From "ballast stone" to "source of volatility": Why are global investors nervous about Japanese government bonds?

Once, Japan's government bond yields had long been at low levels, serving as the "anchor" of the global bond market, suppressing the financing costs of governments worldwide. However, this situation has now reversed. In mid-January of this year, the yield on Japan's 40-year government bonds soared to over 4%, reaching a new high for various sovereign bond maturities in over thirty years. The reasons behind this are twofold: firstly, the Bank of Japan, which holds over half of Japan's sovereign bonds, has begun reducing its bond purchase size; secondly, Japanese Prime Minister Kanayama Sanae has proposed a tax cut plan, which may require the government to issue more bonds to raise funds. As a result, the Japanese bond market has experienced rare volatility for several months, with government bond auctions being undersubscribed multiple times. Investors are wary that the volatility in the Japanese bond market may spread to the global market -- currently, the ability of governments worldwide to effectively restrain persistent budget deficits has raised widespread concerns, causing global bond yields to steadily rise. Where is the traditional appeal of government bonds? Government bonds have always been seen as one of the safest investment assets because the issuer - the government - has a relatively low probability of default. Governments can autonomously determine policies and usually raise funds through various channels. For long-term government bonds, investors need to lock in interest rates for periods of twenty to forty years, so these bonds often provide investors with relatively substantial returns at low risk. In particular, Japan's government bond market, with a size of $7.5 trillion, has been considered one of the most stable bond markets globally for decades. However, recent factors have led to weak demand for government bonds, resulting in price declines and subsequent increases in yields. Why is demand weak? For years, the Bank of Japan has been the largest buyer of Japanese government bonds. Since the 1990s, Japan has been in a deflationary cycle known as the "Lost Twenty Years," and bond purchases have supported the government's expansion of bond issuance and increased fiscal spending, serving as an important tool for stimulating the economy. However, as Japan gradually emerges from deflation, the focus of the Bank of Japan's policies is no longer to stimulate the economy through bond purchases, leading to a reduction in its massive holdings of government bonds -- the Bank of Japan's holdings of government bonds hit a historical peak in November 2023. After the bank gradually withdraws from the market, other buyers in the market lack the capacity to absorb the supply of government bonds, ultimately leading to weakened demand. What other factors are exacerbating investor concerns? On November 21 last year, the Japanese government approved an economic stimulus plan worth 21.3 trillion yen ($137 billion), the largest stimulus package launched by the country since the onset of the COVID-19 pandemic. Additionally, Kanayama Sanae announced early elections on February 8 and pledged that if her ruling coalition wins, it will suspend the 8% food consumption tax for two years. These measures have made some investors uneasy because such policies typically require the government to increase its debt issuance, leading to an increase in the issuance of government bonds. Generally, an increase in government bond supply can cause prices to fall, and investors naturally do not want to hold assets that may depreciate in value. The Japanese Ministry of Finance estimates that this tax cut policy may require an investment of around 5 trillion yen annually, but Kanayama Sanae has not clarified the source of the funds. If her administration performs well in the elections, it is highly likely that further stimulus policies will be implemented. Meanwhile, Japan's main opposition party, the "Center Reform Union," has also pledged to permanently abolish the food consumption tax, intensifying concerns in the market about the lax fiscal discipline in Japan's political circles. However, the rise in Japan's government bond yields may ultimately provide support for bond prices. The current yen government bond yields are at multi-year highs, and overseas investors can lock in additional returns by hedging against exchange rate risks and converting these returns into their own currency, thus increasing their allocation to Japanese bonds. Data from the Japan Securities Dealers Association shows that overseas investors currently hold about 65% of Japan's government bond monthly cash trading volume, while this ratio was only 12% in 2009. However, it is important to note that domestic financial institutions remain the largest holders of Japanese government bonds, and the volatility in the bond market is dampening their willingness to increase their holdings. What are the consequences if the weak demand for government bonds continues in 2026? If demand for government bonds remains weak for an extended period, coupled with rising yields, the overall financing costs in Japan will increase, affecting the government, businesses, and households. In fact, concerns about Japan's high corporate debt levels have long been a cause for worry in the market. This situation puts the Bank of Japan in a dilemma: on the one hand, the market is calling for the central bank to maintain low borrowing costs to stabilize the economy; on the other hand, to control inflation, the bank needs to raise interest rates and tighten monetary policy. For Japanese life insurance companies, the rise in government bond yields means that their portfolios of domestic bonds will face significant unrealized losses. The four major life insurance companies in Japan revealed that in the most recent fiscal year, the total of unrealized losses on their domestic bond holdings amounted to about $60 billion, triple the amount from the previous fiscal year. Are the Japanese government and central bank concerned? Various indicators suggest that both the Bank of Japan and the government are concerned about the increased volatility in the bond market. On January 20th, the Japanese bond market experienced a significant sell-off that spread to other markets. Afterwards, Japanese Finance Minister Katsuki Mototsuki called on market participants to "stay calm." U.S. Treasury Secretary Janet Yellen also stated that during this period of sell-offs, she had spoken with relevant Japanese officials and noted that this volatility had also affected the U.S. bond market. In fact, even before this recent bond market selloff, the Bank of Japan had been cautious. On December 9 last year, Bank of Japan Governor Kazuo Ueda pointed out that long-term government bond yields were rising "at an accelerated pace." To prevent the bond market from becoming volatile, the Bank of Japan plans to slow down its exit from the bond market: starting in April this year, it will reduce the monthly purchase size of government bonds from the current 400 billion yen to a quarterly reduction of 200 billion yen. Ueda also emphasized that if necessary, the bank is prepared to increase bond purchases in special circumstances to stabilize the market. The Japanese government is also working to avoid further increases in yields. To fund the economic stimulus plan, the government chose to focus on issuing short-term bonds -- increasing the issuance of 2-year and 5-year government bonds by 300 billion yen each, rather than issuing more long-term bonds. Nevertheless, Japanese Prime Minister Kanayama Sanae still stated that the primary focus of her administration is to promote economic growth, rather than excessively worrying about yield fluctuations. She also mentioned that it is difficult to analyze the impact of fiscal policy on yields separately. How are bond markets in other regions around the world faring? Since U.S. President Donald Trump announced his "Liberate Day" tariff policy in April last year, long-term bonds in several major markets globally have suffered significant setbacks. The tariff policy has exacerbated inflation risks, leading to higher bond yields. Additionally, Trump's recent proposal to purchase Greenland has also exerted downward pressure on U.S. bond prices. Making matters worse, traders increasingly bet that central banks in some countries will slow down or even halt monetary easing policies this year, further weakening global demand for bonds, and continuing to increase upward pressure on yields.