Korean bonds stay strong, despite rising tensions

Sound economic fundamentals have meant South Korea’s sovereign bond yields have remained low despite the political standoff on the Korean peninsula.

Bond yields in Korea have remained relatively stable despite escalating tensions between North and South.

South Korea has accused the North of sinking one of its warships, the Cheonan, on March 26, killing 46 sailors. A report from South Korea’s Ministry of Defence, published on May 20, concluded the ship was sunk by a North Korean torpedo.

On May 25, a spokesman for the Ministry of Unification announced a series of reprisals against North Korea for the alleged attack, including a suspension of trade and humanitarian aid and a prohibition on North Korean vessels in South Korea’s territorial waters.

The escalating tensions have had a significant effect on credit default swap spreads. South Korea’s five-year sovereign CDS was trading at 136.6 basis points on May 27, having been as low as 78.9bp as recently as April 20.

Though the Eurozone debt crisis has led to spread widening across Asia, the political standoff on the Korean peninsula has led to much wider CDS spreads for South Korea than comparable countries in the region. Korea’s sovereign CDS is trading wider than countries such as Malaysia (107bp on May 27) despite Korea’s higher credit rating: Malaysia is rated A3 by Moody’s, two notches lower than South Korea (A1).

“The recent tensions have certainly exacerbated moves in South Korea's CDS spreads,” says Peter Eerdmans, head of emerging market debt at Investec Asset Management in London. “Due to the debt problems in the Eurozone, most sovereign CDS spreads have widened in recent weeks, but South Korea’s widening of some 100bp stands out relative to peers that saw moves more in the region of 50bp.”

But despite the fluctuation in CDS levels, bond yields have remained relatively stable. A 10-year US dollar-denominated bond from the South Korean government, maturing in 2017, was yielding 4.9% on May 26, only slightly higher than the 4.7% yield on April 29 and lower than the 5.3% yield on January 18. Local bonds too, have weathered the storm. “In the five-year area of the curve yields are only 10bp higher than at the start of the month,” says Eerdmans.

Peter Park, a fixed income analyst at Woori Investment and Securities in Seoul, cites strong economic fundamentals for the solid performance of Korean government bonds.

“Korea has stable economic growth, around 5% this year, and a sound fiscal environment, which means bond yields have declined a lot since the beginning of the year. The concept of risk-free assets is changing. Because of the European debt crisis, global fixed income investors are rebalancing their portfolios from European debt to the Asian market, and countries like South Korea with good fundamentals are beginning to look more attractive,” Park says.

Korea’s debt-to-GDP ratio stands at 28%, much lower than Europe’s peripheral economies, such as Greece (115.1%) and Italy (115.8%), but also the continent’s more advanced economies, such as France (77.6%) and Germany (73.2%).

As for the political risks, Park says bond investors are, on the whole, optimistic that the tensions between North and South Korea will not escalate into a full-scale war. “Most bond investors don’t consider the possibility of war to be that high,” he says.

Eerdmans agrees, arguing that war is in neither country’s interests. “The South Koreans have an issue with the North Korean regime, but know that a military conflict would be very bad for the people of North and South Korea – even though the South would be very likely to win such a war. They certainly don’t want to be seen as the aggressor, so as not to create a situation where China would rise to the support of the North.

“While the motives of the North are more based around a desire to show their military might, we believe China will be able to keep the North under control. History has shown that market spikes during political tension in Korea have lasted days, rather than weeks, as the markets quickly come to realise that the situation is unlikely to spiral out of control,” Eerdmans says.

But others are less sanguine. In a research note published on May 27, Simon Ballard, senior credit strategist at RBC Capital Markets, warned that tensions on the Korean peninsula could deteriorate further, and even raised the possibility of nuclear warfare.

“Geopolitical risk and the current tensions in the Korean peninsula may be dismissed by some market commentators as irrelevant to the broader financial markets, but we would warn against complacency in this respect. At the very least, the prospect of a deterioration in North/South Korean relations – if they can deteriorate further that is – will tend to create investor unease across the globe. That the word nuclear may even be mentioned will only add fuel to market nervousness,” Ballard wrote.