Japan and a whole range of other countries could see upheavals in their bond markets if Norway goes ahead with new proposals for its sovereign wealth fund, according to industry experts.
In a letter released over the weekend, Norges Bank proposed some big changes to its benchmark index for bonds - an index used to gauge the performance of its fund. It suggests that only government bonds priced in dollars, euros or sterling should be used in the benchmark, adding that the debt should not have a maturity of more than "about 10 years".
The fund can continue to invest in the currencies and segments that were recommended to be removed from the benchmark index - such as emerging market currencies, the Japanese yen, the Canadian dollar and the Swiss franc. However, the bank's portfolio usually aligns itself to its benchmark over time.
Norges Bank currently manages more than $987 billion in assets, with 30 percent invested in fixed income. It is the world's largest sovereign wealth fund.
The justification is that the bank doesn't see a benefit from diversifying its bond investments: "In the long term, the gains from broad international diversification are considerable for equities but moderate for bonds. For an investor with 70 percent of his investments in an internationally diversified equity portfolio, there is little reduction in risk to be obtained by also diversifying his bond investments across a large number of currencies."
The letter has now been sent to Norway's Ministry of Finance who will conduct their own assessment and will then make a decision following parliamentary deliberations in June 2018. It's unlikely to have an immediate effect on the fixed income market — as it does not stipulate that the bank has to sell its existing holdings. But traders think such a move could set a precedent for others in the future and could have negative repercussions for emerging markets and Japan.
Squeezed out of Japan?
Norges Bank's proposed move provides evidence that the Bank of Japan is squeezing investors out of its own bond market, according to strategists at Japanese investment bank Nomura. The Bank of Japan has set its yield target for the 10-year Japanese government bond at zero, and has aggressively purchased bonds in order to hit that number.
"While major foreign central banks would have a smaller presence in the bond market, the Japanese bond market's liquidity problem, which Norges Bank specifically highlighted, could discourage foreign investment in (Japanese government bonds), on top of their persistently low yields," the analysts at Nomura said.
"If approved by the government, Norges Bank's forthcoming portfolio shift alone could generate $19 billion" of selling of Japanese yen, Nomura said. The Bank of Japan owns more than 40 percent of all Japanese government bonds.
Implications for emerging markets?
Norges Bank "is a huge player in global bonds, and as such, many sovereign wealth funds follow the allocation lead of Norway," said Nicholas Glinsman, chief investment officer at financial advisory firm Evo Capital. "Emerging market debt is one asset class so removed, and it really cannot afford to lose such a significant source of demand."
"According to the Institute of International Finance, (emerging-market) debt grew to an incredible $56 trillion by the end of the first quarter this year, equivalent to 218 percent" of those countries' gross domestic product, Glinsman said. That means an "inevitable" hit to the emerging-market debt and currencies "should demand soften, while supply continues to grow at such an electric pace."
Other market players have noted that the timing could be interesting, especially given how expensive corporate bonds are trading as well as the price of Asian low-yielding bonds — specifically in Singapore and South Korea. Announcements like these also serve to highlight there may still be value in owning U.S. and European fixed income should another recession strike.
Correction: This story has been updated to reflect that the Norges Bank has proposed changes to its benchmark index for bonds.