Japanese banks are likely to pivot toward investing in U.S. Treasurys and other higher-yielding foreign assets as they seek better returns on their swelling deposits. That marks a change after local lenders in 2020 raised their holdings of near-zero-yielding domestic government bonds to the highest point in five years.

In April, the start of the fiscal year for most of Japanese companies, Japan's holdings of U.S. Treasurys increased 2.9% from the previous month to $1.277 trillion, the highest in three months, according to U.S. data on foreign holdings of Treasury securities. The holdings had fluctuated through most of 2020, the data showed. Japan is the biggest foreign holder of Treasury securities, followed by China.

"A rate hike [in the U.S.] is not imminent," said Toyoki Sameshima, a senior analyst at SBI Securities Co. Japanese banks are "looking for a chance" to revisit U.S. Treasurys, he said.

Although the U.S. Federal Reserve is not in a rush to raise interest rates, most analysts interpreted the central bank's advancement of the timing of expected rate hikes to late 2023 as a sign of a more hawkish Fed. Still, yield on the benchmark 10-year U.S. Treasury bond cooled after the Fed's June 16 policy announcement and hovered near 1.467% on June 23, although it touched a 14-month high of 1.776% in March as the U.S. economy recovered from the pandemic.

Agile trading

Hajime Takata, executive economist at Okasan Global Research Center, who expects the 10-year Treasury yield to test 2% in 2021, said that Japanese banks likely will seek higher returns from the U.S. bonds through "agile trading, not placing a big bet on them."

Meanwhile, the Bank of Japan is expected to keep loose monetary policy, which may make the spread between U.S. Treasurys and Japanese government bonds, or JGBs, more attractive. The U.S. dollar, too, has gained against the Japanese yen since the start of 2021. The dollar traded at ¥110.79 on June 22, compared with ¥103.21 at the end of 2020.

In the last fiscal year, Japanese financial institutions turned to domestic government bonds, increasing their aggregate holdings by 46% to ¥89.9 trillion and halting eight straight years of declines in their yen bond assets. The outstanding amount held in JGBs in the last fiscal year was the highest since ¥100.1 trillion in the fiscal year through March 2016.

The increase in domestic fixed-income assets of Japanese banks also reflected ballooning deposits during the pandemic as companies and individuals sought to rein in spending. Aggregate deposits at Japanese banks rose 4.5% in the last fiscal year to a record ¥283 trillion in March 2021, surpassing the previous high of ¥272 trillion in September 2019, according to data from the Bank of Japan.

Shift in investment focus

"The banks don't want to hold massive amounts of JGBs," said Michael Makdad, an analyst at Morningstar. "It's not positive for earnings."

Mitsubishi UFJ Financial Group Inc. — Japan's largest bank, also known as MUFG — said it aims to diversify its overseas investments under a three-year plan that started in April. MUFG intends to invest in alternative assets such as private equity or real estate funds mainly in the U.S. for higher yields, in addition to bonds and stocks.

MUFG increased its yen bond assets by about 57% to ¥32.3 trillion in the last fiscal year through March 2021. The megabank said profits on its yen bond investments declined 30% in the year to ¥86.9 billion on higher interest rates. It trimmed its holdings of foreign bonds by about 13% to ¥21.2 trillion during the same period, and reported an 86% plunge in profit to ¥103 billion on that investment portfolio. It didn't break down the foreign assets by type.

Concordia Financial Group Ltd., one of Japan's largest regional banking groups, also plans to allocate more cash to U.S. Treasurys and mortgage bonds this fiscal year compared to the previous, stepping away from lower returns on domestic government bonds.

"We're seeking to take an income gain" from the Treasurys, an official at the banking group said. Concordia held ¥193 billion worth of foreign bonds at the end of March, though it did not break down the assets by type.

At Sumitomo Mitsui Financial Group Inc., yen bond assets nearly doubled to ¥14.2 trillion last fiscal year and the company reported a loss of ¥14.1 billion on the portfolio. Holdings of foreign bonds, meanwhile, increased 4% to ¥12.1 trillion, earning the bank a profit of ¥1.3 billion. Mizuho Financial Group Inc. said its holdings of domestic bonds swelled by about 66% to ¥20.9 trillion and it resulted in a ¥31.7 billion loss in the last fiscal year. Its foreign bonds investments were little changed at ¥12 trillion, though the portfolio incurred a loss of of ¥33 billion.