As the Bank of Japan loosens its stranglehold on yields, opening the door for them to rise in a more volatile market environment, Japanese pension funds have started to recognize the merits of actively investing their Japanese fixed-income portfolio, sources said.

For instance, the Government Pension Investment Fund, Tokyo, revealed in its annual report in July that it would shift an in-house ¥9.1 trillion ($62 billion) passive domestic bond fund to be actively managed.

“The decision to shift the in-house domestic bond fund from passive to active is one of our current best efforts to optimize our overall portfolio risk management,” said Chief Investment Officer Eiji Ueda in an emailed response to questions.

Most of the largest pension fund in the world’s roughly $1.5 trillion in assets is externally managed and this will likely remain the same, he said. “But because managers’ mandate is to optimize only their portfolio, sometimes we need to finetune (the) entire portfolio’s risk-return,” he said.

Yields of Japanese bonds have been on the rise as the Bank of Japan loosened its strict controls that had kept yields hovering around zero for years. The BOJ effectively raised the yield cap on Japanese government bonds to 1% on July 28, eight months after it set its yield curve control target between plus and minus 50 basis points.

Fund managers expect the central bank to continue tweaking monetary policy in response to Japan’s rising inflation and stronger economic growth, as its core consumer price index rose 3.1% year-over-year in July and GDP growth reached 6% in the second quarter of the year.

A more flexible monetary policy will lead to a more volatile market, which bodes well for active investing, said Seiji Maruyama, CIO and head of fixed-income portfolio management at PGIM Japan Co. Ltd., in an emailed interview. PGIM, the investment management business of Prudential Financial Inc., has $1.27 trillion in assets under management.

“The rise in volatility will also increase opportunities to generate excess returns, especially for active managers who can selectively buy securities that have been mispriced,” he added.

Mr. Maruyama, who is based in Tokyo, acknowledged that increases in volatility and yield generally affect credit markets negatively, but the Japanese credit market is an anomaly this year because “last year the degree of deterioration in the market was more severe than in previous years,” he said.

“The Japanese credit market has already experienced spread widening in 2022 due to the decline in market functioning — specifically liquidity and price discovery. Last year, the gap between the market’s view on fair interest rates and the curve controlled by the BOJ widened, especially for 10-year JGBs,” he explained.

“As a result, the liquidity of the government bond market has decreased significantly, and the liquidity of the general bond market, which is priced based on the government bond curve, has also decreased, making it difficult to issue 10-year corporate bonds,” he added.

With the BOJ’s recent moves and its anticipated further loosening of controls, PGIM expects a rise in demand for spread products, Mr. Maruyama said.

Other fixed-income managers agreed that the market is becoming more attractive to institutional investors as yields rise.

The Japanese bond index is currently yielding 40 to 50 basis points year-to-date, and the domestic index returns are sitting at 1.1% as of Aug. 9, but the starting level of yields is worth noting, said Tomoya Masanao, Tokyo-based managing director, co-head of PIMCO Japan and co-head of Asia-Pacific portfolio management, in an interview. PIMCO has $1.79 trillion in AUM.

“It’s very important to recognize that this year started after the yield rise on the back of the BOJ’s yield curve change last December,” he said, referring to when the BOJ widened the target range for 10-year Japanese government bonds to 50 basis points from its zero target, up from 25 basis points previously.

Because of the higher starting levels of yields this year, the index return is positive, at slightly over 1%, he said.

Both PIMCO and PGIM spokesmen said they have exceeded benchmarks and investment objectives year-to-date, without providing specifics.

“Many active managers in the Japanese fixed-income market have been outperforming the domestic index, which is on the contrary to the general perception that not so many active managers are producing excess returns,” Mr. Masanao said.

Top-quartile active domestic fixed income managers were found to have achieved 50-60 basis points of excess returns in annualized returns over three and five years as of June 30, he added. Globally, only 30% of active bond fund managers outperformed their average passive peers in 2022, according to the year-end 2022 Morningstar Active/Passive Barometer.

Considering current returns, and the size of active domestic bond portfolios of some institutional investors such as GPIF, which has ¥18.74 trillion in actively managed domestic bonds, 50 basis points can make a significant difference, another senior executive at an asset management firm said on condition of anonymity.

However, shifting a passive portfolio to active is not an easy task. “From our perspective, it depends on the type of investors. For public pension funds, the capacity of active funds in managing large portfolios would be a challenge, given the AUM would potentially be too large for market liquidity, making it difficult to construct the ideal portfolio and generate the target alpha,” said Mr. Maruyama of PGIM.

On the other hand, smaller corporate pension funds with high liability costs might be put off by the relatively low expected returns of yen bonds, as they tend to have higher target returns and debt costs, he said.

But as Japanese bond returns increase as the BOJ loosens its controls on yields further, corporate pension funds may increase allocation to Japanese bonds and choose active managers, he said.

Then comes the challenge of selecting good managers that can generate returns over a long-term horizon of around five years or more. “You may have noticed I tried to be careful not to say many managers produced an ‘alpha.’ Because ‘excess returns’ and true ‘alpha’ are different things. Excess returns can be just luck, or what we call levered beta,” said Mr. Masanao of PIMCO.

“Many managers who produce excess returns in the Japanese fixed-income market have typically been relatively credit heavy. By overweighting credit sectors, or having highly concentrated exposures in a few high-beta credit, they have been able to perform very well when the credit spreads were tightening. But obviously, these managers would have underperformed during the spread widening in 2022,” he said.

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