By Junko Fujita and Tom Westbrook

TOKYO/SINGAPORE- Japan’s $9 trillion bond market is bracing for disruption as a shortage of paper caused by the central bank’s massive buying is expected to hit the settlement of derivatives used by investors and the dealers who underwrite the nation’s debt sales.

Decades of fighting deflation drove the Bank of Japan (BOJ) into asset purchases and made it the majority owner of the country’s national debt, with a balance sheet bigger than the $4 trillion economy and five times the size of the US Federal Reserve’s, relative to gross domestic product.

That has kept yields down and made the Japanese market unattractive to investors, leaving its bonds illiquid and unreliable as a benchmark for interest rates.

Now as the BOJ pares back its balance sheet towards a normalization of markets, the long-awaited revival of trading in the debt pool is proving a slow and bumpy process.

A test looms in the futures market from December when 10-year contracts will be linked to the government bond #366 tranche that is 95 percent owned by the BOJ.

Participants say the bond’s scarcity in the open market will interfere with buying the so-called ‘cheapest-to-deliver’ bonds to settle derivatives contracts at maturity, crucial for the market to trade smoothly and price with precision.

“The lack of the cheapest-to-deliver bonds makes it hard for investors to hedge risks for rising rates,” said Keisuke Tsuruta, senior fixed income strategist at Mitsubishi UFJ Morgan Stanley Securities. “This makes overall trading difficult.”

Tsuruta said this will affect not just trade and speculation but also government bond auctions, since primary dealers who bid at these auctions mostly use futures to offset their exposure.

With the BOJ having embarked on a rate hike path, investors are also seeking the cheapest bonds to settle short positions in futures, and distortions in the derivatives market would hurt them. – Reuters