U.S. bond holders could have a nasty surprise in store if Japan's banks fail to recover from their economic woes, says one analyst.

This year, U.S. bond investors started snapping up trust-preferred securities issued here by Japanese banks' subsidiaries. The newfangled debt is designed to replenish the capital of economically troubled institutions.

The investors are getting a good yield, but the risk is greater than they might think because the economic struggles of Japan's banks appear to be worsening, said a bond analyst. He asserted in a recent report that dividends on the securities are at risk.

"We think the risk has become so high that several of these banks would pass on paying on their coupons," said Allerton J. Smith of Donaldson, Lufkin & Jenrette Inc.

More than $5 billion of the securities were sold here in February and March. They are modeled after trust-preferred securities, which were popular among U.S. banks two years ago. One meaningful difference is that the Japanese securities have a step-up feature, meaning they can be "called" by the investor after 10 years.

Because of the risk, Mr. Smith has told clients to dump the hybrid securities and buy good, old-fashioned bank bonds.

Some investors have already obliged.

"We owned some, but thank God we got out early," said an investor in bonds and hybrid securities. "They looked cheap, and we thought it was an interesting way to play Japan. We lost money. But can you imagine what would have happened if we still owned them? I would have been told not to come back to work."

The troubles in Japan appear to be deepening, said Mr. Smith.

Japan's Ministry of Finance has reported the country's banks have $160 billion of nonperforming loans on their books, said Mr. Smith. The writedowns and provisions for bad loans have taken a considerable bite out of capital ratios.

"And there appears to be no easy solution to these problems," said Mr. Smith. "You cannot lower interest rates because they're already low, they can't expand loan portfolios, and these half-baked stimulus packages by the government appear to be lacking direction."

The spreads on these securities have widened considerably as Japan's banks flounder in a sea of economic uncertainty.

According to Goldman, Sachs & Co., spreads on the securities have widened to a range of 430 to 660 basis points over Treasuries, from a range of 325 to 440 basis points.

Japanese banks began issuing these trust-preferred securities late last winter for the same reason U.S. banks began issuing them in quantity two years ago: They provide cheap regulatory capital.

Japanese banks began wobbling several years ago from large corporate loans that yielded little return but imposed substantial capital requirements and began depleting capital reserves. Trust-preferred securities offered a quick and cheap solution to a problem that easily could have gotten out of control, said capital market experts.

In February and March, Sumitomo, Industrial Bank of Japan, Fuji Bank, and Tokai Bank issued $5.4 billion worth of the hybrid securities into the eager hands of U.S. bond investors who were not only familiar with the structure but salivating for higher yields.

Two-thirds of the issuance was bought by U.S. bond holders, said bank bond analyst Van Hesser of Goldman, which underwrote three of the four Japanese deals.

Goldman Sachs' stake in these securities is clear. The bulge-bracket firm pioneered the trust-preferred securities market in 1996 and made them so popular that banks were elbowing each other in a mad rush to market.

As the capital problems of Japan's banks became more apparent, Goldman was among the first to pitch a similar solution there. Of the $5.4 billion worth of Japanese trust-preferred securities issued, Goldman Sachs has underwritten $4.4 billion. Salomon Brothers underwrote $1 billion.

Mr. Hesser acknowledged that some investors in the securities have become concerned about Japan's troubles. But he is unwavering in his advice: Keep buying.

"The Japanese banks that have issued are among the largest in the country," said Mr. Hesser. "We believe that they are too big to fail."

Mr. Hesser also pointed out that the widening in the bonds' spreads have created tremendous bargains.

"Buy these bonds now," said Mr. Hesser. "These bonds have widened to single-B levels and are very cheap." u

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