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Trading and Capital-Markets Activities Manual

Japanese Government Bonds and Notes
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

Japanese government bonds (JGBs) are issued by the Japanese national government. The Ministry of Finance (MOF) authorizes the issuance of coupon and non-coupon-bearing JGBs in a variety of maturities: long-term (10 and 20 years) and medium-term (two through five years). The MOF also issues short-term Treasury bills, which are issued at a discount with a maturity of 180 days. JGBs are guaranteed by the Japanese national government and, therefore, are considered to have very little credit risk. 

CHARACTERISTICS AND FEATURES 

The two types of long-term bonds are ''long-term'' and ''super long-term.'' The long-term bond, the most common, has a maturity of 10 years, and the super long-term bond has a 20-year maturity. Both long-term and super long-term bonds are numbered serially. They are referred to by number and issue month (for example, #182 August) rather than by maturity and coupon. 

JGB issues are categorized as construction bonds, deficit financing bonds, or refunding bonds, although there is no difference among these bonds from an investment perspective. JGBs are typically issued in registered form but they may be converted to bearer form within two market days of issue. Exchange transactions of registered bonds must be issued in blocks of 1,000. There are no such restrictions for bearer bonds. JGBs have bullet maturities and are callable at any time, although call provisions are rarely exercised. Ten-year JGBs maEagle Tradersg after mid-1997 pay interest on the standard March/September or June/December semia-nnual coupon cycle. Twenty-year JGBs, however, pay interest only in March and September. Since new issues can appear monthly, the practice of using quarterly coupon dates leads to odd first coupons for both 10- and 20-year JGBs. 

The two types of medium-term bonds are coupon bonds and five-year discount, or zero-coupon, bonds. Medium-term coupon bonds are issued with maturities of two, three, and four years. Issue sizes of both types of bonds vary considerably from month to month. However, the most common issue sizes are yen () 50,000, 100,000, 1 million, 10 million, and 100 million. Medium-term coupon bonds make interest payments semiannually, and redemption is on the 20th day of the month in which the bond matures. 

Previously, trades in JGBs were settled on the 5th, 10th, 15th, 20th, 25th and 30th of each month, based on trade date. This convention has been replaced by a T+7 (trade date plus seven Japanese business days) settlement method as of September 19, 1996. 

USES 

Domestic and foreign investors use JGBs for investment, hedging, and speculative purposes. U.S. investors, including commercial banks, may purchase JGBs to speculate on interest rates or foreign-exchange rates, to diversify portfolios, to profit from spreads between U.S. and Japanese interest rates, and to hedge various positions. 

DESCRIPTION OF MARKETPLACE 

Issuing Practices 

The Bank of Japan (BOJ) is responsible for issuing JGBs in an aggregate amount not to exceed the limit set by the MOF. JGBs are issued monthly by the BOJ by competitive auction and syndicate. A syndicate comprising banks, life insurance companies, and securities firms underwrite 40 percent of each 10-year issue. The remaining 60 percent are issued via competitive auction. The coupon size and issue size are announced on the day of the auction after consultation with the syndicate. The average auction price determines the price of the syndicated portion. No firm may bid for more than 30 percent of the tranche issued via competitive auction. All 20-year bonds are issued via fully competitive auction. Medium-term coupon bonds are issued primarily through public subscriptions, but a certain portion are issued through fixed-rate private placements. 

Secondary Market 

Most JGBs are listed on the Japanese stock exchanges, although the majority of JGB trading occurs in the over-the-counter (OTC) market. While the OTC market is characterized by very large trading volume, stock-exchange trading is important in that it enhances transparency in pricing-the Tokyo Stock Exchange closing prices serve as a public pricing source for JGBs. Long-term government bonds account for the largest share of secondary-market trading of government securities, partly because they have higher credit ratings and greater marketability than shorter maturity JGBs. In the secondary market, the broker and investor negotiate the ''invoice price,'' which includes commissions for the agent. 

The secondary market for JGBs has some unusual features. The first relates to the benchmark or bellwether bond issue. In the U.S. Treasury market, the on-the-run issue (that is, the most recently auctioned issue for a given maturity) is the benchmark issue for each maturity. However, the Japanese benchmark issue is determined through an informal process that occurs over a few weeks. Benchmark issue characteristics are as follows: (1) a coupon that is near the prevailing rate, (2) a large outstanding amount (approximately 1.5 trillion or more), (3) a wide distribution or placement after its issue, and (4) remaining maturity that is very close to 10 years. 

Another unusual feature of the JGB market is the so-called reverse coupon effect. In most bond markets, high-coupon bonds trade at a higher yield than low-coupon bonds of the same duration. This ''coupon effect,'' which varies with the duration of the bond as well as over time, is often attributed to such institutional factors as different taxation of capital gains and ordinary income. In Japan, however, there is a strong preference for high-coupon bonds. As a result, high-coupon bonds trade at lower yields than low-coupon bonds for the same duration (the ''reverse coupon effect''). This effect occurs in spite of the Japanese tax code that requires income tax to be paid on coupon income but generally not on capital gains on Japanese government bonds. Banks prefer coupon interest because banks' current income ratios are closely monitored by Japanese bank regulators. 

Market Participants 

Sell Side 

JGBs are issued through a syndicate consisting of domestic (Japanese) banks, life insurance companies, other domestic financial institutions, and some foreign securities firms. 

Buy Side 

A wide range of domestic and foreign investors use JGBs for investing, hedging, and speculation. Japanese financial institutions, particularly city, long-term credit, regional banks and insurance companies, tend to be the largest investors in yen-denominated bonds, although corporate and individual investors are very active investors in the medium-term government bond market. Foreign investors, such as U.S. commercial banks, securities firms, insurance companies, and money managers, are also active in the Japanese government bond market. 

MARKET TRANSPARENCY 

Price transparency is relatively high for JGBs. JGBs are actively traded and pricing information is available from a variety of price information services, including Reuters and Telerate. 

PRICING 

JGB prices are quoted in yield, specifically on the basis of simple yield, in basis points. Market price is calculated from simple yield. The following formulas are used to calculate price and yield:

 Ys = [C + (100 - P / T] / P, or P = [(C * T) + 100] / [1 + (T * Ys)], 

where 

Ys = simple yield 
C = coupon stated in decimal form 
P = price 
T = time to maturity = number of days to maturity/365 

Discount Bonds 

Discount bonds are quoted on a simple-yield basis, which is different from the simple yield used on coupon bonds. Simple yield is used for discount bonds with a maturity of less than one year, but the formula is adjusted to reflect the fact that discount bonds do not pay interest. Annually compounded yield is used for discount bonds with a maturity greater than one year. 

The yield on a discount bond with less than one year remaining to maturity is the value of Ys that solves- 

P = 100 / (1 + T + Ys). 

The yield on a discount bond with more than one year remaining to maturity is the value of Ym that solves- 

P = 100 / ( 1 + Ym)t, 

where t is the number of days to maturity (excluding leap days) divided by 365. 

HEDGING 

Because of the multiple risks associated with positions in foreign government bonds, investors may need to hedge one position in several markets using various instruments. Interest-rate risk related to JGBs is typically hedged by taking contra positions in other government bonds or by investing in interest-rate forwards, futures, options, or swaps. Similarly, foreign exchange risk can be reduced by using currency forwards, futures, options, or swaps. 

RISKS 

Liquidity Risk 

The market for longer-term JGBs tends to be more liquid than for the shorter-term issues, although liquidity has improved for the shorter-term issues in the past few years. The benchmark 10-year JGB still accounts for the majority of trading volume in the secondary market and therefore enjoys the best liquidity. More recently issued JGBs also tend to be more liquid than older issues. The market for medium-term bonds is less liquid because such bonds are typically purchased by individuals and investment trust funds, which tend to be buy-and-hold investors. The existence of a large and active JGB futures market enhances the liquidity of these issues. 

Interest-Rate Risk 

Like all bonds, the price of JGBs will change in the opposite direction from a change in interest rates. If an investor has to sell a bond before the maturity date, an increase in interest rates will mean the realization of a capital loss (selling the bond below the purchase price). This risk is by far the major risk faced by an investor in the bond market. Interest-rate risk tends to be greater for longer-term issues than for shorter-term issues. Therefore, a large concentration of long-term maturities may subject a bank's investment portfolio to unwarranted interest-rate risk. 

Foreign-Exchange Risk 

A non dollar-denominated bond (a bond whose payments are made in a foreign currency) has unknown U.S. dollar cash flows. The dollar-equivalent cash flows depend on the exchange rate at the time the payments are received. For example, a U.S. bank that purchases a 10-year JGB receives interest payments in Japanese yen. If the yen depreciates relative to the U.S. dollar, fewer dollars will be received than would have been received if there had been no depreciation. Alternatively, if the yen appreciates relative to the U.S. dollar, the investor will benefit by receiving more dollars than otherwise. Over the last few years, volatility in the U.S.-Japanese exchange rate has been particularly high, primarily due to the Japanese banking crisis. 

Political Risk 

A change in the political environment, withholding tax laws, or market regulation can have an adverse impact on the value and liquidity of an investment in foreign bonds. Investors should be familiar with the local laws and regulations governing foreign bond issuance, trading, transactions, and authorized counterparties.

ACCOUNTING TREATMENT 

The accounting treatment for investments in foreign debt is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

Japanese government bonds and yields are assigned to the 0 percent risk-weight category. 

LEGAL LIMITATIONS FOR BANK INVESTMENT 

Japanese government bonds and notes are type III securities. As such, a bank's investment in them is limited to 10 percent of its equity capital and reserves. 

REFERENCES 

 Credit Suisse First Boston Research. ''The Yen Bond Markets.'' 1988. 
 Fabozzi, Frank J., and T. Dessa Fabozzi, ed. The Handbook of Fixed Income Securities. 4th ed. New York: Irwin, 1995. 
 Fabozzi, Frank J. Bond Markets, Analysis, and Strategies. 3d ed. Upper Saddle River, N.J.: Prentice-Hall, 1996. 
 J.P. Morgan Securities. Government Bond Outlines. 9th ed. April 1996. 
 Merrill Lynch Capital Markets Research. ''Japanese Yen Bond Market.'' Merrill Lynch Guide to International Fixed Income Investing, 1989. 
 Tatewaki, Kazuo. Banking and Finance in Japan. 1991. 
 Troughton, Helen. ''The Impact of Deregulation.'' Japanese Finance. Euromoney Publications, 1990. 
 Urich, Thomas J. U.K., German and Japanese Government Bond Markets. Monograph Series in Finance and Economics. New York: New York University Salomon Center at the Leonard N. Stern School of Business, 1990.

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