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Amid Negative Rates, Is Japanese Bank Debt Still Attractive?

Sound credit fundamentals and regulation-driven supply pressures could create attractive valuations for Japanese bank capital instruments.

When Japan’s central bank surprised markets by taking interest rates negative on 29 January, Japanese bank equities sold off on concerns theirprofits will be squeezed. Should investors in Japanese bank credit be equally worried? We think not.

In our base case scenario, the Bank of Japan (BOJ) is unlikely to push rates deeply negative – to -1%, for instance, as moves in share prices imply –because regional banks’ profits could fall significantly and pose major risks to Japan’s financial system. Indeed, the BOJ moved with caution: It adopted athree-tier system in which negative rates apply to only part of the BOJ’s entire reserves (23 trillion yen out of 253 trillion yen as of 29 February). Thisminimized the direct impact on the financial system and left the door open to deeper cuts if needed.

However, in our risk scenario, in which the BOJ cuts rates to -1%, the indirect impact of deeply lower lending rates and reinvestment yields could besignificant. Unlike the case with negative rates in Europe – where, for instance, Scandinavian banks rely on wholesale funding, and thus their fundingcosts also decrease – the majority of liabilities held by Japanese banks are retail deposits denominated in yen, making it difficult for banks to pass onnegative rates. We estimate the recurring profit of regional banks would likely fall over time by some 60%. In our view, the magnitude of this indirectimpact makes it unlikely the BOJ will push rates as deeply negative as it originally indicated.

Nonetheless, even in our risk scenario of -1% rates, we believe Japan’s globally systemically important financial institutions (G-SIFIs) – which also aremajor debt issuers – would be able to manage. For these institutions, which include Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group andMizuho Bank, we estimate recurring profits would fall by 22% over time.

This is significant yet much smaller than the 60% hit to regional banks’ recurring profit (see Figure 1). G-SIFIs are less affected mainly because they areless reliant on domestic spread business than regional banks. G-SIFI’s domestic spread business, for example, represents only 25%-30% of revenue, comparedwith about 85% among regional banks. G-SIFIs derive the balance of their revenue from overseas loans and fee income. Therefore, Japanese G-SIFIs couldincrease their common equity Tier 1 capital ratio (CET1 ratio) by 0.4% to 0.7% annually, even if their profit level drops by 22% as estimated under ourrisk scenario.

Opportunities in Japanese G-SIFI credit
In our view, the best investment opportunities in Japanese G-SIFI credit lay in their foreign currency (FX)-denominated Basel III Tier 2 capital and insenior notes issued by bank holding companies in February and March as their inaugural total loss-absorbing capacity (TLAC)-eligible regulatory capital.These bank capital instruments have unique characteristics, sound fundamentals and favorable valuations due to constant supply. We believe they would beespecially attractive to Japanese and non-Japanese investors looking for moderate-risk, income-oriented products.

In general, systemic support globally is less likely for bank capital; it is more vulnerable to idiosyncratic risks, as reflected in the additional spreadthese notes command. However, the Japanese approach to regulation and resolution is unique in the global context. For instance, it allows the government toinject capital without triggering principal write-downs.

In Japan, the likelihood of systemic support for Japanese banks remains very high, and in our view, there would be no burden-sharing for either Basel IIITier 2 notes or the TLAC notes of Japanese banks if the government provided support. These structural factors help explain why Japanese Basel III Tier 2notes showed much lower volatility than other bank capital asset classes during the market turbulence seen in January and February. We think thatrisk/reward is skewed favorably for credit investors, making this asset class an attractive source of middle-risk income in a global context (see Figure2).

Fundamentals will likely remain sound. As noted above, Japanese G-SIFIs have diversified their revenue sources and become much more resilient to economicturbulence. Yet, because of the regulatory requirements, these banks have been accumulating capital; it has been increasing by 0.5% annually since thefiscal year ending in March 2008, from approximately 7% (for Basel II Tier 1) to about 12% at the end of 2015 for Basel III CET1 (Common Equity Tier 1), atrend we thinkwill continue.

Other key metrics also are in good shape. NPLs (non-performing loans) are at historical lows around 0.8%-1.0% and liquidity is backed by ample domesticdeposits (the loan-to-deposit ratio is around 66%). However, exposure to domestic equities (48% of CET1) makes their CET1 potentially volatile and a globaleconomic slowdown could lead to a pickup in NPLs. Overall, however, we assess these risks, as well as pressure on net interest margins, as manageable.

The valuations of FX-denominated Basel III Tier 2 and TLAC senior notes also are favorable, even after hedging back to the Japanese yen, because spreads ofregulatory-driven supply tend to widen while new issuance eventually enhances the capital of the banks. Japanese G-SIFIs have been proactive issuers,representing 29% of FX-denominated issuance by Japanese companies since 2013. Part of the reason for their sizable issuance is to fund their rapidlygrowing overseas lending, which has a 23% compound annual growth rate over the last five years. Another reason is to meet regulatory requirements. BaselIII regulations require banks to issue subordinated notes (e.g., Basel III Tier 2/Additional Tier 1 [AT]) notes to enhance their capital. In addition,G-SIFIs are required to accumulate TLAC-eligible notes equal to at least 16% of their risk assets by 2019.

Investment Implications
The BOJ’s negative rate policy poses difficulties for Japan’s banking sector, including Japanese G-SIFIs. But Japanese G-SIFIs’ sound credit fundamentalsand the structural uniqueness of their bank capital instruments (Basel III Tier 2, TLAC notes) provide unique investment opportunities. Regulation-drivensupply pressures could result in attractive valuation of these notes. We also see attractive investment opportunities in FX-denominated Basel III Tier 2and TLAC of Japanese G-SIFIs, especially for investors looking for moderate-risk, income-oriented product.

The Author

Tadashi Kakuchi

Portfolio Manager, Japanese Bonds

Takanori Miyoshi

Credit Analyst, Asian Financials

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