The FT carries an article today by Takatoshi Ito, who chaired a panel of experts, on sovereign debt holdings of Japanese pension fonds:
How much of its assets should a public pension fund invest in bonds? Consider the question assuming that bond yields in developed economies remain low for a few more years, but are expected to rise, the economy is expected to go back to a growth path and the inflation rate is expected to rise from a deflationary level to a normal 2 per cent in a year or two.
Ito goes on to call this Finance 101. Here is his answer:
There is a widespread belief in Japan, shared by some in the GPIF, that government bonds are “safe” and stocks are risky, and that bonds are for pension funds and stocks for speculators.
Fifteen years of deflation and the 25-year decline of the Nikkei 225 index have reinforced this belief. There is insufficient consideration of the interest rate risk of long-dated bonds and the benefits of diversifying into a variety of asset classes.
The panel members unanimously agreed that the GPIF bond portfolio is exposed to too much risk from an expected rise in interest rates, a natural consequence of Prime Minister Shinzo Abe’s economic programme and Bank of Japan governor Haruhiko Kuroda’s 2 per cent inflation targeting.
I disagree with his view. First of all, the widespread belief that Japanese government bonds are safe is based on the fact that they are, well, safe! The way the monetary system works in Japan, the government can always approach the central bank and get fresh reserves in return for government bonds (either directly or indirectly). So the probability of default is zero, unlike in the euro area where the central bank does not directly finance the governments.
Now about the fact that when bond prices are very high, so that effective yields are basically zero, the yields can only go up, which means prices can only go down. We heard this for many years now. However, if you hold bonds that pay you zero interest and you hold them to maturity – which is something which a pension fund will probably do – then you will not have lost any money, although the valuation of the bond will have decreased after the interest rates rose (even though I cannot see any reason to do that in Japan, which is far, far away from an inflationary spiral). You just did not make more money than you could have made if – and that is a big if – the interest rates have started to rise. So, if pension funds won’t buy as many sovereign bonds as in the past, will interest rates in Japan go up? Not if the central bank controls the interest rate and buys up any excess sovereign bonds to keep it that way.