(Bloomberg) -- Fidelity International is buying the world’s worst-performing bonds and using currency hedging to make the trade profitable. 

The investing giant is taking advantage of the low-yielding yen by financing the purchase of Japanese bonds with dollars and then hedging the US currency. This can yield almost 6% on two-year government notes. The strategy, which has been active since the start of the year, focuses on tenors maturing in three years or less.

“You get paid to not take the foreign-exchange risk,” Lei Zhu, head of Asian fixed income, said in an interview. “Given it’s a hiking cycle we are mostly at the front-end but we are also not expecting a huge hike in the Japan fixed-income space,” she added.

As speculation swirls that the Bank of Japan may raise rates again to hinder further weakening in the yen, the yield gap between the US and Japan remains wide especially for shorter notes, which makes the carry trade more appealing. 

Fidelity had $817 billion of assets under management as of the end of March. Its strategy exploits a 5.25 percentage point divide in the policy rates between the US and Japan. 

Investors who would like to hedge against possible further depreciation in the yen typically enter a so-called foreign-exchange swap. They sell dollars in the spot market to finance their purchase of Japanese debt and simultaneously sell yen against the dollar via forward contracts. A three-month swap offers an annualized return of more than 5% should the yen remain stable, data compiled by Bloomberg show.

The future of the trading strategy hinges on how quickly Japan’s super-easy monetary policy will be dialed back and how much further yields may rise. Swap markets are pricing in an increase of about 30 basis points in the BOJ’s policy rate by year-end. The next policy meeting is on June 13-14. 

Fidelity expects Japanese policymakers to take a “cautious and conservative” stance on the pace of hikes, depending on the inflation impact and the global monetary environment. That stands in contrast to more hawkish bets from fund titans Pacific Investment Management Co. and Vanguard Group Inc. which are underweight and short Japanese government notes. 

The latter don’t appear to be alone. “My conversations with global investors have led me to believe that the most concentrated convicted alpha position in global portfolios is underweight duration here in Japan,” Matthew Hornbach, global head of macro strategy at Morgan Stanley, said at a conference in Tokyo on Thursday. 

Japanese government bonds lost 1.1% this month, making them the worst performers among major markets, according to data compiled by Bloomberg.

Fidelity’s Zhu sees the hedged currency theme playing out across other strategies for high quality bonds of lower-yielding Asian nations such as China and Singapore. 

“The trade will continue on because they are relatively attractive on the adjusted return basis and it makes sense as it fits into the diversification and safety categories we are looking at,” she said.

--With assistance from Ronojoy Mazumdar and Hideyuki Sano.

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