Two of Japan's largest financial institutions have announced plans to increase their holdings of Japanese Government Bonds (JGBs), even as unrealized losses on their existing bond portfolios continue to grow. The banks anticipate that rising interest rates will ultimately lead to higher returns.

Mitsubishi UFJ Financial Group and Sumitomo Mitsui Financial Group have been steadily reducing their JGB exposure over the past decade. This strategy was adopted in response to the Bank of Japan's ultra-low interest rate policy, which made government bond returns unattractive.

This trend now appears poised for a reversal.

Driven by the spending plans of Japanese Prime Minister, JGB yields have climbed significantly since November, negatively impacting bond valuations. However, markets have shown some stabilization in recent weeks. Demand has remained robust during the last four government bond auctions, and the yield on the 30-year JGB has retreated by 32 basis points from its historical peak of 3.88% recorded on January 20.

Takayuki Hara, a Managing Director in the CFO office at Mitsubishi UFJ Financial Group, stated at a press conference on Wednesday, "With signs that long-term interest rates are peaking, we will cautiously rebuild our Japanese government bond holdings."

The increase in JGB holdings is expected to be gradual.

Japan's largest bank, Mitsubishi UFJ Financial Group, reported unrealized losses on its bond portfolio of 200 billion yen ($1.3 billion) at year-end, a substantial increase from 40 billion yen at the end of March. The group indicated that it had sold long-term bonds between September and December of last year, avoiding even larger losses.

Rising yields decrease the market value of bonds purchased during periods of lower yields, resulting in these paper losses.

Sumitomo Mitsui Financial Group, Japan's second-largest bank, shares a similar outlook with its competitor.

A spokesperson for the bank said during an earnings briefing last week, "The rise in interest rates has caused some valuation losses on our yen-denominated bond holdings. However, considering the market outlook, we plan to gradually increase our Japanese government bond holdings."

Sumitomo Mitsui Financial Group's unrealized losses on JGBs more than doubled to 98 billion yen during the nine-month period ending in December.

In recent years, Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group, and Japan's third-largest bank, Mizuho Financial Group, have consistently favored short-term bonds. The average remaining maturity of Mizuho's JGB holdings was only 1.8 years as of the end of December.

Increasing JGB holdings may contribute to future profit growth momentum.

Some investors and analysts believe that the major Japanese banks may not immediately make large-scale purchases of long-term bonds. This caution stems from expectations of further interest rate hikes by the Bank of Japan and ongoing market concerns about Japan's substantial public debt burden.

Polls suggest the Prime Minister is likely to secure a majority in Sunday's general election, which could strengthen the impetus for her expansive fiscal policies. This development has the potential to push yields even higher.

Toshinobu Chiba, a fund manager at Simplex Asset Management, commented, "I think the Japanese government bond yield curve will continue to shift upward, and the 10-year yield could reach 2.5%." He added that this level might serve as an entry point for banks to begin increasing their bond purchases more significantly.

The current yield on the 10-year Japanese Government Bond is 2.195%.

The Bank of Japan implemented its first rate hike in 17 years in March 2024 and has since raised rates three more times, bringing its key policy rate to 0.75%.

This shift has led all three major banks to forecast record profits for the current fiscal year. The Topix Banks Index has also surged dramatically, doubling in value since the initial rate hike in March 2024, significantly outperforming the 33% gain of the broader Topix index.

Analysts suggest that profitability momentum for the banks could be bolstered over the coming years as they increase their holdings of longer-term JGBs amid a higher yield environment.

Goldman Sachs analyst Makoto Kuroda last week raised profit forecasts for the three banks for the fiscal year ending March 2028. The revisions reflect the impact of the Bank of Japan's most recent rate hike in December, the rise in JGB yields, and the depreciation of the yen.

Net profit forecasts for Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group, and Mizuho Financial Group were raised by 20%, 11%, and 21%, respectively.