In the research for my previous piece on Piero Sraffa's investments in Imperial Japanese Government Bonds, I happened upon an extremely interesting sterling loan issued by the Imperial Japanese Government in 1930. Sraffa only briefly owned these bonds, and so, regrettably, details of the 1930 loan were relegated to an appendix.

Below, I revise and expand this appendix so as to give a more complete treatment to this particular loan.

The 1930 loan was issued on the first of May 1930 by the Imperial Japanese Government in London with a maturity of 35 years and a semi-annual coupon of 5.5% per annum. The loan was issued under British law, was denominated in British pounds and traded on the London Stock Exchange with price quotations readily available in the media of the day.

The loan was issued with a currency option that allowed the owner to take their coupons and principal in either GBP or USD. Intriguingly, the rate of exchange on this option was fixed and so, if the pound weakened subsequent to issuance, this option would become valuable; opening up the possibility of a currency arbitrage and protecting the holder from a depreciation of the pound vis a vis the dollar.

Post issuance, the loan traded poorly, settling first around 80 to 90 on par before beginning to slide in 1935. In 1941, when Japan formally defaulted on its sterling debt, the loan collapsed, finding its nadir in the early 1940s at a mid single digit percent of par.

Japan serviced the loan right up until July 1941, which was when coupon #22 was paid. Coupon #23, due January 1942 was the first defaulted coupon.

Service would not resume until January 1953, at which time the loan had cumulative defaulted coupons of £60.5. As part of the settlement of pre-war debts, maturity of the loan was restructured and extended by fifteen years.

When servicing resumed, the loan paid two coupons per semi annual period (one current and one historical) in order to slowly amortise the backlog of defaulted coupons. This had the practical effect of doubling the coupon on the bond from January 1953 through July 1962 from 5.5% of par to 11% of par (in GBP terms).

When issued, the 1930 loan allowed for the election of payment of coupons and principal in GBP or USD at a fixed exchange rate of 4.865 USD per GBP. We can see from the below chart that this was the prevailing exchange rate at issuance. However, the pound subsequently weakened dramatically against the dollar. Such that, by the early 1950s, the rate had fallen to 2.80 USD per GBP.

Here lay the arbitrage.

The buyer could elect to take their reinstated coupons and principal in USD at the old rate (4.865 USD per GBP or 0.206 GBP per USD), and then convert them back to pounds at the new rate (2.80 USD per GBP or 0.357 GBP per USD).

In essence, turning 0.206 GBP into 0.357 GBP, a gain of 73.75%.

£1 -> $4.865 - ( 1 * 4.865)

$4.865 -> £1.74 - (4.865 * 0.357 OR 4.865 / 2.80)

Of course, this arbitrage was available only if the loan was honoured, and if the currency option was honoured. It didn't become clear that this would be the case until November 1952.

If the reader studies the chart of the 1930 loan, she finds that unlike the other Imperial Japanese Government issues, this bond in particular traded for far more than its GBP face value. This is because the market was alive to the embedded arbitrage and priced the loan correctly at +/- 175% of GBP face value.

I modelled this arbitrage in two ways: In the first, I simply allowed the arbitraged coupons to accumulate in cash (dark green line = dark blue line + light blue line), and in the second, I reinvest the arbitraged coupons back into more of the underlying loan (dark red line) at prevailing market prices.

I did the same exercise assuming no arbitrage (yellow line and light green line) and also calculated the cumulative cash coupons received both without (orange line) and with (light blue line) the currency arbitrage.

What do we learn from the above chart? Assuming arbitrage and reinvestment of coupons with no frictions and no taxes, we start with a May 1946 price of ~ £15 and end with a December 1960 total value of ~ £415. An MOIC of 27.6x, or ~ 25.5% per annum over 14.6 years.

For references and preferred reference style, please see the prior piece.


29/4/24. Corrected the total defaulted coupons at resumption of servicing from £24.75 to £60.5. The former value is the balance as of the end of 1945.