Bankers have a proposition for Japanese investors: Why don't youput your money into bundles of junk-rated U.S. loans?

It'll be a classic win-win, as the thinking goes. For Japaneseinstitutions tired of decade after decade of paltry returns onJapanese government debt, they'll earn higher yields; and for theriskiest U.S. companies, they'll get access to a cheaper source offinancing. What could possibly go wrong?

To make it easier for Japanese investors to get to this U.S.debt, bankers have repackaged a dollar-denominated collateralizedloan obligation (CLO) into yen-denominated bonds, using derivativesto hedge out risk related to currency fluctuations.

The Repackaged CLO Series GG-A1 Ltd., for example, “consists ofa special-purpose entity that will issue Japanese yen-denominatednotes and is backed by the U.S. dollar-denominated notes” issued byKitty Hawk CLO 2015-1 LLC, according to a Standard & Poor'sMarch 24 pre-sale report.

Essentially, it transforms US$249 million worth of a $331million U.S. CLO managed by Guggenheim Partners InvestmentManagement into highly-rated Japanese-yen denominated bonds,according to an April 15 Moody's Investors Service report.

The transaction was arranged by Mitsubishi UFJ Financial GroupInc., which is also the counterparty on the currency swap thatmitigates the risk of losses from changes in the yen-dollarexchange rate.

Here's why this is happening now: Yields in Japan are ultralow—0.3 percent on 10-year notes—as the Bank of Japan (BOJ) employsrecord stimulus in its effort to end decades of economicstagnation, including increased bond purchases.

As the BOJ buys, pensions are selling. Japan's $1.2 trillionGovernment Pension Investment Fund, the world's largest, said onApril 2 it hired managers to help shift money from domestic debtinto stocks and foreign investments.

Yes, U.S. Treasuries remain an easy target for Japanesebuyers—the country just overtook China as the top foreign holder of U.S.government debt, a title it hadn't held since the financialcrisis—but many of the other typical global alternatives generallyaren't that appealing right now. The universe of negative-yieldingassets in Europe has expanded as the region's central bank pledgesto maintain its stimulus until it sees sufficient economicgrowth.

CLO Sales

“If you're sitting here in Japan, and you need an alternative toJGBs to pick up some return, where are you going to go?” DanielSmith, a senior managing director at Blackstone Group's GSO CapitalPartners unit, said in a February interview. “You can go toemerging markets, but those look quite risky to us, so by processof elimination, U.S. credit markets are a relatively easy and soberchoice.”

This helps in part explain the surging demand for U.S. CLOs,which slice pools of risky corporate loans into pieces of varyingrisk and return. Firms led by Blackstone's GSO unit issued amonthly record of $15 billion in CLO sales in March, surpassing theprevious high of $13.8 billion in June 2014, according to datacompiled by Bloomberg and JPMorgan Chase & Co.

About $35 billion of CLOs have been issued this year afterrecord sales of $124 billion in 2014, according to JPMorgan.

With U.S. corporate-default rates still low on a historicalbasis, the risk-reward equation seems to work for Japaneseborrowers. At least until the cycle turns.

– With assistance from Kristen Haunss in New York and FinbarrFlynn, Chikako Mogi, and Shigeki Nozawa in Tokyo

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