buy EMTNs are not the familiar names, such as the life insurance companies, which have been buying foreign securities for years. Rather they are a mixed group that includes small local banks, such as shinkin banks, credit associations, and agricultural co-operatives; the central banks of these institutions, such as Zenshinren and Zenkyoren; investment trusts (similar to closed-end mutual funds); industrial companies; government bodies such as the Trust Fund Bureau of the ministry of finance; and private and public pension funds.

A combination of factors has caused this surge in MTN buying. Small banks find that their customers don't want to borrow any more, so they are forced to buy more securities. As the pension fund system is deregulated, more funds are being run by aggressive, less hidebound fund managers. But, most important, institutions lack attractive investment opportunities: yen interest rates are low (10-year Japanese government bonds yield little over 3%, for example), and the stock market has yet to show that it can sustain its recent mini-recovery. Investors, therefore, are desperate for yield. Pension funds, in particular, are required by law to obtain a current yield on their investments of 5.5% a year. The only way they can achieve that sort of return is by taking foreign exchange or interest rate risk ­ in other words, by buying structured instruments. In effect, they are risking their capital to boost artificially their return in year one.

If this sounds foolish, that is exactly what it is. Consider how Watanabe of the Public Teachers' Pension Fund has shifted his strategy over the past 12 months. (Watanabe declined to meet Euromoney for this article saying, in a 15-minute telephone interview: "I tell my trustees what I am doing, but I'm not able to reveal my strategy to the public". However, by talking extensively to the investment bankers who sell MTNs to Watanabe, Euromoney has pieced together with a high degree of accuracy the details of how he invests.)

Bonds at a price

In the summer of 1995, the Public Teachers' Pension Fund made the decision to bring a portion of its assets in-house. Watanabe, assisted by three junior fund managers, began to buy 10-year reverse dual-currency bonds. The coupon was 5.5%, paid in US dollars. In effect, Watanabe was playing the forward foreign exchange curve ­ taking a bet that the differential between Japanese and US interest rates would not be wiped out over the life of the bond by a depreciation of the dollar against the yen. If he was wrong, the yen value of his 5.5% coupon in dollars would be worth less and less each year until the bond was repaid. In other words, he was taking the risk of sacrificing future annual returns to beat the important 5.5% target in year one. His capital, though, is not at risk: the bonds are paid in full at maturity in yen. In that sense, his investments are less risky than buying dual-currency bonds, where the (high) coupon is paid in yen, but redemption is in a foreign currency.

As the yen fell against the dollar during the second half of 1995, Watanabe's plan looked highly successful. He could have sold his bonds in the secondary market for a profit (although bankers say he has chosen to hold onto them). The snag, though, was that both yen and dollar interest rates continued to fall. It became harder and harder to hit the 5.5% target on new purchases ­ particularly as Watanabe's internal rules severely limit the range of credits he can buy. He extended the maturity of the bonds he was buying to 15 years, and then to 20. Rates continued to fall. He switched the coupon to Australian dollars. By the middle of 1996, to achieve a 5.5% coupon, he was having to buy bonds with a maturity of 33 years, with the coupon payable in US dollars, Australian dollars or Deutschmarks at the choice of the issuer.

Watanabe's next puzzling move, around the start of this year, was to begin buying reverse duals with a 10-year put. The put, however, is nothing like a conventional bond put option, which typically specifies a fixed price (usually as a percentage of par) at which the bonds can be put back to the issuer. The puts Watanabe bought allow him merely to sell back the bonds at a "market rate", minus a fee, 10 years after issue and then on one date each year until maturity. The market rate is determined by a complicated formula that refers to swap rates and the price of equivalent credits in the secondary market. "The structure itself doesn't have a very clear meaning," says the syndicate head at one of the big four Japanese securities houses in Tokyo. Indeed, Watanabe is the only investor who buys bonds with this sort of put.

This syndicate head's explication is simple: "After Mr Watanabe starting buying 30-year bonds, his bosses got a bit nervous. They wanted a warranty that there was some way of getting out of the bonds." In other words, the put is little more than a guarantee that Watanabe can sell the bonds back to the lead manager (which has structured the deal with derivatives, so that the issuer itself doesn't have to buy back the bonds).

But the effect of the puts is to make the bonds even more expensive for Watanabe. This is clear from the way the puts work for the borrower: the bonds become 10-year money at, say, 40bp below Libor and, subsequently, a flow of one-year money at 60bp below Libor, according to syndicate managers who have arranged these deals. Add to these cheap funds for the borrower, fat fees for the arranger of the structure and the swap provider, and it becomes clear that Watanabe is not getting a good deal.

Indeed, buyers argue that much of what Watanabe buys is mispriced. "When he buys his reverse duals [with the coupon in a currency other than yen]," says one London-based investment banker, "he is selling a call on the currency at far too cheap a price. He simply doesn't understand the mathematics." As an example of how richly priced the derivatives embedded in these deals are, this banker cites an issue which he had subsidized, at a loss, to win the mandate from the borrower. To help his bank break even, he asked AIG (which handles much of the long-dated swaps business necessary for these structured products) to reduce its charge for the swap by $1 million. "It was unbelievable," the banker recalls. "AIG came back within 10 minutes and said 'yes' without any hesitation. That's a sign of how much money they're making on these deals." Rumours in Tokyo suggest that Merrill Lynch which, through subsidiary Merrill Lynch Derivative Products, also handles a lot of long-dated swaps business, made $100 million from Japan-targeted MTNs last year, much of that from business with Watanabe. (Merrill in Tokyo was unable to provide an executive to respond.)

Other fund managers have become upset with the way Watanabe buys at very high prices. "Mr Watanabe has become quite famous," says Morimasa Nakata, a fund manager in the international investment division of Zenkyoren, the insurance arm of the agricultural cooperative movement. "But what he's done has not exactly been welcomed by other investors. He's had quite an impact on the level at which we can invest. Borrowers expect to get their funds much more cheaply now."

Buying frenzy on MTNs

The way Watanabe picks which deals to invest in is also treated with derision by bankers. He has evolved an auction process whereby once or twice a week he asks for quotes. Usually, about 15 banks put in bids. In total, maybe 30 or so banks have dealt with him. At each auction, Watanabe will typically buy five separate issues of ¥10 billion each. But the criteria for his choice are unclear. What sort of credit does he want? What is his target level? Bankers fret whether to show him a double A corporate at Libor minus 15bp or a strong triple A sovereign at Libor minus 40bp: his preferences seem to vary from week to week. Some houses suspect that Watanabe buys from banks on a rota basis, but they are not sure. The auction is a conundrum for borrowers, too. Only a dozen or so names are able and willing to sell to Watanabe. Should they bid the same price to each of the five or so MTN houses that approach them?

The splurge of the Public Teachers' Pension Fund seems now to be over. Bankers report that Watanabe has bought little over this summer. Some argue that he believes the yen to be undervalued, but would start to buy again if it rose above ¥105 to the dollar.

But bankers believe that other pension funds could soon start to buy MTNs in big volumes too. "Other funds are actively thinking of moving the same way as the Teachers," says Tsutomu Sato, manager of fixed-income sales at Goldman Sachs in Tokyo. So far, a few, including the Policemen's Pension Fund, have made experimental investments. Says an official at the securities operation of one of the Japanese banks: "Public pension funds' preferred investments would be 10-year JGBs at, say, 5% yields. However, given that such rates are some 200bp below these targets, they are forced to consider other credits, structured notes, longer maturities and, reluctantly, currency risk."

But pension funds are not the only big MTN buyers. One syndicate head estimates that about 50% of MTNs go to shinkin banks, agricultural cooperatives and other small financial institutions, 20% to corporates, 20% to pension funds and 10% to investment trusts.

At Zenshinren, the central bank of the shinkin banks, Ikuo Sawada, deputy general manager of the securities investment department, says total holdings of Euroyen bonds by his institution are just below ¥1 trillion. Of that, 70% or 80% are EMTNs, and that percentage "has increased quite a lot in the past few months". Sawada likes MTNs because "they are very flexible. We can find exactly the sort of cashflow that meets our needs."

Zenshinren, however, buys only fairly plain-vanilla paper, he says: "We don't buy structures that distort the cashflow or take foreign exchange risk because this makes it difficult to handle the liability management." But Sawada has recently experimented with buying callable notes and swaption callable notes. Swaption callables work as follows: on an eight-year deal, the first three years will be at an attractive floating rate, perhaps Libor plus 40bp. There is a call after three years, with the remaining five years at a fixed rate if the bonds aren't called. In effect, the option premium for the call is used to provide the pick-up in yield.

Some of the 140 individual shinkin banks are considerably less conservative. "I get the feeling that quite a lot are buying MTNs in substantial amounts now," says Sawada. Shinkins buy some of the riskier paper available: anything from dual-currency bonds to samurai bonds issued by sub-investment-grade issuers. Few buy reverse duals ­ they view these as too low-yielding and uninteresting. Indeed, Zenshinren thinks the structured-note market has so much potential that it will set up its own securities subsidiary in September to originate and sell MTNs to the shinkins.

Zenkyoren, the insurance arm of the agricultural cooperatives, which has ¥27 trillion in assets, began buying yen MTNs as an alternative to yen loans. "We've being making yen loans to foreign sovereigns for some time," says Naruto Takahashi, assistant manager in the international finance division. "But the trend is for these borrowers to use their MTN programmes. To cover that, we have moved to buying Euroyen bonds and Euro-MTNs. The proportion has grown quite a lot." Zenkyoren owns about ¥800 billion in foreign securities, mainly yen instruments. To increase the return, Takahashi has recently been buying reverse dual-currency bonds and callable bonds. "We have increased our assets in these securities quite a lot, and we're thinking to increase it further," he says.

Another important buyer of MTNs is the investment trust industry. "Investment trusts started buying in a big way in April this year," reports Mikio Sugihara, head of the global capital markets group at Nomura Securities in Tokyo. "They typically buy reverse dual-currency bonds." At Nikko Securities Investment Trust, Hiroshi Uchiyama, general manager of the fixed-income department, says: "We are a big investor in MTNs. We have increased our investment a lot in the past year or two." For him, the key advantage of an MTN is that he can buy a newly issued security with a current coupon. "We like the flexibility of the instrument so that we can buy what we want, when we want." Uchiyama, though, buys few MTNs with complicated structures, although he adds: "if we find something with a structure that suits us, then we will buy it".

Another advantage of MTNs for investment trusts is that they can produce cosmetic effects on investment returns. Nobue Sato, general manager of fixed-income sales at Sanwa Securities, points out how investment trusts, needing to produce results every three months, "use MTNs to help their quarterly results". They can, for example, buy a step-down floater with a high, early first coupon ­ in effect, taking a large chunk of the cashflow from the security at the beginning.

The beauty of the structured MTN product is that it can be used in a variety of ways like this to distort ­ sorry, customize ­ cashflow. It is noticeable, for example, that there is always a flurry of MTN issues around the end of the Japanese financial year in March and half-year in September as banks, corporates and institutional investors seek either to enhance or dampen their results. "We use MTNs to smooth out the yearly cashflows," admits Daisetsu Muso, a fund manager for pension fund money at IBJNW Asset Management. Some corporates have even started to buy three-year structured MTNs as an alternative to hedging foreign exchange exposure, and to avoid relying too heavily on the credit risk of their Japanese relationship banks. But most of the MTN buying is concentrated on boosting year-one returns at the risk of seeing returns fall in later years. Reverse duals do this. So do the capped floaters that smaller banks buy.

The signs are that purchases of MTNs by Japanese investors could get even bigger. A number of other investors ­ besides the pension funds mentioned earlier ­ are poised to start buying. Recently, insurance companies (with total assets of ¥213 trillion) have started to increase their holdings of foreign bonds again, after six years of decline. For example, the proportion of Nippon Life's portfolio invested in foreign securities rose to 7.1% last year, up from 6.2% a year earlier. Currently, most life companies are highly conservative, buying only US treasuries and Bunds. But Fukoku Life, for instance, is reported to have bought reverse duals in March to take its foreign exchange profits early, and is looking at other structured trades.

Huge changes in the corporate pension market will also boost MTN buying. Until recently, only trust banks and life insurance companies could manage pension money. Deregulation has allowed companies to move funds to independent investment managers, including foreigners. Moreover, from March, life companies reduced the fixed return they guarantee on pension money from 4.5% to 2.5%. This prodded many companies to withdraw their funds from life companies and move them to independent investment managers. The total of pension money with the independents had already risen 41% in the year to March 1996, to reach ¥6.8 trillion. The independents are more innovative and aggressive investors than the life companies. So bankers expect a shift of this money into MTNs, foreign securities and equities.

The biggest hope for investment bankers comes from the government sector. This includes the national public insurance funds ­ managed by the Trust Fund Bureau of the ministry of the finance (with ¥369 trillion in assets) and Nenpuku (¥119 trillion) ­ and the postal system, Yucho (¥213 trillion) and Kampo (¥90 trillion). (Some of these asset figures are duplicated because, for example, Yucho deposits 85% of its money with the Trust Fund Bureau.) Until recently, these institutions were highly regulated and bought little other than Japanese domestic bonds. But recently, they have begun to open up. The Trust Fund Bureau has tentatively started buying Euroyen bonds from top-rated sovereigns and supranationals. Yucho and Kampo have done the same: Kampo, for example, has ¥409 billion in foreign securities.

The most stunning sign that things are changing is that, in January this year, Nenpuku shifted the management of no less than ¥5 trillion from life companies to independent managers. It now invests the money via a series of limited partnership vehicles based in Delaware and the Cayman Islands. Why the limited partnerships? "Because Nenpuku is part of the government, it was difficult for us to buy company shares [directly]," says Yasunori Usui, deputy general manager of the fund management activities department. Under the new arrangement, Nenpuku will be able to look at a wider range of investments ­ including MTNs.

The next stage for the MTN market in Japan, says John Muros, associate director at Daiwa Securities in London, is simple: "To get more investors to do it. And that will push the current investors to become more sophisticated." More sophisticated, perhaps, than Mr Watanabe. *