South Korea’s tight bond spreads mean that there is relatively little chance of its credits performing well against US Treasuries and quite a high possibility of them underperforming, according to Morgan Stanley.
The country accounts for 21% of the notional amount of debt outstanding in the Asian US dollar credit market but the tight yields of its bonds means that it accounts for just 14% of carry spread, according to a Morgan Stanley research report on September 28.
A bond’s carry spread is the difference between its yield and that of an underlying benchmark, in this case US Treasuries.
Morgan Stanley believes that an investor’s portfolio can be underinvested in the biggest part of the Asian credit market and still make money. It notes that an Asian credit portfolio with a zero percent allocation to Korean credits would lose out on 40 basis points (bp) of returns out of a total of 280bp paid out by the Asian market.
While this may seem like a substantial amount, Morgan Stanley notes that it would only require the rest of the Asian credit universe to tighten by 10bp against US Treasuries to compensate for this loss of carry.
“[This is] not a big number when you compare it to the 100bp tightening we’ve seen so far this year [by the rest of the Asia credit universe],” said Viktor Hjort, Hong Kong-based head of fixed income research at Morgan Stanley. “A bullish investor is unlikely to need to be in Korea. A bearish investor may not need to be in Korea either.”
Additionally, Korea’s credit carry is most easily wiped out compared to its other Asian peers. Its bonds would only need to widen by an average of 33bp to wipe out the country’s carry, notes Morgan Stanley, a process known as breakeven spread widening.
In comparison, China’s credit spreads would need to widen by 88bp to wipe out its carry.
“The poor bond economics of investing in Korean credit is arguably one of the key arguments for being underweight: in a bullish market a mere 10bp tightening can make up for the loss of Korean credit’s carry and in a bearish market Korean bonds have the worst breakeven cushions,” said Hjort.
No signs of new buyers
The market re-rating has put Korea valuation-wise firmly between ‘emerging’ and ‘developing’ Asia, highlights Morgan Stanley.
From a traditional emerging-Asia perspective, the value of Korean credits now looks about right, irrespective of whether one looks at sovereign, quasi-sovereign or financial credits. A further re-rating, on the other hand, is required for the market to take a view that Korean credit should increasingly be compared to that of Japan, Australia and Singapore’s, believes the bank.
“While certainly possible, we see such convergence playing out, at best, only over a very long time period,” said Hjort. “The reality is that across a number of metrics relevant for the overall credit profile, there’s still a substantial gap to ‘developed’ Asia.”
While Korea is growing and is an increasingly rich country it is more leveraged than many of the emerging Asia credits that trade wider, which suggests that Korean financial and corporate valuations have very little immediate tightening potential in the future.
Korea’s ‘developed market’ profile and higher rating could in theory attract non-traditional investors with a different and most importantly, tighter perception of what is attractive value.
‘Asian credit’ is a US dollar asset class and therefore, any increase in non-Asia or non-emerging market investor interest – particularly global investment grade or high yield funds – would have to be reflected in an uptick in the allocation of Asian primary deals into US-based funds, notes Morgan Stanley.
However, based on Morgan Stanley’s analysis, there is no sign yet of that happening.
“The percentage has not gone up substantially in 2012 – the year of Korea’s re-rating,” said Hjort. “In fact, the 2012 percentage US allocation is well within the three-year range for Korea. In other words, there’s no evidence so far that the re-rating has been driven by changes in the technical landscape for Korean debt.”
Financials favoured within Korea
Morgan Stanley would normally be underweight Korean credits in an Asian portfolio, but within the asset class the bank prefers financial institutions over quasi-sovereigns and private sector corporates.
“Banks still account for the bulk of Korea’s credit improvement, but corporate credit metrics are actually deteriorating; private corporate leverage ratios have been deteriorating on the bank of weakening Ebitda (earnings before interest, tax, depreciation and amortisation) trends and quasi-sovereign debt has also continued to rise,” said Hjort.
Quasi-sovereign corporate debt has continued to rise from 16% of gross domestic product (GDP) in 2005 to 29% in 2011.
From a technical perspective, Morgan Stanley also notes that Korean banks have successfully diversified their foreign currency funding sources away from US dollars in the past few years.
The proportion of non-US dollar funding has increased from 11% in 2009 to 52% year-to-date, which indicates that US dollar bond issuance has been falling every year.
Within banks, policy financial institutions are preferred to commercial banks. The spread differentials between policy and commercial banks have compressed to 20bp currently, highlights Morgan Stanley.
“Our preference would be in the policy banks where there is more explicit government solvency guarantee language,” said Hjort. “From a credit rating perspective, these policy banks’ ratings are firmly linked to the sovereign and in ‘AA’ range.”
“As such, the potential technical bid for highly rated ‘AA’ assets by global investors that we had highlighted will likely benefit these ‘AA’-rated policy banks more than commercial banks going forward,” he added.