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Japan Navigator No.565
RATES

Global Markets Research
This is a direct translation of the original Japanese report issued on 11 April and reflects data as of that date. 14 April 2014

Research analysts

1: Near-term market environment and investment strategy
JGB curve is unlikely to flatten materially further on US factors alone Next week the focus will be on the 5yr and 20yr JGB auctions. As there will be few other domestic factors, the market will remain susceptible to external factors. However, we do not think US factors alone can bring the risk-off driven flattening further. The key will be whether investors revise down their outlook for economies other than the US based on their view for unexpectedly weak US growth and hawkish Fed, in which case they should reduce risk positions in these markets. This week, risk-off momentum strengthened more than expected. 10yr UST rates have declined to levels signalling that a rate hike, as communicated by the Fed, would be premature, and are also approaching to levels that even reject QE3 tapering. (We note that 10yr rates traded around 2.50% when former Fed Chair Bernanke began talking about a QE exit.) These levels were tested in October 2013, but data do not look as poor as to suggest momentum has slowed to levels equivalent to that period. Even US shares, despite the current adjustment, are trading about 10% higher than in October 2013. We surmise that the issues that the US is currently facing are not cyclical, but rather structural (see below). For this reason, we believe any surprises in terms of a rates market rally could come from emerging economies, which are dependent on US growth, or in Japan and Europe, whose monetary policy rest on a strong USD. Indeed, China‟s export data released this week surprised on the downside, and EUR approached highs for the year. In Japan, while JPY has not strengthened materially due to real-demand selling, stemming from large trade deficits and foreign direct investments, the stock market is approaching the year‟s low. Considering the strength of risk-off momentum this week, we believe JGBs could have rallied more than they did. However, the market remained subdued likely because of concerns over supply and demand in the super-long zone. Although these concerns apparently have played out this week, we believe investors are unlikely to go long shortterm positions yet. This is because JPY is slow to strengthen and the BOJ continues to communicate the market in such a way as to disappoint near-term easing expectations, in our view. We expect these conditions to remain in place next week. In this environment, only the stock market could weaken further. To this, we believe the government is more likely to feel the need to take any action than the BOJ, and thus could begin discussing a policy response. The ECB, which appears more willing to take easing action than the BOJ, could communicate to the market in such a way as to keep EUR from strengthening. In this case, a weaker EUR should pressure the BOJ more into taking action, in our view. Based on the current supply and demand conditions and fundamentals, we believe the 20yr auction will come in at lower levels than in the previous auction (average of 1.527%). Although 20s are unlikely to rally on short-term flows, the lack of potential bearish factors means that some investors may value in the new issue for carry and roll, which is as high as those for the 7yr range.

Japan Rates Strategy
Naka Matsuzawa - NSC naka.matsuzawa@nomura.com +81 3 6703 3864

See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

Nomura | Japan Navigator No.565

14 April 2014

Fig. 1: JGB market indicators
(bp) 2 10 Apr yield curve (RHS) 1 0 Yrs -1 -2 -3 0.4 -4 -5 0.2 0.0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 1.2 1.0 0.65 0.8 0.60 0.6 0.55 0.50 1.6 1.4 0.85 0.80 0.75 0.70 (%) 1.8 (%) 0.90

Changes in JGB yields: 10 Apr - 4 Apr (LHS)

10yr JGB yield

20140228

20140310

20140314

20140331

20140404

20140304

20140306

20140312

20140318

20140320

20140325

20140327

20140402

20140408

(bp) JGB curve spread 2-5yr 9.6 10 Apr - 4 Apr Asset sw ap spread 2yr -10.5 10 Apr - 4 Apr
Source: Nomura Securities Co., Ltd.

5-10yr 43.9 (-1.5) 5yr -13.9 (0.9)

7-10yr 27.8 (1.1) 10yr -17.0 (0.8)

10-20yr 88.9 (2.5) 20yr -5.7 (2.8)

20-30yr 20.0 (1.4) 30yr -9.0 (3.8)

(-1.1)

(0.2)

20140410

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Decline in potential growth in global markets We believe the issues that the US is currently facing are structural rather than cyclical. Investors are increasingly asking whether the US economy‟s nominal potential growth rate, and thus the neutral policy rate, have declined (see Japan Navigator No. 563, 31 March). Originally, these concerns started in the US following the 2007 sub-prime shock. Before the crisis broke out, a prevailing view was that the US‟s real potential growth rate was near 3.0%. (The Fed‟s long-term forecast at that point was 2.5-2.6%.) Subsequently, these concerns took hold in Europe in 2010-2011 because of the euro area fiscal crisis, and then in China in 2011-12, causing a downward revision in growth and inflation forecasts for the global economy as a whole and destabilizing financial markets. Now this trend seems to have returned to the US. Currently, there are concerns that the real potential growth rate may be lower than the 2.2-2.3% expected by the Fed, or that it may not return to 2% under current Fed policy. Almost five years after its turnaround, US growth and inflation have not picked up. This has led to widespread concerns that the economy lacks underlying momentum, which is unlikely to be dispelled unless substantially strong data prints continue. For that matter, we believe a recovery in corporate capital spending would be necessary. In our view, overseas investors likely have lowered their expectations on Fed policy now, which apparently has led to their risk aversion. Based on this, we believe it would be crucial for the Fed to recover confidence by investors, which was apparently lost due to the failure of its forward guidance policy, while at the same time demonstrating that Ms. Yellen is in control of its policy. Japanese shares' price earnings are declining Japan has also been affected by potential growth concerns taking hold globally, with its financial markets having destabilized several times. However, its own potential growth rate has been affected little by this trend (Figure 2). This is because it led others in experiencing a decline in potential growth. However, to the extent that Japan‟s potential growth rate remains low, Japanese shares have been affected by the decline in global potential growth, with the price earnings ratio (PER) edging down gradually through 2012. The PER recovered to levels seen just before the 2008 Lehman bankruptcy due to the Abenomics boost, but is beginning to fall again now that expectations for Abenomics have played out and there is a risk of another downward correction in the global potential growth rate (Figure 3).

Fig. 2: Japan’s estimated potential growth rate
(%)

1.6
1.4 1.2 1.0 0.8 0.6 0.4

0.2
0.0 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Note: No estimate available in 2011 due to the impact of the natural disaster in March. Source: Cabinet Office

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Fig. 3: Japanese shares' price earnings
(PE) 35

30

25

20

15

10

5 2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Note: Based on FTSE data and forecast earnings after 12 months. Source: Nomura Securities Co., Ltd.

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Next week’s events
5yr JGB auction (15 April Overview: Look for carry and roll until BOJ easing is played out The BOJ is signalling little intention of easing policy further in the near term, easing expectations. Hence, we believe short-term buying is unlikely to pick up. Even if additional easing does become more realistic, yields are likely be resisted in the mid0.1% range unless rate cut expectations heighten, meaning that yields below 0.20% would not look attractive for short-term buyers, in our view. Judging by current fundamentals, we believe policy duration of near 4yrs lacks logical support. Despite this, we believe the front to intermediate part of the curve is likely to be supported by the BOJ‟s new lending facility, which allows banks to borrow at 0.1% for four-year terms, providing opportunities for carry trades in the JGB market. In terms of supply and demand, we do not expect many investors to shed intermediates materially until BOJ easing expectations play out. However, we expect selling to pick up once the Bank takes its next easing action, as investors are likely to become wary of a QQE exit and look to take profits. Auction backdrop: Decline in easing expectations has little effect The previous 14 March supply was well received. The average came in at 0.204%. Undisclosed takedowns, which reflect direct investor bidding, amounted to JPY515.9bn, or a low 19% (Figure 4). The takedown in the No. 2 non-competitive auction was 99%. 5s subsequently traded in a 0.185-0.20% range, closing at 0.19% on 10 April. The 2s5s curve traded in a 9-12bp range, closing at 10bp on 10 April. The 5s10s curve traded in a 43-45bp range and closed at 44bp on 10 April. The recent BOJ language has made near term easing action even more unlikely, but 5s apparently have barely been impacted, with yields trading in an extremely narrow range at slightly higher levels than in the previous auction.

Fig. 4: Ratio of undisclosed takedown in 5yr auctions

60% Average since 2012 50%

40%

30%

20%

10%

0% 12/01

12/04

12/07

12/10

13/01

13/04

13/07

13/10

14/01

Source: Quick, Nomura Securities Co., Ltd.

The main events since the previous auction were as follows: (5yr yields rose to 0.20% on 18 March.) 19 Mar Fed chair Yellen suggests that Fed could raise rates about six months after QE3 has been wrapped up. 8 April BOJ Governor Kuroda‟s spoke with unexpectedly hawkish language, disappointing easing expectations. (5yr yields fell to 0.185% on 9 April.) 9 April FOMC minutes were more dovish than expected, lowering rate hike concerns.

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Investor analysis: Recovery in investor demand in February Banks are the main investors in the 5yr. Since the QQE adoption, however, as 5yr rates have moved significantly lower, and with little likelihood of further BOJ easing, they appear to have continued to shed intermediates and adjust risk exposure using long and super-long JGBs and swaps. JSDA data suggest that, in reaction to the 4 April easing, city banks have been shedding intermediate JGBs (Figure 5). As net selling increased in July-September and December, we believe they may have sold yen bonds to compensate for losses on foreign bond investments. Conversely, their net selling was limited in January and February, when UST and JGBs both rallied. JSDA data do not reflect investor selling into BOJ operations and direct takedown in auctions, making it difficult to determine actual investor trends. Based on BOJ data, city banks shed JGB investments by JPY22.0trn in April-June (Figure 6). This suggests that they brought a substantial amount into BOJ operations, in addition to selling in the market. Subsequently, while they basically continued to shed JGB investments, their behaviour differed considerably depending on the month. They were large net sellers in January but became net buyers in February, albeit slightly. Judging from the amount of undisclosed takedowns, major banks‟ direct bidding was apparently subdued, but was relatively aggressive in February (Figure 4). Regional financial institutions are apparently slow in reducing investments (Figure 6). We think this is because they do not look to reduce JGB holdings via BOJ operations and they are not positioned well in taking on large investments in foreign bond markets (in terms of staff and repo lines). Some may look to shed JGB duration by shifting out from long-term JGBs into intermediates – as major banks did after the 2003 VaR shock – while others may be adding back duration while monitoring the market. Either of these flows could become more pronounced depending on market trends. Reflecting their contrarian stance, they were net sellers of long-term bonds for a total of JPY3.4trn and shifted into intermediates when the market rallied in June-September 2013 (Figure 5), but became net buyers of long-term JGBs in the selloff in OctoberDecember. They became net sellers again in January-February when the market rallied, but during this period their net buying of intermediates declined and they may have turned to securities other than JGBs.

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Fig. 5: Bond purchases by investor data: Banks
(JPYbn) City banks (including long-term credit banks) Super longterm FY08 FY09 FY10 FY11 FY12 2013 Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2014 Jan Feb -1,292 -111 -1,500 -385 -1,625 -156 -151 -183 -95 -109 -156 110 240 -71 -76 185 -237 Long-term -1,826 -3,448 147 -2,153 -555 2,792 -1,501 233 53 661 976 1,245 -2,008 -132 -188 516 1,478 Intermediateterm 5,749 15,613 11,298 2,350 -1,178 -1,853 -1,052 -860 -909 -1,440 -2,592 -1,938 -1,208 -750 -1,683 -670 -366 Non-JGBs -688 730 390 -686 -749 8 -94 -208 -64 -36 -146 32 -48 -22 -43 -139 13 Total 1,942 12,784 10,334 -874 -4,107 792 -2,797 -1,018 -1,014 -924 -1,918 -551 -3,024 -975 -1,991 -107 888 Super longterm 1,373 1,149 116 -1,359 -521 -434 228 -140 -151 -125 -269 -269 -253 -177 -102 -180 -249 Regional financial institutions Long-term 2,529 7,883 6,015 4,025 4,007 331 1,159 314 -185 -317 -702 -1,184 39 459 863 -402 -215 Intermediateterm 4,132 4,405 5,345 6,840 1,769 61 827 692 429 360 647 571 572 440 264 220 189 Non-JGBs 4,928 3,538 5,642 5,983 5,849 221 822 494 389 348 266 227 659 622 480 217 613 Total 12,962 16,976 17,118 15,489 11,104 178 3,037 1,360 482 266 -57 -655 1,017 1,345 1,505 -145 338

Source: JSDA

Fig. 6: City and regional banks JGB holdings
(JPYtrn) 120 110

City banks

Regional banks

100 90
80 70 60 50 12/01
Note: Data include Treasury bills Source: Add source here

12/07

13/01

13/07

14/01

Yield levels: Policy duration is range-bound at 4yr, i.e., 5yr rates near 0.20% The 5yr par yield closed at 0.18% on 10 April, down 1bp since the previous auction. This is below the median in the post-QQE range (Figure 7). 5yr rates traded mostly in the low 0.1% range (trading as low as 0.095% at one point) in March 2013, when there were expectations that the BOJ would lower the rate it pays on excess bank reserves. Yields traded as high as 0.245% at one point during the risk-on selloff into end-2013, and were near 0.25% just before the September 2013 FOMC. The BOJ increased its liquidity supply via a bolstered bank lending facility at the 17-18 February meeting. 5yr rates have remained below 0.20% since then, on the view that JGBs with remaining maturities of around 4yrs would benefit most from carry flows funded by the new lending program. Calculated from JGB forward rates, BOJ policy duration (expected length of time until the next BOJ rate hike) as factored in by the forward market was 3.8yrs on 10 April (Figure
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10). The BOJ set a two-year timeframe for achieving its inflation target, making the outlook of its policy after the two-year period uncertain. This led to the shortening of policy duration to the 2yr range at one point. Policy duration now has recovered to levels near 4.0yrs, moving in a narrow range around this level. It should be kept in mind that, when the BOJ took easing action in the past, policy duration has tended to become subsequently volatile. We note that the three-year policy duration is equivalent to 0.30% 5yr yields (right, Figure 10). If policy duration lengthens to four years, 5s could rally to 0.20%, but shortening to two years could bring yields as high as 0.55%.

Fig. 7: 5yr yield levels and relative value comparison
(%, bp) 5yr JGBs 10 April 2014 14 Mar (prev. 5yr auction) 1st QE period (19 Mar 2001 ~ 8 Mar 2006) Low High Median 2nd QE period (1 Dec 2009 ~) After Italian debt shock (12 Jul 2011 ~) QQE period (4 Apr 2013 ~) Low High Median Low High Median Low High Median Yield 0.18 0.19 0.16 1.11 0.53 0.10 0.65 0.33 0.10 0.44 0.22 0.13 0.44 0.22 2-5yr 10 11 13 73 45 6 42 20 6 29 12 6 29 11 5-7yr 16 16 9 50 35 10 35 24 10 32 22 10 32 20 5-10yr 44 45 28 101 81 32 84 63 32 72 58 32 58 45 5-20yr 133 134 61 164 144 101 165 146 101 165 142 101 147 134 ASW -14 -14 -20 9 -6 -28 -5 -15 -22 -8 -15 -22 -12 -16

Source: Nomura Securities Co., Ltd.

Fig. 8: 5yr JGB breakeven yields
10 Apr 14 0.0 0.0 0.0 0.184 End Jun 14 End Sep 14 End Dec 14 End Mar 15 0.6 1.4 2.2 2.9 0.8 1.8 2.9 3.9 1.4 3.2 5.1 6.8 0.198 0.215 0.234 0.252 End Jun15 3.5 5.0 8.6 0.269 End Sep15 4.3 6.1 10.4 0.288

Cushion (bp) Roll (bp) Cushion + roll (bp) Break-even 5yr JGB par yield (%)

Notes: The cushion in the table refers to the cushion against a rise in yields provided by carry income. Breakeven is calculated in comparison with Treasury bill rates for durations corresponding to each period, and thus reflects rate hike expectations. Source: Nomura Securities Co., Ltd.

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Fig. 9: 5yr JGB yields and OIS rates
(%) 0.7 [a] less [b] (RHS)
5yr JGB yields [a]

(%) 0.5

0.6

5yr JPY OIS [b]

0.4

0.5 0.3
0.4

0.2 0.3 0.1 0.2 0

0.1

0

-0.1

Source: Bloomberg

Fig. 10: BOJ policy duration and 5yr rates
6 1.2

5yr JGB yields less 6M Treasury bill rates (%)

BOJ QQE
5

1

BOJ comprehensive easing
BOJ policy duration (yrs)
4 VaR shock 3

0.8

0.6

2

0.4

1

0.2

0
2001/10 2002/03 2002/08 2003/01 2003/07 2003/12 2004/05 2004/10 2005/03 2005/08 2006/02 2006/07 2006/12 2007/05 2007/10 2008/03 2008/09 2009/02 2009/07 2009/12 2010/06 2010/11 2011/04 2011/09 2012/02 2012/07 2012/12 2013/06 2013/11

0 0 1 2 3 4 BOJ policy duration (yrs) 5 6

Notes: The time until the BOJ raises rates to 0.25% is estimated using forward rates on JGBs. The period during which there was no policy duration in effect (9 March 2006 – 30 November 2009) has been excluded from the data. In order to account for differences in policy rates, the spread between 6-month and 5yr rates are used in the vertical axis of the graph to the right. In the graph on the right, the red circle indicates the break-even yield on 6 March 2014. Source: Nomura Securities Co., Ltd.

Relative value: 5s became less undervalued to 10s The 2s5s spread was 10bp on 10 April, 1bp narrower since the previous auction. This makes 5s look expensive in the range since the 4 April BOJ easing. The 5s10s spread narrowed by 1bp to 44bp, making 5s look slightly cheap in the post-QQE range. Looking at OIS rates to exclude the impact of BOJ purchases, the 5-10yr spread was 37bp. Compared with the 44bp average since 2012, the 5yr looks cheap at current levels (Figure 11). The 5yr asset swap spread was -14bp, unchanged since the previous auction. This makes cash JGBs look cheap in the range since the QQE adoption. Carry and roll on 5yr asset swap positions is -1.4 over a six-month horizon.

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Fig. 11: 2-5yr and 5-10yr OIS spreads
(%) 0.6 2-5yr OIS spread 5-10yr OIS spread Average since Jan 2012 Average since Jan 2012

0.5

0.4

0.3

0.2

0.1

0

-0.1

Source: Bloomberg

Fig. 12: 5yr JGB-OIS spread and 5yr asset swap spread
(%)
0.3 (%)

5yr JGB rates - 5yr OIS (LHS)

5yr JGB rates - 5yr swaps (RHS)

0

0.25 -0.05 0.2 -0.1 0.15 0.1 0.05 -0.2 0
-0.25

-0.15

-0.05 -0.1 -0.3

Source: Bloomberg

20yr JGB auction (17 April) Overview: Yields should look attractive for short-term buying from 1.55% Considering that 20s attracted lifer buying below 1.60%, even during the risk-on driven JGB selloff into end-2013 (during which 20yr rates averaged 1.56%), it is unrealistic to expect yields of 1.6% or higher in the near term. Assuming that volatility remains subdued before the July BOJ meeting (or before the BOJ actually eases policy) and the low risk of 20s selling off to 1.6%, 20 yr yields should look attractive for short-term buying from 1.55%, taking carry and roll into account. The auction environment has improved compared with last month. The uncertainty over supply and demand in the super-long space (reduction in BOJ purchases, relaunch of super-long futures, and absorption of 30yr supply with increased issuance) has now been cleared. Globally, markets are apparently becoming risk-off again. Investors can take bull flattening positions on this, but short-term buying is unlikely to pick up unless the BOJ shows at least some inclination to take further easing action.

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Auction backdrop: Relationship with risk-on/off flow declines The 18 March auction was disappointing for a second consecutive month. The average came in at 1.527%. Undisclosed takedowns, which reflect direct investor bidding, amounted to JPY317.0bn, or a somewhat low 26% (Figure 13). The takedown in the No. 2 non-competitive auction was 12%. Yields subsequently traded in a 1.465-1.52% range, closing at 1.49% on 10 April. The 10s20s spread traded in an 87-90bp range, closing at 88bp on 10 April. 20s posted a low on the day after the auction, after which they have moved sideways despite strengthened risk-on flows that followed and the recent risk-aversion. It appears as if their relationship with other markets has fallen markedly, moving on their own supply and demand dynamism. 20yr swaps move more in line with risk-on/off flows. The main events since the previous auction were as follows: (20yr yields rose to 1.52% on 19 March.) 19 Mar Fed chair Yellen suggests that Fed could raise rates about six months after QE3 has been wrapped up. (20yr yields fall to 1.465% on 1 April.) 8 April BOJ Governor Kuroda‟s spoke with unexpectedly hawkish language, disappointing easing expectations. 9 April FOMC minutes were more dovish than expected, lowering rate hike concerns.

10 April 30yr supply was easily absorbed, with an average of 1.696%.

Fig. 13: Ratio of undisclosed takedown in 20yr auctions
70% 60% 50% 40% 30% 20% 10% 0% 12/01 Average since 2012

12/04

12/07

12/10

13/01

13/04

13/07

13/10

14/01

Source: Quick, Nomura Securities Co., Ltd.

Investor analysis: Lifers continue with regular purchases, slow to shift into foreign bonds Life insurers and pension funds as well as public financial institutions are the main investors in the 20yr. Although lifers have continued with regular purchases after the QQE adoption, the monthly average purchase in April 2013-February 2014 was JPY509.9bn, which is about 70% of FY12 (JPY744.4bn) (Figure 14). We attribute this to a decline in insurance premium revenues following the reduction of the standard guaranteed rate in April and because they focused more on foreign bonds during this period. After sharply increasing net purchases in December, life and non-life insurers‟ buying returned to levels in line with the FY13 average in January and February. With all of the super-long auctions since February having largely been disappointing, lifers do not seem to have bought more than their usual levels after rates fell in January, with 20yr yields trading at around 1.50%. Major lifers‟ H2 investment plans suggest that, on average, they expect 20yr JGB yields to trade in a 1.43%-1.83% range. Compared with this, they expect 10yr UST rates to
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trade in a 2.38-3.25% range, so we would not be surprised if they shift to foreign bonds. In reality, their foreign bond purchases have not picked up. Instead, they shed a net JPY107.2bn in Jan-Mar as UST rates fell (Figure 15). As the Fed is exiting QE3, the lifers may be looking at the risk of rate hikes. We note that lifers generally continue with regular purchases when the market is rallying, but tend to abstain when super-longs are selling off, as they are apparently aware that few others would absorb selling in this zone. Some pension funds may have revised investment plans in such a way as to increase riskier asset investments on Abenomics expectations. This, coupled with the GPIF‟s plans to sell a net JPY2.6trn in assets in FY13 and a net JPY2.4trn in FY14, may make pension funds cautious on JGB investments, as suggested by their increasing focus on intermediates when allocating new funds. Trust banks were relatively substantial net buyers of long-term and super-long JGBs in December-January and appear to have partly added back duration, but they shed risk again in February (Figure 14). At 7.6yrs, the median of the pension fund portfolio duration was substantially underweight relative to the bond index (7.66yrs) at end-March (Figure 16). Trust banks that shortened duration into the fiscal year-end may be looking to add back risk after the new fiscal year began. City banks are not consistent investors in the super-long zone, but rather trade for shortterm gains. To this extent, they could have a significant impact on auction results should they look to buy aggressively. City banks are required to buy new super-long issues as primary dealers (taking down 1%; not reflected on JSDA data), and tend to sell these bonds in the market after the auctions. As risk aversion took hold unexpectedly around the 20yr auction in late January, they began to add back super-longs and became net buyers of these bonds in January (Figure 5; not including direct takedowns). However, they became net sellers in February, and are unlikely to be actively involved in short-term activity, as suggested by disappointing super-long JGB auctions since February.

Fig. 14: Bond purchases by investor data: Life/non-life insurers and trust banks (pension funds)
(JPYbn) Life / non-life insurers Super longterm FY08 FY09 FY10 FY11 FY12 2013 Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2014 Jan Feb 5,705 5,783 10,248 10,591 8,933 927 57 655 481 654 507 628 227 494 882 560 464 Long-term -1,738 -136 -1,011 1,251 223 96 -263 43 4 -252 -61 -11 86 -110 93 13 -42 Intermediateterm 171 219 -74 742 94 -91 257 41 209 101 160 114 250 58 180 69 -11 Non-JGBs 1,124 1,539 870 945 648 91 190 64 119 125 99 162 114 138 91 81 117 Total 5,262 7,406 10,033 13,529 9,898 1,022 241 803 812 628 704 893 676 579 1,245 724 528 Trust banks (representing pension funds' purchases) Super longterm 4,479 6,262 3,629 3,021 5,153 1,118 419 266 390 124 281 420 309 184 138 75 304 Long-term 5,418 1,920 1,143 2,558 2,673 768 -263 -455 195 319 -264 472 315 -51 38 632 -221 Intermediateterm 3,266 4,378 250 3,546 4,011 1,166 1,205 1,447 1,026 419 641 561 291 457 328 136 825 Non-JGBs 1,437 4,227 2,475 138 1,183 158 265 -26 91 200 86 46 146 95 100 -6 2 Total 14,601 16,787 7,496 9,263 13,020 3,211 1,626 1,231 1,702 1,061 744 1,499 1,061 685 605 837 910

Source: JSDA

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Fig. 15: Life insurers’ foreign bond investments
(JPYbn) 1,500

Insurers shifted portfolios as the difference between yen and foreign interest rates widened.

1,000

500

0

-500

-1,000

2002

2005

2007

2010

2012

2013

2003

2004

2006

2008

2009

2011

Source: MOF

Fig. 16: Average pension fund duration vs. Nomura BPI duration
(Yrs) 0.3 0.2 0.1 0.0 -0.1 -0.2 -0.3

Median duration of pensions less NOMURA BPI

Mar-01

Mar-03

Mar-05

Mar-07

Mar-08

Mar-09

Mar-10

Mar-12

Note: Interview of about 35 pension funds at the end of every month. Source: Quick, Nomura Securities Co., Ltd.

Yield levels: Yields were supported at 1.59% in risk-on selloff into end-2013 The par yield was 1.51% on 10 April, down 2bp since the March auction. This is slightly below the median of the range since the BOJ‟s adoption of QQE. Yields traded as high as 1.59% in the risk-on selloff into end-2013, and traded in the high 1.6% range just before the 18 September FOMC announcement. Looking at OIS rates to eliminate the impact of BOJ purchases on supply and demand, we note that 20yr OIS rates were 1.26% on 10 April. 20yr OIS traded below 1.20% at the height of the European financial crisis in July 2012, and also for a few days after 4 April (Figure 19). They sold off to 1.60% on 22 May as the BOJ conceded a rise in long-term yields, heightening concerns over a QE3 exit. 20yr OIS rates have not remained consistently above 1.60% after the outbreak of the euro area crisis in 2011. Based on this, we expect 20yr OIS rates to trade in a 1.20-1.60% range in the near term. Major lifers expect 10yr JGB yields to trade in a 0.54-0.94% range in H2 FY13 (average of eight insurers). Adding in the median 10s20s spread since QQE (89bp), this would be equivalent to a 1.43-1.83% range for 20yr cash bond yields. 20s are most likely to react sensitively to global risk-on/off flows since they are less likely to be absorbed in BOJ operations (about one-third of new issuance) under the current

Mar-14

Mar-02

Mar-04

Mar-06

Mar-11

Mar-13

2014

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monetary policy and since super-long swaps are used in hedges on currency-structured notes.

Fig. 17: 20yr yield levels and relative value comparison
(%, bp) 20yr JGBs 10 April 2014 18 Mar (prev. 20yr auction) 1st QE period (19 Mar 2001 ~ 8 Mar 2006) After Lehman bankruptcy (16 Sep 2008 ~) 2nd QE period (1 Dec 2009~) After Italian debt woes (12 Jul 2011 ~) Low High Median High Low Median Low High Median Low High Median Low High Median
Source: Nomura Securities Co., Ltd.

Yield 1.51 1.53 0.78 2.47 1.98 1.20 2.23 1.80 1.20 2.18 1.76 1.20 1.90 1.69 1.20 1.78 1.55

5-20yr 133 135 61 164 144 95 165 144 101 165 146 101 165 142 101 147 134

10-20yr 89 90 28 73 60 52 103 80 64 103 82 64 103 86 64 96 89

20-30yr 20 18 10 50 33 6 27 15 6 27 15 9 27 18 9 20 13

JGB-swap -6 -4 -31 9 -10 -15 47 6 -15 19 4 -15 19 7 -15 2 -4

QQE period (4 Apr 2013)

Fig. 18: 20yr JGB breakeven yields
10 Apr 14 End Jun 14 End Sep 14 End Dec 14 End Mar 15 0 1.8 3.9 6.0 8.1 0 1.4 3.1 4.9 6.8 0 3.2 7.0 10.9 14.9 1.506 1.538 1.575 1.615 1.655 End Jun15 10.3 8.8 19.1 1.697 End Sep15 12.6 10.9 23.5 1.741

Cushion (bp) Roll (bp) Cushion + roll (bp) Break-even 20yr JGB par yield (%)

Notes: The cushion in the table refers to the cushion against a rise in yields provided by carry income. Breakeven is calculated in comparison with Treasury bill rates for durations corresponding to each period, and thus reflects rate hike expectations. Source: Nomura Securities Co., Ltd.

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Fig. 19: 20yr JGB yields and OIS rates
(%)
2.4

(%) [a] less [b] (RHS) 20yr JGB yields [a] 20yr JPY OIS [b]
0.7

2.2

0.6

2 0.5 1.8 0.4 1.6 0.3 1.4
0.2 1.2

1

0.1

0.8

0

Source: Bloomberg

Relative value: 20s look less cheap to 10s The 10s20s JGB spread closed at 88bp on 10 April, 1bp narrower since the previous auction. This puts 20s in the middle of the post-QQE range. The 20s30s spread was 18bp, 2bp wider from the previous auction. This puts the 20yr at its most overvalued level in the range since QQE. Looking at the 10-20 OIS spread (73bp) to disregard the impact of QQE, we note that the 20yr looks slightly cheap to the average since 2012 (70bp). The 20-30yr OIS spread is 23bp, making 20s look somewhat cheap relative to the average since 2012 (17bp; Figure 20). The 20yr asset swap spread was -6bp, 2bp richer since the previous auction (Figure 21). Cash JGBs look rich in the range since 4 April. Carry and roll on 20yr asset swap positions is quite positive, at 2.0bp for a six-month period.

Fig. 20: 10-20yr and 20-30yr OIS spreads
(%) 1
Average since Jan 2012 Average since Jan 2012

10-20yr OIS spread

20-30yr OIS spread

0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

Source: Bloomberg

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Fig. 21: 20yr JGB-OIS spread and 20yr asset swap spread
(%) 0.7 20yr JGB rates - 20yr OIS (LHS) 20yr JGB rates - 20yr Swap (RHS) (%) 0.2 0.15 0.1 0.5 0.05 0.4 0
-0.05 -0.1

0.6

0.3

0.2 -0.15 0.1 -0.2 -0.25

0

Source: Bloomberg

2. Medium-term outlook and strategy (Changes/additions since last week highlighted)
Fig. 22: Rates forecast
(%) Latest 10-Apr Japan Basic loan rate Unsecured O/N call 3M Tibor 2yr JGB 5yr JGB 10yr JGB 20yr JGB 30yr JGB 0.30 0.07 0.21 0.08 0.19 0.60 1.49 1.69 0.30 0.08 0.20 0.07 0.19 0.60 1.45 1.65 2014 April 0.30 0.08 0.20 0.07 0.19 0.60 1.45 1.65 June September 0.30 0.08 0.20 0.14 0.35 0.90 1.80 2.00 0.30 0.08 0.20 0.14 0.35 0.90 1.80 2.00 Decmber 0.30 0.08 0.20 0.13 0.33 0.85 1.75 1.95 March 0.30 0.08 0.20 0.12 0.30 0.80 1.70 1.90 2015 June

0.00 0.18 0.06 0.17 0.55 1.40 1.55

~ ~ ~ ~ ~ ~ ~

0.10 0.22 0.11 0.30 0.80 1.75 1.90

0.00 0.18 0.06 0.17 0.55 1.40 1.55

~ ~ ~ ~ ~ ~ ~

0.10 0.22 0.11 0.30 0.80 1.75 1.90

0.00 0.18 0.07 0.18 0.60 1.50 1.65

~ ~ ~ ~ ~ ~ ~

0.10 0.22 0.16 0.50 1.10 2.00 2.20

0.00 0.18 0.10 0.25 0.70 1.60 1.75

~ ~ ~ ~ ~ ~ ~

0.10 0.22 0.16 0.50 1.10 2.00 2.20

0.00 0.18 0.10 0.25 0.70 1.60 1.75

~ ~ ~ ~ ~ ~ ~

0.10 0.22 0.16 0.50 1.10 2.00 2.20

0.00 0.18 0.10 0.25 0.70 1.60 1.75

~ ~ ~ ~ ~ ~ ~

0.10 0.22 0.16 0.50 1.10 2.00 2.20

Source: Nomura Securities Co., Ltd.

Scenario Our scenario is as follows: Investors should be more risk averse now that the Fed has become hawkish unexpectedly early, with USD carry flows remaining subdued. As the BOJ decides not to ease policy at its April meeting, markets begin to call for action in their movements. We doubt the BOJ will increase its purchases in the super-long area until it comes under considerable stress. Expectations for further BOJ easing should decline as the BOJ begins to show confidence in economic growth following the consumption tax hike. In this event, we would expect the stock market rally and JPY depreciation to slow and JGBs to stabilize around 10yr yields of 0.70%. In response to a slow improvement in CPI inflation and disappointing outcomes of the spring labor negotiations (i.e., smaller wage increases), we believe the BOJ could begin revising its policy framework in such a way as to raise inflation expectations in April-June, thus shifting its focus to quality from quantity (to riskier assets from JGBs). In July, the BOJ may decide to increase JGB and ETF purchases. At the same time, we believe the BOJ will officially announce that it will continue QQE into 2015. Once easing expectations play out, banks may begin to shed yen bond portfolios. In autumn 2014, the market may begin to factor in a Fed rate hike and a halt to BOJ easing in earnest as the Fed approaches its exit from QE, and concerns over asset inflation makes the Fed more hawkish. This should push yields higher. After testing 10yr yields of 1.0% again in Sep-Nov, the market should stabilize or edge up on BOJ
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purchase operations into end-2014 and speculations over a decision on the second consumption tax hike. Investment strategy Over a long time horizon, the JGB rally, fuelled by BOJ easing, likely ended in April 2013. Given this, we recommend investors look to dip buy and sell on strength through mid2014 on the premise that: 1) neither the Fed nor the BOJ will shift to a tightening bias; and, 2) that the JGB trading range will shift in line with the global risk-on/off trends. Investors should maintain short duration positions on JGBs by following a risk-on trend in early 2014. We expect a brief pickup in risk-on flows, with 10yr rates likely to sell off to 0.7%, in which event investors may as well add long short-term positions. Conversely, JGBs could rally in June-July as the market prices in expectations for BOJ easing, in which case investors should look to shed duration. USTs have not adequately priced in the risk of a rate hike. For this reason, we recommend shifting into euro area bonds, which have a similar monetary policy and inflation environment as Japan. Investors could also consider taking on currency and stock market exposure. As expectations for BOJ easing weaken and risk-on momentum slows in January-March, investors can buy 10yr yields in the 0.7% range for short-term gains. Conversely, in April-June, if easing expectations rekindle and the JGB market rallies again, investors should look to shed duration, targeting yields near 0.60%. As US markets in H2 2014 begin to price in a Fed rate hike, expectations of an end to BOJ easing should emerge. We recommend adding back duration at 10yr UST yields of 3.253.5% and 10yr JGB yields in a 0.9-1.0% range. Risks (Bear flattening) Central banks take a hawkish stance as signs of asset inflation appear. The BOJ would refute any intention of easing policy further and exiting QQE. (Bear steepening) Crude oil prices rally sharply as emerging economies bottom. The BOJ significantly increases purchases of risk assets. (Bull flattening) The BOJ lengthens tenor of signal operations. The Fed embarks on QE4. China tightens monetary conditions early and faces a hard landing. (Bull steepening) The BOJ cuts rates. The ECB adopts QE measures.

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Appendix A-1
Analyst Certification
I, Naka Matsuzawa, hereby certify (1) that the views expressed in this Research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this Research report, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of my compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

Issuer Specific Regulatory Disclosures
The term "Nomura Group" used herein refers to Nomura Holdings, Inc. or any of its affiliates or subsidiaries, and may refer to one or more Nomura Group companies.

Issuer THE STATE OF JAPAN

Disclosures A13

A13 The Nomura Group has a significant financial interest (non-equity) in the issuer.

Important Disclosures
Online availability of research and conflict-of-interest disclosures
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This information is based on information Nomura has received from sources it believes to be reliable as of September 24, 2010, but it does not guarantee accuracy or completeness of the information. For details, please refer to its website above. Fitch -Name of the rating agency group and registration number Name of the rating agency group: Fitch Ratings (Fitch) Name of the registered credit rating agency within the group and registration number: Fitch Ratings Japan Limited. (Financial Services Agency Commissioner 7) -The way of obtaining summary information on the policies and method used for assigning credit ratings Please refer to Fitch Ratings‟ Japanese website at (http://www.fitchratings.co.jp) and access 「格付方針等の概要」in the section「規制関連」. -Assumptions, Significance and Limitation of Credit Ratings Ratings assigned by Fitch are opinions based on established criteria and methodologies. Ratings are not facts, and therefore cannot be described as being "accurate" or "inaccurate". Credit ratings do not directly address any risk other than credit risk. Credit ratings do not comment on the adequacy of market price or market liquidity for rated instruments. Ratings are relative measures of risk; as a result, the assignment of ratings in the same category to entities and obligations may not fully reflect small differences in the degrees of risk. Credit ratings, as opinions on relative ranking of vulnerability to default, do not imply or convey a specific statistical probability of default. In issuing and maintaining its ratings, Fitch relies on factual information it receives from issuers and underwriters and from other sources Fitch believes to be credible. Fitch conducts a reasonable investigation of the factual information relied upon by it in accordance with its ratings methodology, and obtains reasonable verification of that information from independent sources, to the extent such sources are available for a given security or in a given jurisdiction. The assignment of a rating to any issuer or any security should not be viewed as a guarantee of the accuracy, completeness, or timeliness of the information relied on in connection with the rating or the results obtained from the use of such information. If any such information should turn out to contain misrepresentations or to be otherwise misleading, the rating associated with that information may not be appropriate. Despite any verification of current facts, ratings can be affected by future events or conditions that were not anticipated at the time a rating was issued or affirmed. This information is based on information Nomura has received from sources it believes to be reliable as of September 24, 2010, but it does not guarantee accuracy or completeness of the information. For details, please refer to its website above.

Disclaimers required in Japan
Investors in the financial products offered by Nomura Securities may incur fees and commissions specific to those products (for example, transactions involving Japanese equities are subject to a sales commission of up to 1.404% on a tax-inclusive basis of the transaction amount or a commission of ¥2,808 for transactions of ¥200,000 or less, while transactions involving investment trusts are subject to various fees, such as commissions at the time of purchase and asset management fees (trust fees), specific to each investment trust). In addition, all products carry the risk of losses owing to price fluctuations or other factors. Fees and risks vary by product. Please thoroughly read the written materials provided, such as documents delivered before making a contract, listed securities documents, or prospectuses. Transactions involving Japanese equities (including Japanese REITs, Japanese ETFs, and Japanese ETNs) are subject to a sales commission of up to 1.404% of the transaction amount (or a commission of ¥2,808 for transactions of ¥200,000 or less). When Japanese equities are purchased via OTC transactions (including offerings), only the purchase price shall be paid, with no sales commission charged. However, Nomura Securities may charge a separate fee for OTC transactions, as agreed with the customer. Japanese equities carry the risk of losses owing to price fluctuations. Japanese REITs carry the risk of losses owing to fluctuations in price and/or earnings of underlying real estate. Japanese ETFs carry the risk of losses owing to fluctuations in the underlying indexes or other benchmarks. Transactions involving foreign equities are subject to a domestic sales commission of up to 1.026% of the transaction amount (which equals the local transaction amount plus local fees and taxes in the case of a purchase or the local transaction amount minus local fees and taxes in the case of a sale) (for transaction amounts of ¥750,000 and below, maximum domestic sales commission is ¥7,668). Local fees and taxes in foreign financial instruments markets vary by country/territory. When foreign equities are purchased via OTC transactions (including offerings), only the purchase price shall be paid, with no sales commission charged. However, Nomura Securities may charge a separate fee for OTC transactions, as agreed with the customer. Foreign equities carry the risk of losses owing to factors such as price fluctuations and foreign exchange rate fluctuations. Margin transactions are subject to a sales commission of up to 1.404% of the transaction amount (or a commission of ¥2,808 for transactions of ¥200,000 or less), as well as management fees and rights handling fees. In addition, long margin transactions are subject to interest on the purchase amount, while short margin transactions are subject to fees for the lending of the shares borrowed. A margin equal to at least 30% of the transaction amount and at least ¥300,000 is required. With margin transactions, an amount up to roughly 3.3x the margin may be traded. Margin transactions therefore carry the risk of losses in excess of the margin owing to share price fluctuations. For details, please thoroughly read the written materials provided, such as listed securities documents or documents delivered before making a contract. Transactions involving convertible bonds are subject to a sales commission of up to 1.08% of the transaction amount (or a commission of ¥4,320 if this would be less than ¥4,320). When convertible bonds are purchased via OTC transactions (including offerings), only the purchase price shall be paid, with no sales commission charged. However, Nomura Securities may charge a separate fee for OTC transactions, as agreed with the customer. Convertible bonds carry the risk of losses owing to factors such as interest rate fluctuations and price fluctuations in the underlying stock. In addition, convertible bonds denominated in foreign currencies also carry the risk of losses owing to factors such as foreign exchange rate fluctuations. When bonds are purchased via public offerings, secondary distributions, or other OTC transactions with Nomura Securities, only the purchase price shall be paid, with no sales commission charged. Bonds carry the risk of losses, as prices fluctuate in line with changes in market interest rates. Bond prices may also fall below the invested principal as a result of such factors as changes in the management and financial circumstances of the issuer, or changes in third-party valuations of the bond in question. In addition, foreign currency-denominated bonds also carry the risk of losses owing to factors such as foreign exchange rate fluctuations. When Japanese government bonds (JGBs) for individual investors are purchased via public offerings, only the purchase price shall be paid, with no sales commission charged. As a rule, JGBs for individual investors may not be sold in the first 12 months after issuance. When JGBs for individual investors are sold before maturity, an amount calculated via the following formula will be subtracted from the par value of the bond plus accrued interest: (1) for 10-year variable rate bonds, an amount equal to the two preceding coupon payments (before tax) x 0.79685 will be used, (2) for 5-year and 3-year fixed rate bonds, an amount equal to the two preceding coupon payments (before tax) x 0.79685 will be used. When inflation-indexed JGBs are purchased via public offerings, secondary distributions (uridashi deals), or other OTC transactions with Nomura Securities, only the purchase price shall be paid, with no sales commission charged. Inflation-indexed JGBs carry the risk of losses, as prices fluctuate in line with changes in market interest rates and fluctuations in the nationwide consumer price index. Purchases of investment trusts (and sales of some investment trusts) are subject to a purchase or sales fee of up to 5.4% of the transaction amount. Also, a direct cost that may be incurred when selling investment trusts is a fee of up to 2.0% of the unit price at the time of redemption. Indirect costs that may be incurred during the course of holding investment trusts include, for domestic investment trusts, an asset management

21

Nomura | Japan Navigator No.565

14 April 2014

fee (trust fee) of up to 5.4% (annualized basis) of the net assets in trust, as well as fees based on investment performance. Other indirect costs may also be incurred. For foreign investment trusts, indirect fees may be incurred during the course of holding such as investment company compensation. Investment trusts invest mainly in securities such as Japanese and foreign equities and bonds, whose prices fluctuate. Investment trust unit prices fluctuate owing to price fluctuations in the underlying assets and to foreign exchange rate fluctuations. As such, investment trusts carry the risk of losses. Fees and risks vary by investment trust. Maximum applicable fees are subject to change; please thoroughly read the written materials provided, such as prospectuses or documents delivered before making a contract. In interest rate swap transactions and USD/JPY basis swap transactions (“interest rate swap transactions, etc.”), only the agreed transaction payments shall be made on the settlement dates. Some interest rate swap transactions, etc. may require pledging of margin collateral. In some of these cases, transaction payments may exceed the amount of collateral. There shall be no advance notification of required collateral value or collateral ratios as they vary depending on the transaction. Interest rate swap transactions, etc. carry the risk of losses owing to fluctuations in market prices in the interest rate, currency and other markets, as well as reference indices. Losses incurred as such may exceed the value of margin collateral, in which case margin calls may be triggered. In the event that both parties agree to enter a replacement (or termination) transaction, the interest rates received (paid) under the new arrangement may differ from those in the original arrangement, even if terms other than the interest rates are identical to those in the original transaction. Risks vary by transaction. Please thoroughly read the written materials provided, such as documents delivered before making a contract and disclosure statements. In OTC transactions of credit default swaps (CDS), no sales commission will be charged. When entering into CDS transactions, the protection buyer will be required to pledge or entrust an agreed amount of margin collateral. In some of these cases, the transaction payments may exceed the amount of margin collateral. There shall be no advance notification of required collateral value or collateral ratios as they vary depending on the financial position of the protection buyer. CDS transactions carry the risk of losses owing to changes in the credit position of some or all of the referenced entities, and/or fluctuations of the interest rate market. The amount the protection buyer receives in the event that the CDS is triggered by a credit event may undercut the total amount of premiums that he/she has paid in the course of the transaction. Similarly, the amount the protection seller pays in the event of a credit event may exceed the total amount of premiums that he/she has received in the transaction. All other conditions being equal, the amount of premiums that the protection buyer pays and that received by the protection seller shall differ. In principle, CDS transactions will be limited to financial instruments business operators and qualified institutional investors. No account fee will be charged for marketable securities or monies deposited. Transfers of equities to another securities company via the Japan Securities Depository Center are subject to a transfer fee of up to ¥10,800 per issue transferred depending on volume.

Nomura Securities Co., Ltd.
Financial instruments firm registered with the Kanto Local Finance Bureau (registration No. 142) Member associations: Japan Securities Dealers Association; Japan Investment Advisers Association; The Financial Futures Association of Japan; and Type II Financial Instruments Firms Association. Nomura Group manages conflicts with respect to the production of research through its compliance policies and procedures (including, but not limited to, Conflicts of Interest, Chinese Wall and Confidentiality policies) as well as through the maintenance of Chinese walls and employee training. Additional information is available upon request and disclosure information is available at the Nomura Disclosure web page: http://go.nomuranow.com/research/globalresearchportal/pages/disclosures/disclosures.aspx Copyright © 2014 Nomura Securities Co., Ltd.. All rights reserved.

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...Action Required Items Student Portal Guide Where Can I Find my Action Required Items? Step 1: Access your Student Portal Log in to the student portal at my.devry.edu with your Student ID Number (D number) and password • If you have not logged into the portal before, your default password is your date of birth in the Mmm-YYYY format, (e.g., Mar-1980). Passwords are case sensitive Continued… FAFSA is a registered trademark of the U.S. Department of Education. In New York, DeVry University and its Keller Graduate School of Management operate as DeVry College of New York. DeVry is certified to operate by the State Council of Higher Education for Virginia. DeVry University is authorized for operation by the THEC. www.state.tn.us/thec. Nashville Campus - 3343 Perimeter Hill Dr., Nashville, TN 37211.  2015 DeVry Educational Development Corp. All rights reserved. Where can I find my Action Required Items? Step 2: Click on the Student Finance tab From the Home page, click on the Student Finance tab. It is located on the top navigation bar. Step 3: Navigate to the Financial Aid Awards Section Once the Student Finance page loads, scroll down to the Financial Aid Awards section and click on the View More link. Continued… In New York, DeVry University and its Keller Graduate School of Management operate as DeVry College of New York. DeVry is certified to operate by the State Council of Higher Education for Virginia. DeVry University is authorized for operation by the THEC.......

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