Japan’s Evolving Discount Rate — Re-examining Corporate Valuation in a Rising Interest Rate Environment

Interest Rate Trends and Background

Long-term interest rates in Japan have been rising. Comparing January 2025 rates to one year prior, the 10-year government bond yield rose from 1.25% to 2.25%, an increase of 1.00 percentage point, indicating a significant rise in domestic market yields over the year. The increase was even more pronounced in ultra-long bonds, with the 40-year government bond yield surging from 2.67% to a peak of 4.23% before settling at 3.90% by month-end, representing a 1.23 percentage point increase year-on-year.

Meanwhile, the policy rate has risen only modestly, from 0.50% to 0.75% (a 0.25 percentage point increase) over the past year, as the Bank of Japan has proceeded cautiously with rate hikes. This has resulted in a notable widening of the gap between long- and short-term rates.

The backdrop to this trend is believed to be market awareness that expansionary fiscal policy is affecting medium- to long-term government bond supply-demand dynamics and inflation expectations. Prime Minister Takaichi has signaled a more proactive fiscal policy stance compared to previous administrations. In particular, her January announcement of a plan to reduce the consumption tax on food to zero for two years triggered a sharp rise in long-term interest rates. Subsequently, interest rates in Europe and the U.S. also rose, leading to views that Japanese interest rate movements may have contributed to the global increase in yields.

Market Perception of Japan’s Fiscal Position

Looking at Japan’s national finances on a stock basis, the level of liabilities is notably large. According to Ministry of Finance data (*1), Japan’s debt-to-GDP ratio stands at approximately 230%, an exceptionally high level among major advanced economies. However, this ratio has been improving each year since peaking at 258% in 2020. Moreover, as Japan holds substantial net foreign assets, its net debt-to-GDP ratio is a more moderate 130%, suggesting that fiscal conditions are not at an immediate breaking point. On a flow basis, the fiscal deficit-to-GDP ratio was 1.4% in 2024 and 0.6% in 2025, favorable compared to the 2–8% range observed in Western economies. Accordingly, credit rating agencies have maintained investment-grade ratings of A to AAA for Japan, and assessments suggesting an imminent fiscal crisis remain limited.

While the near-term risk of a fiscal crisis appears low, the possibility of medium- to long-term fiscal deterioration cannot be ruled out. The cabinet approval rating for the Takaichi administration—widely regarded as fiscally expansionist—has remained at a very high level of 70–80% during its first approximately three months, in stark contrast to the previous administration, which pursued fiscal consolidation amid low approval ratings. Given the strong political incentive to continue the expansionary fiscal path, this is likely a contributing factor to the upward pressure on long-term interest rates.

Narrowing of the Yield Spread and Implications for the Equity Market

Changes in interest rates have important implications for equity investing. Many investors evaluate equity returns by using long-term interest rates as a benchmark, adding a premium to reflect expectations and risks associated with the equity market. A useful metric for understanding overall market dynamics is the yield spread—the difference between the TOPIX earnings yield (the inverse of the P/E ratio) and the 10-year government bond yield. This spread has generally ranged between 5% and 7% over the past decade.

However, since 2022, the yield spread has declined intermittently from approximately 7% to the mid-3% range at present. During this period, the TOPIX earnings yield fell from the 7% range to the mid-5% range (corresponding to a rise in the P/E ratio from the low-14x range to the high-18x range), while the 10-year government bond yield rose from approximately 0.2% to the mid-2% range. The yield spread was compressed from both sides.

This suggests a decline in the equity risk premium, a rise in medium- to long-term growth expectations, or both occurring simultaneously. Contributing factors likely include the economy’s ongoing exit from prolonged deflation and progress in corporate earnings improvement and corporate governance reform.

A narrowing yield spread can be interpreted as a reduction in equity market undervaluation. However, in the U.S. market, the yield spread has reportedly compressed to negative levels; by comparison, the Japanese market, which still maintains a healthy positive spread, may still have room for further valuation normalization.

Impact on Corporate Valuation Models

At Cadira, we use a proprietary model based on the discounted cash flow (DCF) framework, incorporating sustainability-based adjustments for corporate valuation. The discount rate is set as “long-term interest rate + equity risk premium + company-specific factors.” The yield spread (the difference between the TOPIX earnings yield and the 10-year government bond yield) serves as a reference indicator when setting the equity risk premium.

Since 2022, the yield spread has declined intermittently, falling from over 6% to the mid-3% range by the end of January 2025. When such structural changes in the market environment are confirmed, we will look to revise the applied discount rate. The portfolio manager proposes changes to the equity risk premium component of the discount rate, and the revision is implemented following discussion at the Board of Directors, which also serves as our Investment Policy Committee. This framework enables us to adapt our corporate valuations to evolving market conditions while ensuring that frequent changes to discount rate assumptions do not compromise the stability of portfolio management.

*1 “Japan’s Fiscal Conditions” (In Japanese)

https://www.mof.go.jp/policy/budget/budger_workflow/budget/fy2026/seifuan2026/04.pdf