Japan 2007: New horizons for munis
The Japanese government is encouraging local governments to stand on their own feet, which means an upturn in municipal bond issuance is certain. And with plans to exempt foreigners from withholding tax, Japanese muni bonds are set to be the next big area of interest for foreign investors in the yen markets, writes Atanas Dinov.
Japan has the world’s largest public debt. The public purse owes a whopping ¥834.4trn and the central government’s efforts to reduce this debt through cutting expenditure, including subsidies to local government, is driving an increase in municipal bond issuance. New regulations coming into effect in January will facilitate greater international investor participation in municipal bonds, which should lead to substantial market growth.
The Ministry of Finance plans to issue ¥25.4trn of new government bonds in fiscal 2007 – ¥4.5trn less than it issued in fiscal 2006.
This reduction is part of the government’s debt reduction programme and will put increased pressure on local governments to raise funds themselves. The new regulations will allow local governments to become more fiscally autonomous, as former prime minister Junichiro Koizumi intended in his Trinity reforms.
The reforms essentially decentralise the funding of local government, make it more transparent and reduce the central government’s role in financing local authorities.
The central government has slowly been reducing the level of funding it provides to local governments. In 1998, it provided 70% of municipal funding but that had fallen to 40% by 2006.
Japan’s high public debt is a relatively recent phenomenon. Just 15 years ago, public sector debt was only about 60% of GDP. When the property bubble burst, the government responded by aggressively subsidising municipalities, which inflated the national public debt level.
Beyond decentralisation, last year the government adopted a new pricing mechanism for municipal debt, abandoning the so-called unified pricing system in favour of a more competitive market approach for issuers.
Reform, reform, reform
From January 1, 2008, the Japanese municipal bond market will change even more when non-Japanese residents investing in municipal bonds will become exempt from paying the 20% withholding tax.
The withholding tax exemption will be very similar to that provided to non-resident investors in the Japanese government bond market and those investors who have gained withholding tax exemption on government bonds will automatically also be exempt from the tax on municipal bonds.
This change aims to attract foreign investment, especially from investors in Western Europe, where there is considerable interest in investing in Japanese municipal bonds.
"These are foreign investors that can usually fund themselves at Libor flat or at a single digit spread, and will use Japanese municipal bonds as collateral for their covered bond issuance," said a syndicate banker at a leading underwriting house in Tokyo.
A potential issue is that many foreign investors have a preference for long-dated paper, with tenors of 20 years or 30 years or even longer. "Generally, for foreign investors 30-year Japanese municipal bonds are more attractive than, for example, 20-year bonds, in terms of swap spreads," said the syndicate banker.
There is not very much Japanese municipal paper around with tenors as long as this and that is unlikely to change overnight. Super-long paper, defined as issues with a maturity longer than 10 years, were introduced only in 2003.
Japan Expressway Holding and Debt Repayment Agency sold Japan’s first ever 40-year bond, a ¥30bn deal through Goldman Sachs, and is soon returning with a new ¥100bn 30-year deal.
"The super-long issues will be less than what investors are looking for and that could lead to frustration from their side due to this demand-supply mismatch", said Katsuki Yasunobu, chief credit analyst covering municipal bonds at Mizuho Securities. "But in the next couple of years there is no doubt that there is the potential for increased flows from foreigners."
Of the total municipal bond issuance for fiscal year 2007, only ¥520bn will be in the super-long sector, from total volume of ¥5.4trn planned by Ministry of Internal Affairs and Communications. Most of the paper issued will be in the five-year, seven-year and 10-year tenors and domestic players are likely to be the main buyers.
Additionally, the majority of the issuance is done non-lead manager-style, with the exceptions of the super-long papers. On the lead manager-style deals Goldman Sachs has cemented the top spot on the league tables for the fiscal year to date, with Nikko Citi grabbing the second spot, according to data from Thomson Financial.
A report by Mizuho Securities puts the preparedness of foreign investors interested in Japanese munis into three categories: 5% are advanced or already buying debt via domestic subsidiaries; 35% are progressive and so own Tokyo and Yokohama paper; and the remaining 60% are classified as basic, meaning they holding government guaranteed bonds. The report suggests the biggest possible rush will be from the “progressive” investors.
"The withholding tax exemption for non-residential investors starting from January 2008 will surely bring a huge impact to the Japanese fixed-income business," said Higashi Tatsuro, co-head of DCM at Nikko Citi. “With more foreign demands coming in, spreads will be determined from a global as well as a domestic perspective. This in turn will facilitate further globalisation of the debt business in Japan.”
According to the Japan Local Bond Association (JLBA), the financing of Japanese regional municipalities is similar to that of German regional governments and this in turn should make it easier for foreigner buyers to approach the market.
The Ministry of Internal Affairs and Communications and the JLBA are already working with local governments to set up investor meetings abroad, mainly in Europe. Non-deal roadshows are expected to be scheduled before the end of the fiscal year in March 2008.
Some regional governments, however, have already held their own investor meetings abroad and are already attracting significant foreign investment.
Strong municipalities will have an advantage because they are the most frequent issuers of the tenors that foreign investors desire. They also boast higher credit ratings from Moody's and Standard & Poor's, which are internationally better recognised than domestic Japanese rating agencies.
On October 11, Moody’s decision to upgrade Japanese government bonds to A1 from A2 resulted in a number of upgrades in the ratings of local governments, to Aa1 from Aa2. The upgrades included Metropolis of Tokyo, Osaka city government, Fukuoka and Shizuoka prefectures, the city of Kyoto and Hamamatsu city. However, according to a syndicate banker, those upgrades will not attract further foreign investors for the time being.
Investors consistently rate Tokyo Metropolis as the favourite among all the regional issuers, followed by Tokyo-area municipalities, along with cities of Yokohama and Kawasaki. At the bottom of the list are the Osaka and Hokkaido-centered groups, which have weaker fundamentals.
The City of Yokohama has issued the first ever 20-year municipal paper, which Tokyo Metropolis followed with a 30-year issue.
Another positive aspect is that the current global credit market volatility has only lightly touched the Japanese regional debt market, according to both analysts and bankers.
"Municipal spreads widened, as did spreads elsewhere in Japan, but this widening was not because of a direct impact from the sub-prime crisis," said Katsuki. "It was due to municipal bonds being sold amid profit taking, although the reason why there was profit-taking was because interest rates declined due to the sub-prime turmoil. The oversupply seen by Samurai and domestic issues in the period of April to June played a role as well."
Several bankers confirmed already strong demand from abroad even ahead of the exemption, pointing to the strong buying of the 20-year and 30-year Yokohama paper launched in March.
Some recent long-term deals that appeared on the market are City of Kyoto’s ¥20bn 20-year through joint-lead managers Goldman Sachs and Nikko Citi, which priced at 18bp over government bonds.
A day later City of Yokohama printed ¥15bn 20-year bullet via Nikko Citi and Nomura Securities. Marketing had started at the price guidance level in the range between 15bp to 18bp over government bonds, but the final spread came out to the tight side of the range – 15bp over. The issue was increased by 50% to ¥15bn from the initial ¥10bn planned.
"From early this year, we are already receiving greatly increased enquiries from global investors to Japanese municipal bonds,” said Higashi. “I would personally suspect some may wish to get hold of the paper prior to the tax exemption, before spreads tighten."