Shorting Japanese Government Bonds: Trade Of The Decade

I dedicated a major section of the 2012 Outlook to the coming Japanese debt crisis.  I want to push further on this topic today because when bond yields are low, as they are today in Japan, investors pay absolutely no attention to that nation's balance sheet.

The following chart shows the 10 Year government bond for Greece from January 1998 (8%) to October 2009 at under 5%.  During Halloween in Greece in 2009, there was not one report, discussion, or mention of trouble in their bond market.
The following chart shows the 10 Year government bond for Portugal during this same period, January 1998 (at less than 5.5%) to October 2009 where it fell under 4%.  As with Greece, there was not a single headline from the media at this point that trouble was even possible for interest rates in Portugal.

Before we move forward, it is important to understand that at these points (October 2009) both these countries were insolvent and their debt should have been rated as junk. A junior finance analyst at a local community college could have spent 15 minutes reviewing their balance sheet in terms of income, expenses, and future debt projections and come up with the fact that their bonds had no right being close to the "risk free" ratings they held.

There were a few select hedge fund managers that took the 15 minutes to do this math and loaded up on insurance protection against both Greece and Portugal bonds entering default, which at the time cost them close to nothing to carry the insurance payments and had close to infinite upside should the bonds enter trouble. (The most prominent name is Kyle Bass who did the same thing during the subprime crisis back in 2007 - 2008.)

Let's fast forward to today. The following chart shows Greek 10 Year bonds from January 1998 to January 2012.  As you can see, the chart, in just a few short months, has gone parabolic.  Any demand for Greek bonds has disappeared and any investors holding the debt have dumped in mass.  The country financially has suffered a heart attack and now lives only on life support from the IMF and bailouts from the rest of Europe.
The next chart shows the Portugal 10 Year bond from January 1998 to January 2012, completing their chart to present day. Their bonds, just like Greece, have begun to move parabolically higher.  They have also accepted their first bailout and are moving toward the point where any access into the debt markets will be unavailable (see Portugal: Rising Tide Of The 10 Year Bond).
The last chart shows the Japanese 10 Year government bond from January 1998 to today, January 2012.  The rates have moved from 2% to under 1%.  The market has priced this debt as "risk free".
No media outlet discusses a coming problem with Japanese rates.  Why would they?  The market knows when a country has the ability to pay their debt services and how to price their bonds accordingly.  Right?

I will attempt to dig into the current Japanese finances further using a highly specialized form of financial modeling called algorithm CS. Also known as common sense.

Japan Post Holdings, the largest financial institution in the world holds over $1 trillion in Japanese government bonds, which makes up 75% of their total holdings.  The retirement fund is now liquidating (selling) $80 billion per year in government bonds to pay out benefits, and they want to further diversify (sell more bonds) their holdings.

Japanese banks hold a staggering 25% of their assets in government bonds.  Bonds lose value when interest rates rise, so if the interest rates (currently below 1%) rise just a small amount to say 2%, it will destroy the balance sheet of every major bank in Japan.

The savings rate in Japan has been enormously high for the past 20 years (Japanese people were buying government bonds to save for retirement).  It has now fallen to 2%, and will soon go negative (Japanese people will be selling government bonds every month to pay for living expenses during retirement).

There are ETF's available to short long term Japanese government bonds.  As a word of caution, there are those who tried to short subprime bonds and sovereign debt bonds early and although they were right, they had to wait and take losses in the short term to realize the gains on their investment.

You must have both patience and perseverance to be first in a winning trade.

For more on this coming disaster see: 2012 Outlook: Japan's Debt Crisis



    1. I certainly would never recommend a 3x leveraged ETF for anything, especially Japanese bonds, a trade that may take considerable time to wait out.

      The idea that Japan has been in a deflation for 20 years makes the argument more valid. If you study history, highly inflationary or hyper-inflationary periods usually begin in response to a deflation.

  2. Hi, Can you recommend any broker to do this trade. I have physical PM's and an sold on the Japanese problem. Not sure how to go about actually doing it. Any advice on how to do this would be greatly appreciated.

  3. I do not like to give out specific trades, but I would look for a single leveraged (see above comment) ETF that shorts the long term bonds. I use TradeKing for my trading account (low cost). Click the banner on this page to get started.

    1. Thanks a lot for taking the time to reply. I appreciate it and think your site, and insight is great. Kyle Bass said in normal circumstances Japanese debt could start to explode in 2013 but that other global events may bring that date forward. I know that the timing of these things is hard to predict and some leeway should be applied to this. Do you have any opinion on the time of this short?

    2. I would guess it would be within the next 24 months. Kyle Bass put the subprime trade on in 2006, and he put the Greece trade on in 2008. Both blew up 2 years later. He has the Japanese trade on now.

  4. Im not looking for any specific trade advice, but can you name 2 ETF's that actually short long term bonds?

  5. (JGBS) - Please talk with a financial advisor and take time to read and understand how a specific ETF works before making an investment.


Post a Comment