KOREA - South Korean bonds are the poorest performers in Asia this year -- but they are set to attract the biggest foreign inflows in more than a decade. What gives?
The nation’s debt is benefiting from the same phenomenon that can make investments profitable for overseas investors in Japanese and European negative-yielding debt -- the magic of cross currency basis.
While Korea’s three-year bonds only yield around 1.3%, dollar-based investors who hedge their purchases in currency markets for three months can earn an extra 1.1% on top of that. The combined return of 2.4% easily exceeds that on similar-maturity Treasuries or hedged investments in either French or Japanese government debt.
The attraction of its currency-adjusted yields has seen overseas investors snap up $16.4 billion of Korea bonds in the first seven months of the year, according to the most recent balance-of-payments data. Should these inflows be maintained, this year will see the biggest purchases of local debt since they reached a record in 2007.
Even with surging inflows, Korea’s government bonds have been anything but stellar performers this year.
The securities have handed investors a loss of 1.9% in dollar terms, the worst in Asia and the fourth-poorest performance among the 46 global markets ranked by Bloomberg. The reason for the underperformance has been entirely due to the weakening won, which has tumbled almost 7% this year as the U.S.-China trade war pummeled the nation’s exports.
The outlook for further inflows remains bright with central banks boosting purchases in recent years. Their share of the total foreign holdings of the nation’s debt jumped to 52.5% at the end of last year, from 11% in 2009, according to a report from the Ministry of Economy and Finance released earlier this year.
The Reserve Bank of Australia made the Korean currency the fourth-largest holding in its foreign-exchange reserves on a gross basis in 2018, according to its annual report. The won and Chinese yuan were the only two emerging-market currencies held by the Swiss National Bank at the end of last year.
Although the won isn’t a typical reserve currency, the country’s AA credit rating puts Korean bonds on par with French and U.K. securities, and above Japanese ones.
On the downside, some of the inflows that have recently been going to Korea could start being diverted to China after Bloomberg Barclays and JPMorgan Chase & Co. have both moved to include the larger country in their benchmark bond indexes.
“The Korean bond market benefited as a proxy to China when the Chinese bond market was closed,” said Kiyong Seong, an Asia rates strategist at Societe Generale SA in Hong Kong. Demand from global funds and central banks may now stagnate as China’s bond market opens up much faster than anticipated, he said.