Japan's $550 billion investment in US seen widening gains on hedged JGBs

By Junko Fujita

TOKYO, Feb 18 (Reuters) - Japanese government bonds may become an inadvertent beneficiary of a wave of investment into the United States being hammered out between Tokyo and Washington.

Japan last year agreed to invest $550 billion into the U.S. as part of a deal to lower tariffs, with the first $36 billion in projects announced on Tuesday and more details expected when Prime Minister Sanae Takaichi meets President Donald Trump next month.

If fully realized, the size of the commitment - equivalent to about 14% of Japan's annual economic output - would affect the market for cross-currency basis swaps used by Japanese firms to hedge their U.S. transactions. That would, in turn, boost returns on JGBs for dollar-based investors.

"There is a question on whether the $550 billion project will be carried out in full, but if that is the case, it will have a significant impact on the cross-currency basis swaps," said Yusuke Ikawa, market strategist at BNP Paribas.

The traditionally sedate JGB market has been on a wild ride in recent months. Short-term yields have shot up in response to a tightening cycle by the Bank of Japan, while longer-term yields have hit successive record highs on concerns about increasing stimulus since fiscal dove Sanae Takaichi became prime minister.

But yields have now reached levels that will appeal to both domestic and international buyers, said Richard Cochinos, a G10 FX strategist at RBC Capital Markets.

"Given the BOJ is still pursuing policies that will shrink its balance sheet... we continue to expect higher yields in Japan," Cochinos said. "Those higher yields will be attractive on both an FX-hedged basis for foreign investors and non-hedged basis for domestic investors."

Five-year JGBs JP5YTN=JBTC would have yielded 4.659% on Monday if the dollar holders bought them using currency hedges, surpassing the 3.6% yield on 5-year U.S. Treasuries US5YT=RR, according to the NRI Research Institute.

"It is hard to find an investment target with a single-A rating with this much return in the U.S.," said Yuuki Fukumoto, senior researcher at NRI Research. "That is why foreign investors have been buying JGBs in the past few years."

That hedging advantage is likely to increase if Japan comes through on its promised U.S. investments, analysts say, as stronger demand for the dollar funding widens basis swaps.

The investment package is said to include equity, loans, and loan guarantees from state-owned agencies Japan Bank for International Cooperation (JBIC) and Nippon Export and Investment Insurance (NEXI).

JBIC is expected to convert some 5.5 trillion yen ($35.83 billion) it raises from government funding into dollars through the currency basis swaps.

The basis swap trade has been a key pathway for overseas investors to bet on JGBs, particularly on longer-dated securities from which Japanese life insurers and other traditional buyers have been gradually retreating.

Foreign investors held 12.3% of all JGBs as of September last year, a sharp increase from 5.5% in 2010, according to the BOJ.

"For a long time, foreign investors avoided JGBs as they could be a drain on their fund performance," said Keita Matsumoto, head of the financial markets at SMBC Nikko Securities. "Now they can't afford to do without JGBs. That's how much JGBs boosted its presence."

($1 = 153.4900 yen)