Japan was a global bright spot in 2025. Despite much hand-wringing over its debt burden, it is likely to remain so in 2026.
The county is firmly in a reflation phase with growth, wages and prices all in an upcycle. The Bank of Japan has responded by raising interest rates to their highest level in three decades, prompting some concern among commentators and investors. But this should be seen as a strong vote of confidence in the Japanese economy, which has proven resilient to tariffs and global shocks.
The benchmark Nikkei 225 index is up 26% so far this year, far better than the S&P 500's 17% rise. Normally, investors would expect to see these gains diluted in dollar terms by a weakening yen. In past cycles, the Nikkei has typically gotten a boost from yen depreciation, which increases the profits of Japanese exporters. The yen has weakened recently, causing market jitters. But for 2025 as a whole it is still basically flat against the dollar.
Japan's outperformance is partly due to its still-important role in the global tech supply chain, allowing it to benefit from AI optimism. It is also attributable to successful corporate-governance reforms, dating back to Shinzo Abe's second stint as prime minister from 2012 to 2020. Those have boosted corporate efficiency and financial returns.
The main cause for worry is Japan's famously high debt burden. Total public debt stands at a whopping 200% of gross domestic product. On top of this, rates on Japanese government bonds have been on the rise in response to tighter BOJ policy and stimulus spending.
A package of tax cuts and fiscal spending from newly installed Prime Minister Sanae Takaichi is worth around 3.4% of GDP, according to Fitch Ratings. Ten-year Japanese government bond yields have jumped from 1.09% to 2.08% so far this year, while 30-year bond yields have gone from 2.28% to 3.43%, according to FactSet.
But Japan has tools to manage debt-servicing costs, says Thomas Mathews, head of markets, Asia Pacific at Capital Economics. For one thing, the average duration of the government's debt outstanding is relatively long at over nine years, according to Fitch Ratings. That compares with around six years in the U.S.
So movements in bond yields will have only a gradual impact on financing costs as already-issued debt takes a long time to roll over. And Japan's Ministry of Finance earlier this year cut its planned issuance of ultralong-term debt that has seen the greatest rise in rates.
More broadly, what investors must keep in mind is that Japan's high debt-to-GDP ratio is largely the result of decades of stagnant growth and deflation, not profligate spending. This gradually shrank the crucial denominator of the debt-to-GDP equation.
In recent years, this process has been thrown into reverse: Nominal GDP growth has averaged 3.1% over the last four years, and the debt-to-GDP ratio has in fact fallen from 212% of GDP in 2022 to around 200% now. Capital Economics says Japan is actually deleveraging faster than any major advanced economy.
Importantly, while Takaichi's stimulus package contains some political giveaways, it also allocates money to strategic sectors that Japan's international competitors are also spending on, such as semiconductors and shipbuilding. It would also raise defense spending to 2% of GDP, which seems reasonable in Japan's neighborhood. It is hardly a boondoggle.
A final concern is that rising bond yields in Japan will draw domestic savings home instead of going to the U.S. to finance the American budget deficit. This, of course, is contradictory to the notion that Japan will have difficulty financing its own debt.
Moreover, the potential impact on the U.S. shouldn't be overstated. While Japan's 10-year yield has soared by a percentage point in 2025, the equivalent yield for U.S. Treasurys has fallen around 0.4 percentage point.
Ultimately, the true risks to U.S. Treasurys are of dollar debasement, or a broader loss in confidence in U.S. institutions -- such as compromised Federal Reserve independence -- that would undermine the dollar's reserve currency status. In short, domestic problems rather than something originating from Japan.
Indeed, those risks only underscore why it makes sense for investors to diversify beyond U.S. shores. Japan looks like one of the best places to park money in 2026.
