Uridashi

What is Uridashi

Uridashi bonds are financial instruments that give Japanese retail investors access to foreign currency-denominated bonds. Specifically, a Uridashi bond refers to a secondary offering of bonds outside Japan. These bonds can be denominated in Japanese yen or issued in a foreign currency, catering to the preferences of Japanese investors seeking exposure to different capital markets and currencies. One of the key features of Uridashi bonds is their focus on attracting retail investors from Japan's domestic market.

Understanding Uridashi

Uridashi bonds represent a distinct avenue within the realm of fixed-income investments tailored for Japanese retail investors seeking exposure beyond their domestic market. These bonds, issued outside Japan, offer investors the opportunity to diversify their portfolios by investing in instruments denominated in foreign currencies or even in Japanese yen. The primary appeal of Uridashi bonds lies in their potential to yield higher returns compared to domestic investments, primarily due to the historically low interest rates prevalent in Japan.

Typically, Uridashi bonds are issued in high-yielding currencies, such as the New Zealand Dollar or the Australian Dollar. By investing in these bonds, Japanese investors aim to capitalize on the interest rate differentials between the foreign currency and the Japanese yen. This strategy allows investors to potentially earn higher interest income compared to what they would receive from investing in Japanese yen-denominated bonds.

However, it's important to note that investing in Uridashi bonds involves certain risks. Apart from the credit risk associated with the bond issuer, investors also face currency risk. This risk arises from the need to exchange the foreign currency-denominated coupon payments into Japanese yen. Additionally, if investors decide to sell their Uridashi bonds, they would need to exchange the proceeds from the sale back into Japanese yen, exposing them to potential fluctuations in exchange rates.

Moreover, some Uridashi bonds are linked to foreign currencies or equity indices like the Nikkei. This linkage introduces another layer of complexity and risk, as the performance of these underlying assets can impact the returns generated by the bonds.

Features

• Jurisdiction and Documentation. Documentation for the initial release of Uridashi bonds is typically governed by non-Japanese law, which implies that the legal framework surrounding the issuance is based on the laws of the jurisdiction where the bonds are issued. This contrasts with domestic bonds in Japan, which are typically governed by Japanese law.

• Lack of Japanese Legal Advisor. Unlike bonds issued within Japan, Uridashi bonds usually do not involve the assignment of a Japanese legal advisor to the release organizers.

• Absence of Paying Agent in Japan. Another distinguishing feature of Uridashi bonds is the absence of a paying agent appointed in Japan. A paying agent is responsible for distributing interest payments and managing other administrative tasks related to bond payments. In the case of Uridashi bonds, the lack of a paying agent in Japan underscores the reliance on payment infrastructure outside of Japan's financial system.

Uridashi vs. Shogun

1. Uridashi Bonds. Uridashi bonds are typically secondary offerings of bonds outside Japan, targeting a Japanese retail investor. These bonds can be denominated in Japanese yen or issued in a foreign currency. The primary goal of Uridashi bonds is to offer Japanese investors access to high-yield currencies and financial markets, thereby potentially earning higher returns compared to domestic investments.

2. Shogun Bonds. Shogun bonds, on the other hand, are foreign currency-denominated bonds issued and sold in the Japanese market, specifically designed to provide Japanese individual investors with a local financial instrument for investing in foreign currency-denominated bonds. Shogun bonds are primarily targeted at institutional investors and are aimed at facilitating their access to foreign currency investments within the Japanese market.

Uridashi during the 2008 financial crisis

During the 2008 financial crisis, Uridashi bonds and other foreign currency bonds faced scrutiny in Japan, as they were perceived to have played a role in exacerbating the crisis. Despite a decline in bond issuances from $15 billion in 2006 to $9 billion in 2007, Uridashi bond issuances surged to over $15 billion in 2008, signaling a final surge before the crisis hit. However, the collapse of Lehman Brothers marked a turning point.

One significant risk for issuers of Power Reverse Dual Currency (PRDC) bonds, a type of Uridashi bond, is the embedded short put option. These bonds do not pay coupons if the forward rate of the linked currency pair falls below a certain strike price, typically set at around 30% below the market level at issuance. As the yen depreciated gradually from 2001 to 2008, these strike prices increased, leaving issuers short on put options that were becoming increasingly out of the money.

Moreover, the illiquidity of the foreign exchange implied volatility market for tenors longer than 10 years made it expensive to hedge low-delta puts in 20-year FX options. Consequently, dealers, or bond issuers, often left this short risk unhedged. The aftermath of Lehman Brothers' collapse revealed the hidden risks of PRDC bonds, as dealers faced the realization that the tail risk associated with these bonds was a looming threat waiting to materialize.

Example

An example of a Uridashi bond could be a Toyota bond denominated in Australian dollars (AUD) and issued by a Japanese financial institution targeting retail investors in Japan. The bond has a maturity date of 5 years and offers a higher yield compared to domestic Japanese bonds.

Other Uridashi bonds might be structured to provide higher interest income by incorporating a Power Reverse Dual Currency (PRDC) feature, which allows investors to receive coupons in AUD as long as the exchange rate remains above a certain level against the Japanese yen (JPY).

Retail investors in Japan, seeking higher yields and diversification beyond the domestic market, could purchase this Uridashi bond through platforms provided by financial institutions. The bond's principal and interest payments would be paid out in AUD, with investors exposed to downside risk if the AUD/JPY exchange rate falls below the predefined level.