U.S. debt loses in Japan Post Bank optimization plan

Floating-rate instruments and European credit will gain ground in Japan Post Bank Co. Ltd.'s huge overseas credit portfolio at the expense of U.S. investment-grade paper as the relentless rise in U.S. interest rates boosts the costs of hedging U.S. dollar exposures back to yen.

In a June 29 interview, Taiichi Hoshino — the bank's newly appointed co-chief investment officer and head of external managers — said the global macro-environment now is having an outsized effect on his team's efforts to "optimize" a credit portfolio that's grown to more than $350 billion over a six-year span.

With hedging costs increasing, the bank's focus on U.S. paper "is getting more and more difficult, especially in ... investment grade where spreads are relatively tight," said Mr. Hoshino, who served 2 1/2 years as the bank's head of external credit managers before his June 19 promotion.

Consequently "the direction we're heading for will be ... European paper and floating-rate instruments in non-investment grade, including both public and private debt markets," he said.

For the Tokyo-listed, ¥207.7 trillion ($1.9 trillion) behemoth — restricted from competing with commercial banks in Japan and consequently reliant on its institutional investment skills to garner revenues and profits — U.S. investment-grade paper has been the centerpiece of its efforts to offset the collapse of income from Japanese government bonds. JGBs have yielded next to nothing over the past few years.

As of March 31, the bank reported JGB holdings of ¥62.7 trillion and ¥39 trillion of investment trust assets — primarily externally managed U.S. investment-grade bonds. For the bank's final quarterly report ahead of its November 2015 Tokyo Stock Exchange listing, the corresponding figures were ¥92.8 trillion of JGBs and ¥20.6 trillion of investment trusts.

Japan Post Bank's latest medium-term plan, for the three years through March 2021, released on May 15, showed the focus of the bank's efforts to boost investment returns shifting to alternatives — private equity, hedge funds, real estate and direct lending — from overseas credit.

The plan targets a more than fourfold — or ¥6.9 trillion — jump in alternatives allocations over the three-year period to ¥8.5 trillion, from ¥1.6 trillion, and a boost in that "strategic" segment's contribution to total bank net interest income to 11% by March 2021 from less than 1% for the latest year. That gain would offset an expected decline in the contribution of JGBs and other yen instruments to 26% from 36%.

The medium-term plan estimates the contribution of offshore credit and related investments, meanwhile, will slip to 63% from 64%, even as their portion of the overall portfolio is targeted to edge up to 41% from 39%.

The medium-term plan also predicted a drop in the bank's net income to ¥280 billion for its fiscal year ending March 31, 2021, from ¥353 billion as of March 31, 2018. Guidance from bank executives, meanwhile, points to net income of ¥260 billion for the current year.

Morgan Stanley MUFG Securities Co. Ltd. analysts Mia Nagasaka and Yuki Maeda, in their May 15 report on Japan Post Bank, cited rising hedging costs, due to higher U.S. interest rates, and the continued decline in income from the bank's JGB holdings as factors behind the weaker profit outlook.

In the interview, Mr. Hoshino said while the push to ramp up Japan Post Bank's alternatives exposures is a critical challenge now, a "continuous, relentless" effort to optimize the bank's credit portfolio remains the other major task at hand to strengthen its investment program.

Some money managers might have gotten the impression that those efforts are aimed at shifting active investments to passive or lowering fees, but such developments are outcomes of that optimization process rather than goals, he said.

Mr. Hoshino, while declining to provide specifics, conceded there's been a material increase in the portion of Japan Post Bank's credit exposure — predominantly in the U.S. investment-grade segment — being managed in customized passive strategies over the past two years.

As Japan Post Bank's credit exposures surged quarter by quarter over the past six years, bank executives concluded that tasking a sufficient number of managers, "typically 10 to 20, or even more" with finding alpha in the U.S. investment-grade market was producing investments with substantial "common denominators" — or beta, by another name, said Mr. Hoshino. Japan Post Bank's team could design the bank's own strategy to capture the duration, ratings and sector tilts they sought from that chunk of the investment-grade market more passively, he said.

But "there are still opportunities to gain alpha" in the investment-grade space and "we … continue to work with active managers ... as a satellite" rather than for the bulk of those exposures, said Mr. Hoshino.

There are no hard and fast targets for that passive-active split. "We continuously do this analysis ... to come up with the right mixture of (that) beta-like portion and the alpha portion, which could change over time," Mr. Hoshino said. "If there are dispersions in the market then you have more opportunities to gain excess return from alpha; if markets are benign, probably you don't get much from alpha," he noted.

That optimization of U.S. investment-grade holdings, which make up the bulk of the bank's more than $350 billion credit portfolio, has been proceeding for roughly 16 months, Mr. Hoshino said. More recently, the bank has begun moving to optimize its bank loan exposures — an area that's poised to see a pickup in allocations, he said.

Money managers, who declined to be named, said Japan Post Bank has allocated a combined total of almost $40 billion to roughly 10 firms. Mr. Hoshino declined to comment.

Mr. Hoshino said identifying "beta" in asset segments such as bank loans, or high-yield bonds or emerging market debt is not so simple, but there's still scope for coming up with "intermediate solutions, somewhere between complete passive and complete active."

As part of the bank's ongoing optimization process, its investment team is identifying those quasi-active/quasi-passive steps along the bank loan spectrum and doing the painstaking work of identifying which managers are the best fit to manage each strategy, he said.

"What I mean by optimization is really how to match a manager to the right mandate that this particular manager has an edge in," he said.