Local investors are trying out new techniques to boost returns.

By Margaret Elliott

Japan is in the midst of change. Its highly regulated financial markets loosened in a deregulatory "Big Bang” in September. Yet while deregulation usually attracts activity in the markets, the country's astonishingly low interest rate continues to keep foreign players away.

The discount rate in Japan has sat at a measly 0.5 percent since September 1995. And it doesn't look like it's moving soon. The Bank of Japan is not convinced that the economy has recovered and wants to keep rates low. The Ministry of Finance has made noises that it thinks a hike in rates could easily be accommodated. Nevertheless, the Japanese rates, which rise to about 3.1 percent for 20-year Japanese government bonds (JGBs), are still the lowest among nations in the Organization for Economic Cooperation and Development.

Local investors have a variety of choices when it comes to adding basis points to their yields. These range from dual-currency bonds to bonds structured with embedded options. "The point is that investors in Japan need to extend the maturity by offering an option in order pick up yield,” says Takio Sumino, associate director on the syndicate desk of Nomura International.

In dual-currency bonds, investors pay in yen and receive their coupons in yen, but the redemption is in dollars or another foreign currency. These bonds are usually two or three years duration; a recent issue for IBM of ¥20 billion (about $200 million) was due in 2000 and paid a yield of 1 percent. Hideki Takao, head of debt derivatives trading at Citibank, says that about ¥1.5 trillion or $15 billion of these bonds have been issued this year, about the same as last year. Purchasers are generally retail investors seeking a yield pick-up.

Reverse dual-currency bonds are similar except that the initial payment is in another currency—dollars, or, frequently in the last year, the Australian dollar—and payment of coupon and redemption is in yen. Investors in these products tend to be institutional investors, such as life insurers or pension funds seeking to match assets to liabilities. "The Aussie dollar is less attractive today because it has weakened vs. the yen,” says Nomura's Sumino, "but we are seeing interest in offering sterling dual- and reverse dual-currency bonds, because of the strength of the pound.”

Bonds with embedded options are attractive to institutions because of the low volatility in the yen market. For instance, a one-year JGB would yield, say, 0.6 percent. "By embedding an option with a call feature every three months, the investor could push up the yield to 0.7 percent in the first three months, 0.8 percent in the second, and so on,” says Citibank's Takao. This structure is known as a Bermuda call.

Another variation is the multi-callable step-up note, in which the coupon paid rises on a fixed schedule depending on some external benchmark, such as the level of yen LIBOR vs. the discount rate. These notes can have durations of up to five years, with the coupon rate rising depending on the number of calls in the structure.

Even if interest rates did go, these types of structures don't open the issuer up to too much risk, according to Nomura's Sumino. Particularly because a hike to a 1 percent discount is as far as anyone can see the government moving. "The fact remains that the markets in Japan are betting against an interest rate rise,” says Citibank's Takao. Until a change in central bank policy looks real, the attractiveness of investing in Japanese debt derivatives will be limited to local players.

Big Bang—The Japanese Version Hot on the heels of scandals in the banking and brokerage sector, the Japanese government is forging ahead with deregulation of its financial markets to foster competition and openness. For many global banks and brokers, this is a big opportunity to tap into the last unopened yet mature financial market in the world. And no players are letting grass grow under their feet. Like London's 1986 Big Bang, foreign firms are looking for local talent and contacts. But this time, foreign banks and dealers are pursuing joint ventures rather than buying up every broker in sight. The biggest to date is the joint investment banking and asset management unit set up by Swiss Bank Corp. and Long-Term Credit Bank of Japan, the second-largest long-term credit bank in Japan. The deal involves a total investment of $850 million by SBC Warburg. Other joint ventures worth watching are the Bankers Trust-Nippon Credit Bank link and that of Smith Barney-Nikko. The BT-NCB linkage isn't limited to Japan. Each will take an equity stake in the other. BT will get access to NCB's Japanese distribution system, but will also help bolster the weaker NCB in its efforts outside Japan. Smith Barney's effort is aimed at the Japanese retail client base. Its 50/50 joint venture with Nikko will offer financial advice and quasi-bank account services much like those products on offer in the United States. Banks and brokers with significant Asian operations are simply beefing up their Tokyo presence. Credit Suisse Financial Products just opened a new office in Tokyo, though since it is considered a bank under Japanese regulations, it is limited in the amount of derivatives activity it can pursue before deregulation. JP Morgan has bought a seat on the stock exchange and sees equity and credit derivatives as an area of great opportunity. With debt derivatives still encompassing 80 percent of all derivatives activity onshore in Japan, equities are an area that interests most of the foreign invaders. More bangs Characteristically, Japan isn't deregulating in one fell swoop. The government has always said it would take five years to complete its plans, yet recent indications are that the schedule has been accelerated. Starting with last year's relaxation of the rules regarding repo activity, most of the major changes should be in place by April 1998. The main structural provisions include allowing banks and securities firms to compete on an equal footing. Banks also will be allowed to set up holding companies to facilitate moves into new businesses, and fixed stock commissions will be abolished. But the regulation that may have the most wide-reaching implications for derivatives players is the April 1998 change to foreign exchange controls. Now restricted to domestic banks, foreign exchange will become a competitive market, though the attractiveness to the big foreign exchange players will remain limited unless taxation on foreign exchange transactions is minimized or abolished at the same time. Japan's Big Bang has found its way already to the derivatives exchanges. This summer European-style single stock options were introduced on the Osaka and Tokyo exchanges. An aluminum futures contract was launched on the Tokyo Commodities Exchange in the spring. And spread trading on the Tokyo Stock Exchange's Topix futures contract and Osaka's Nikkei 225 and 300 appeared in May. While this is a remarkable degree of innovation for a country in which it can take 10 years to get approval for a new contract, exchange-traded derivatives still suffer from over-taxation: ¥100 or so tax is charged on every contract traded. And that drives business to Singapore or other offshore centers. If Japan really wants to become a competitive financial center in Asia, it must address the taxation question squarely—and soon. —M.E.