Saturday May 17 2008
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The fall-out is still spreading from last week’s blow-out between bond and swaps spreads in Tokyo’s Japanese government bond market.

Believe it or not, there is talk that total losses among foreign and Japanese hedge funds and investment banks could run to double-figure-billions - all on an aberration last week between yields on seven-year and 20-year JGBs.

The most high-profile victim, as the FT’s James Mackintosh earlier reported, was the $3bn London hedge-fund Endeavour Capital which lost more than a quarter of its value - an eye-watering $810m or so - on so-called “box trades”, that is, highly leveraged bets on JGB swaps and futures (in this case, they were bets that the 20-year bond and swap spreads would widen as seven-year spreads narrowed).

Huge swings in JGB futures saw prices soar on Monday March 17 for the biggest one-day rise since 2003, only to plunge the next day.

In Endeavour’s case, the resulting losses triggered bank covenants, forcing the hedge fund to close other trades in an effort to reduce its leverage from 18 times to almost nothing, said Mackintosh.

But as the dust settled over Tokyo’s battered JGB market this week, it became clear that other hedge funds and banks and securities firms also racked up massive losses on the “great JGB box-trade unwind”.

FT Alphaville knows of at least four hedge funds, several top Japanese banks and at least six big securities firms in Tokyo - western and Japanese - that privately admit they were “killed” on the squeeze, with losses ranging from $100m to $400m, possibly more. Among the biggest losers, alongside Endeavour, were three of Japan’s top banks - although some big investors who stayed in position may since have recouped some of their losses.

Some, such as one western bank, cut their losses as the sell-off in US mortgage-backed securities hit US swap spreads, JGB futures and other credit spreads. This particular bank closed out when its losses reached $10m. But others, including three big Japanese banks, stayed in as the carnage piled up.

No one knows the exact figure, but one equity capital markets banker at a Western firm in Tokyo told FT Alphaville that total losses could stretch to many billions.
So what happened in this normally sedate corner of the fixed interest market? As Mackintosh explained, the spread between yields on the seven- and 20-year JGBs widened to 1.44 percentage points on March 17, the most since 1999, prompting a panic scramble among big investors to unwind their box trades.

The surprise element, as any JGB swaps trader will tell you, is that box-trades usually move within a tight band and are regarded as a fairly stable, unexciting and respectable way to make money. But the margins are tiny and to make it worthwhile, not insignificant amounts of money are required.

When it all goes wrong, as it did last week, the losses are huge.

Compounding the chaos - and adding to the losses for those dabbling in currency-related basis swaps - was the yen’s surge against the dollar, at one point reaching Y95.77 early last week, catching off guard securities firms which had hedged currency-linked structured notes they had sold to Japanese investors (in what Reuters described as a “popular form of the carry trade”).

The Japanese currency is now closer to Y100, and the gap between the seven- and 20-year JGBs has since narrowed, reaching 1.19 percentage points on Thursday, according to Bloomberg. But hedge fund investors told Bloomberg that other well-known funds lost between 5 per cent and 20 per cent of their value last week.

Freddy Lim, an interest-rate strategist at Morgan Stanley in Tokyo, summed up last week’s madness, telling Reuters: “It doesn’t make sense…It doesn’t make sense because it’s called liquidation”.

Related links:

Market Movers at Portfolio.com - Felix Salmon

The America premium? This could hurt - FT Alphaville