Equity-Based Insurance Guarantees Conference June 18, 2012 Tokyo, Japan

Overview of Japanese Capital Markets

Peter von Richthofen

Overview of the Japanese Capital Markets

Peter von Richthofen, Bank of America Merrill Lynch
SOA Equity-Based Guarantees Conference, Tokyo, June 2012

Japan Capital Markets: Background

Deflation2 Japan Household Financial Assets (JPY trn)1

1,600 1 600 1,400 1,200 1 800 600 400 200
1.0%

Slow growth in household wealth

0.5% 0 5%
CAGR since 2000

0.0 00 -1.0%
Annual Inflation Rate

-2.0%

Causes?
Falling Savings Rate driven by demographic trends3
(%)

> 60 yrs old population share (RHS) Savings rate (LHS)

8 11 14 17 20 23 26 29 32

16 14 12 10 8 6 4 2 0

Deposits Inv Trusts

Bonds

Equities

Other

Insurance & Pension Reserves

1) Source: Bank of Japan, Flow of Funds Statistics; 2) Source: Bloomberg; 3) SourceCabinet Office, Statistics Bureau, BofAML Global Research

Composition of Household Financial Assets: International Comparison

Composition of Household Financial Assets (USD trn, end 2011)) Japan 57% 28% $ 19.3trn

Japan households hold their financial assets mainly in bank deposits Distinctly different allocation from the other major economic blocks 29% $ 49.1trn

US

14%

32%

Euro Area

36%
Currency & Deposits Investment Trusts

32%
Bonds

$ 24.0trn

Shares & Equities

Insurance & Pension Reserves

1) Source: Bank of Japan, Flow of Funds, - Overview of Japan, US, and the Euro area . YE 2011

Snapshot of the US Capital Market and Key Financial Institutions

USD 49trn of Household Financial Assets1
Deposits Bonds Equities Inv. Funds Insurance & Pension Reserves

7.1trn

4.8trn

15.5trn

5.6trn

14.3trn

USD 14.6 trn of Depository Institutions Assets2

USD 10.6 trn of Inv. Fund Assets2

USD 6.7 trn of Insurance Reserves2

USD 6.7 trn of Pension Reserves2

Loans Gov Bonds & Bills Corp Bonds & ABS Inv Funds Equities Other

USD 36.8 trn of Fixed Income Assets3

Money Mkt 7% Corp Bond 22% Treasuries Bonds & Bills 27%

USD 14.8 trn of Listed Equities Market Cap4

ABS 28%

Municipal & Agency 10%

1) Source: Bank of Japan, Flow of Funds, - Overview of Japan, US, and the Euro area - YE 2011; 2) Source: Federal Reserve Statistical Release, Flow of Fund Accounts of the United States First Quarter 2012; 3) Source: SIFMA; 4) Source: Bloomberg - Mkt Cap of the Russell 3000 Index which comprises 98% of US listed equities. All data is for YE 2011

Snapshot of the Japan Capital Market and Key Financial Institutions

JPY 1,483trn of Household Financial Assets
Deposits Inv. Bonds Equities Funds Insurance & Pension Reserves

838trn
JPY 1,272 trn of Depository Institutions Assets
1
1

39trn

420trn

JPY 70 trn of Inv. Fund Assets

1

JPY 342 trn of Insurance Reserves

1

JPY 78 trn of Net Pension Reserves

Loans Gov Bonds & Bills Corp Bonds & ABS Inv Funds Equities Overseas Assets

JPY 978 trn of Fixed Income Assets

ABS 0.1% Municipal & Agency 12% Treasuries Bonds & Bills 79% Corp Bond 9%

JPY 256 trn of Listed Equities Market Cap

1) Source: Bank of Japan, Flow of Funds - Overview of Japan, US, and the Euro area - YE 2011; 2) Source: Bank of Japan - Basic Figures of the Flow of Funds - Fourth Quarter of 2011; 3) Source: Japan Secruities Dealers Association ; 4) Source: Tokyo Stock Exchange Fact Book 2012; All data is for YE 2011

Observations - Japan Capital Market vs US Capital Market

Household Financial Assets:

Japan: Almost no growth, heavily concentrated in bank deposits

Depository Institutions:
Japan: Very substantial holders of JGBs (28% of Depository Institutions assets)

Investment Fund Sector:

Large Sector in the US market ( g (3/4 of Banking Sector total assets) ... g ) ... but much smaller in Japan (5% of Banking Sector Assets). Helps retail customers access overseas assets

Size of Fixed Income Market vs Equity Market:

Japan Fixed income market size is close to 4x larger than equity market cap
US: 2.5x

Corporate Bonds and ABS:

Large sector in the US (50% of FI Assets) but much smaller in the Japan market.
US Insurers are predominantly credit investors, and JGB investors in Japan

JGB Market Overview

JGB Yield Curve (Mid June 2012)
2.00 1.50 1 50 1.00
0.848 2.095 1.864 1.66

The JBG market is very substantial in size (larger

than the US Treasury market at YE 2011 FX rates)

JGB maturities extend out to 40yrs, with average

remaining years to maturity of close to 7 years

JGB yields have been at generally low levels since

the mid 1990s
0.10 0.098 0.228

0.50

Currently the 5yr yield is close to all-time lows on

10Y 20Y 40Y 30Y

3M

1Y

5Y

the back of aggressive buying by local banks Composition of JGB Holders

Households 4% Foreigners 7% Others 4%

Source: Bloomberg

JGB Distribution by Tenor Bucket

20yrs - 30yrs 5% 10yr - 20yrs y y 14% > 30yrs 1%

< 3yrs 38%

5yr - 10yrs 25%

Average A remaining years to maturity: 6yrs 11mths

BOJ 9% Public Pensions 9%

Banks 41%

3yrs - 5yrs 17%

Source (both pie charts): Japan MOF, Quarterly JGB Newsletter, April 2012, BAML Data is for YE 2011

Insurers & Private Pensions 26%

Example of JGB Holders: Banks

JGB holdings of the four big mega banks have more then doubled post-Lehman
JPY 40trn JPY 113trn

Bank investment activity is concentrated in the medium term sector of the curve (90% of holdings
are 1 t 5yr t 1yr to 5 tenor) and th i extensive b i h d ) d their t i buying has depressed yield l d i ld levels i th t segment l in that t

"City Banks are evolving into JGB funds" (BAML Research)

JGB Holdings (Banks' Account) JPY trn
180 160 140 120 100 80 60 40 20 0

JGB holdings of city banks by maturity p y y profile ( (Ratio of holding) g)

(%) 100 90 80 70 60 50 40 30 20 10 0 (tn) 120 100 80
1-5y 1 5y r 10y r<

5-10y r

60 40 20 3/20 003 3/20 004 3/20 005 3/20 006 9/20 006 3/20 007 9/20 007 3/20 008 9/20 008 3/20 009 9/20 009 3/20 010 9/20 010 3/20 011 9/20 011 3/20 012
<1y r

2008 8

2009 9

2010 0

1999 9

2000 0

2 2002

2003 3

2004 4

2005 5

2006 6

2007 7

2001

2 2012

2011

tn

JGB Holding (rhs) ( )

Source: BoJ, BofAML Global Research Global Research

Source: Companies, BofAML Global Research

Example of JGB Holders: Japan Post

The worlds largest JGB investor with 203.5tln of holdings through the Japan Post Bank and
Japan Post Insurance portfolios

Likely to remain a core JGB investor, by rolling over the huge investments that mature each year H However, unlikely to be major buyer of new cash JGBs given slowing inflows of new f d and lik l t b j b f h JGB i l i i fl f funds d
pressures to diversify into other assets JGB holdings trend: Banks vs Japan Post
Banks Japan Post

( tn ) 250 200 150 100 50 0

Japan P t S J Post Securities Portfolios iti P tf li

Yucho Bank (Japan Post Bank) 9/2011 JGB Municipal CB Stock Others (tn ) 141.6 5.7 12.9 0.0 0.0 160.3 Kampo (Japan Post Insurance) 9/2011 JGB Municipal CB Stock Others Total (tn) 61.9 7.0 6.2 0.0 0.7 75.8

3/2003 3/2005

3/2007 3/2009

3/1981

3/1983 3/1985

3/1987 3/1989

3/1991

3/1993 3/1995

3/1997 3/1999

3/2001

3/2011

Total

Note: Banks include domestic banks, foreign banks in Japan, Norinchukin, Financial institutions for small businesses. For FY07 & FY08 excluding Japan Post Holdings. Japan Post Holdings represents Yucho Bank and Kampo Source: BoJ, Japan Post Holdings, BofA ML Global Research

Source: Japan Post Holdings, BofA ML Global Research

Example of JGB Holders: Life Insurers

Lifers have spent the last decade moving away from domestic equities and reallocating to fixed
income and foreign assets

They have also aggressively shifted to longer tenor investments, due to:
Yi ld requirements driven b hi t i guaranteed crediting rates ( ki t pick up hi h llong-end yields) Yield i t di by historic t d diti t (seeking to i k higher d i ld ) ALM requirements both from economic and regulatory perspective (new solvency regulations)

Going forward lifers are expected to continue accumulating long end JGB holdings
Life Insurer JGB holdings by maturity
(%) 100 80 60 40 20 0 3/200 01 3/200 02 9/200 02 3/200 03 9/200 03 3/200 04 9/200 04 3/200 05 9/200 05 3/200 06 9/200 06 3/200 07 9/200 07 3/200 08 9/200 08 3/200 09 9/200 09 3/201 10 9/201 10 3/201 11 9/201 11 (tn) 55 50 45 40 35 30 25 20 1 3y 1-3y r 3-5y r 5-7y r 10y r<
9 8 7 6 5 4 3 2 1 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Bloomberg, The Life Insurance Association of Japan, BofA ML Global Research

Guaranteed yield for new p y policies vs 10yr JGB yield

(%) Guranteed y ield (for new policy ) 10y r JGB y ield

7-10y r

Source: Company Disclosure

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JPY Corporate Bond Market Overview

The JPY Corporate Bond market is relatively small compared to the size of the JGB market
(approximately 11% of outstanding JGB notational), or around JPY 87trn Of this, around 10% is in Samurai bonds

Average rating is 'A' with an effective duration of 4yrs Option-adjusted spreads in the JPY corporate bond market are much lower than for instance in
the US corporate bond market JPY Corporate Market: OptionAdjusted Spread by Ratings Bucket
800 BBB Rated 600 A Rated AA Rated 400 400 800 BBB Rated

USD Corporate Bond Market: OptionAdjusted Spread by Ratings Bucket

Tepco

600

A Rated AA Rated

200

200

Source (both charts): BAML Global Index System:

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JPY FX and Interest Rate Derivative Market Overview

Japan has a deep OTC derivatives market where the major players are 18 local "reporting
dealers" including the mega-banks and leading securities houses (accounting for 2/3 of OTC IRS and FX notional)

There is also an active exchange traded JGB bond futures market on the Tokyo Stock Exchange exchange-traded
trading 5yr and 10yr JGB futures as well as options on the 5yr and 10yr JGB futures

Japa OTC a et Japan O C Market: FX & IR Derivative Notionals (YE 2011) (Total Notional USD 52trn)
FX Forwards 6% FRAs 5% IR Options Other 3% JPY IR Options 8% JPY IR Swaps 42% CCS 3% FX Options 2%

Japan Exchange-Traded Market: g FX & IR Derivative Notionals (YE 2011) (Total Notional USD 3.1trn)
IR Options 13%

IR Futures 87% IR Swaps Other

31%

Source (both charts) : Bank of Japan Regular Derivatives Market Statistics in Japan, YE 2011

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JPY IRS Market

Current JPY IRS Yield Curve
2.00 1.782 1.75 1.50 1.25 1.00 0.75 0.50 0.25 0 25 0.143 0.552 0.407 0.855 1.295

The JPY IRS market is very liquid up to the 10y sector

Can absorb DV01 of 100k-250k without significantly moving the market

T h i ll th market extents out to 40yr, but due t Technically the k t t t t t 40 b t d to

clearing regulations with the London Clearing House only 30y swaps are cleared, and hence liquidity is quite thin beyond 30yrs

H d f d and f i accounts th t h Hedge funds d foreign t that have a b i h bearish

views of Japan tend to be better payers (either outright in 5y+ or via steepeners in the back end of the curve)
20000 16000 12000

JPY Swap Spread vs NKY Index

60 40 20 0 -20 -40
JPY 30yr Swap Spread y p p JPY 10yr Swap Spread JPY 5yr Swap Spread
0

NKY Index (LHS)

Equity exotics accounts are active in the long end of

the curve (typically in the 15 20y sectors) and look to 15-20y receive when the Nikkei sells off and pay when Nikkei rallies
The bottom chart illustrates how the 30yr JPY swap spread g turns negative when NKY sells off

8000 4000

Source (both charts) : Bloomberg

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JPY Swaption Market

Active OTC JPY swaption market 80% of market activity is inter-dealer. Key market participants are hedge funds, megabanks and
insurers

Market is very liquid up to 10yr x 10yr Longest liquid tenor is 10 x 20yrs Longer swaption tenors are possible at a price but not frequently seen in the market
key constraining factor is the lack of long-dated swaps

In the last three years there has been the emergence of a new client class of swaption buyer,
namely global tail risk funds seeking buying out of the money payer swaptions These are typically struck at 3% to 3 5% e g quite far out of the money 3.5%, e.g.
Bloomberg News: Ex-Soros Adviser Fujimaki Says Japan May Default by 2017 Japan is likely to default before Europe does, which could be in the next five years, the president of Fujimaki Japan, an investment advising company in Tokyo, said in an interview yesterday. [ ...] Should the Japanese government default the yen may weaken to 400-500 per dollar and the default, dollar, yields on benchmark 10-year bonds could surge above 80 percent, according to Fujimaki."
Source : Bloomberg News 2012-06-15 05:19:55.675 GMT

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Japan Equity Market

Total Market of JPY 255trn with 2,279 listed companies (Tokyo Stock Exchange) and 11 foreign
companies

Total market capitalisation has declined substantially over the last 10 years given the weak
q y performance equity market p

More than a quarter of the market is held by foreign investors. Another prominent investor group
is "other business corporations" - indicating the still substantial amount of cross-holdings in the market TOPIX Index Market Cap over Time
500

Ownership of Equities
Other FIs 7.2 Individuals, 20.3%

400

Trust banks 18.2

300 200

Insurance 6.4 Foreigners 26.7 Business Corporations 21.2

100

Source : Bloomberg

Source : TSE Fact book 2012

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Equity Index Option Market - Overview

Active OTC NKY index option market (with one of better daily option turnovers in Asia, albeit
dwarfed by the KOSPI 2 options market)

Very liquid out to 5 yrs (June 17 expiry) Market generally trades up to 8yrs to 10yrs (longer tenors are visible some times but can be
difficult to execute) Reportedly the Osaka Stock Exchange is planning the introduction of a new exchange traded contract with Dec 2021 expiry
Average Daily Option Turnover (USD bn)
70 60 50 500
700 600

Average Daily Open Interest (USD bn)

NKY HSI AS51 TWSE KOSPI2 (RHS)

HSCEI NIFTY

400
500

(USD bn)

(USD Mn)

40 30 20 10 -

300 200 100

(USD bn)

400 300 200 100 -

NKY HSI AS51 TWSE KOSPI2 (RHS)

HSCEI NIFTY

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-00

Jan-01

Jan-02

Jan-03

Source (both charts) : BAML Equity Derivatives Research and Bloomberg

Jan-04

Jan-12

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Summary Considerations

Looking at the Japan capital market with "Equity-based Guarantee" goggles ...
... the Japan market has ... p

.... so much too offer!

Very liquid long-dated Swap and Swaption market .... plus an active equity index option market with a
new long-dated exchange traded index option contract coming soon

... and yet so little ...

YIELD
10yr JGB yield @ 85bp

... and not too forget:

Consumers with substantial retirement savings needs ... that are underinvested in total return assets ... and overinvested in low-yielding bank deposits ....

The Challenge:
How to make new VA products work with such low risk-free rates? i kf t ?

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