In the last fiscal year, Yamaguchi Financial Group Inc. recorded a $400 million loss from selling Japanese government bonds. At the time, the group believed it had completed its "cleanup" years ahead of schedule, but as it turns out, that was far from sufficient.

Chief Executive Officer Keisuke Mukunashi said the group now plans to further reduce its Japanese government bond holdings within a 2.04 trillion yen ($13 billion) securities portfolio, driven by a faster-than-expected pace of rate hikes from the Bank of Japan. "We had compressed a five-year stop-loss plan into a single year," Mukunashi said in an interview in Shimonoseki, the group's headquarters at the western tip of Japan's main island of Honshu. "But the market moves have been so rapid that our earlier actions alone are no longer enough to keep pace."

As the BOJ attempts to curb inflation in an economy long marked by deflation, surging bond yields are putting immense pressure on banks and investors alike. Mukunashi expects the central bank to raise rates this month—a move now widely anticipated by markets—and may hike again by the end of March next year. On Tuesday, the benchmark 10-year JGB yield touched the 3% level for the first time in three decades, sparking a massive bond selloff and widening unrealized losses across the banking sector.

While banks can sidestep actual losses by holding bonds to maturity, doing so means forfeiting the chance to rotate funds into higher-yielding assets. Mukunashi said Yamaguchi Financial will sell domestic bonds with unrealized losses and shift instead into short-term JGBs with maturities of five years or less, as short-term rates climb in tandem with the BOJ's ongoing tightening. As of the end of March this year, the group's three banks held roughly 1.34 trillion yen in JGBs and other local bonds within their combined securities portfolio. At the start of the current fiscal year, Yamaguchi Financial had planned to shorten the duration of its domestic bond portfolio—a measure of sensitivity to yield changes—by 0.6 years to 4.8 years. Mukunashi revealed the group now intends to compress duration further, with additional losses from bond disposals to be offset by gains on equity holdings.

Mukunashi views Japanese equities as a key inflation hedge. He said the group maintains a "slightly overweight" stance on stocks within its securities portfolio, primarily increasing exposure through exchange-traded funds (ETFs). Additionally, Mukunashi noted that Yamaguchi Financial is actively recruiting external talent, with two experienced professionals having joined its market team in the last fiscal year.

After years of ultra-low interest rates and weak credit demand, Japan's banking sector is now witnessing a recovery in lending, intensifying competition for deposits as a cheap and stable funding source. Meanwhile, as inflation erodes the purchasing power of cash, savers have stronger incentives to shop around for higher-yield deposit products or shift funds into investments. Ironically, JGBs themselves have emerged as a potential investment option. With the BOJ scaling back its unprecedented bond purchases, the Japanese government is exploring ways to attract household funds into the bond market.

"If policies such as tax breaks are introduced to make JGBs more appealing to individual investors, some rate-sensitive time deposits and idle household funds could flow into government bonds," Mukunashi said, noting that retail JGB sales at Yamaguchi Financial are on the rise. "This shift deserves close attention." He added that the group will not engage in a "price war" over deposit rates to attract funds, instead focusing on building "sticky" accounts—primary accounts used for daily transactions such as receiving salaries, pensions, and paying bills.

The group, which operates Yamaguchi Bank, Momiji Bank, and Kitakyushu Bank, holds total assets of approximately 13 trillion yen. Its shares have risen 53% so far this year, slightly outperforming the 50% gain in the Topix Banks Index. With consolidation accelerating in Japan's regional banking sector, speculation over the next wave of mergers is growing. Mukunashi did not rule out the possibility. "If the other party shares our goals and values, a merger could be an option," he said. "But it is only one option. Partners could also come from outside the banking industry."