'WGBI Effect? Not Quite'... Global Heavyweights Held Less Won-Denominated Debt Than the Benchmark [fn Market Watch]

[Financial News] Contrary to expectations that the inclusion of Korean bonds in the World Government Bond Index (WGBI) would bring a massive influx of foreign capital into the Korean bond market, actual inflows have fallen short of forecasts. Some global funds tracking WGBI, including Japan's Government Pension Investment Fund (GPIF), the world's largest public pension fund, have also been found to hold Korean bonds at lower weightings than the benchmark. 
According to the financial investment industry and KB Securities on the 30th, foreign investors' net purchases of Korean government bonds totaled 44.3 trillion won from April, when Korean government bonds began entering the WGBI, through September.
Passive funds expected to ultimately flow into the Korean bond market following the WGBI inclusion amounted to approximately 68 trillion won.
Lim Jae-gyun, a researcher at KB Securities, estimated, "Applying Korea's index weight and exchange rates each month to the approximately $2.5 trillion in funds tracking WGBI, about 50.5 trillion won should have flowed in from April through September to date." He added, "However, total foreign net bond purchases during the same period amounted to only 37.5 trillion won," noting, "Even when the scope is narrowed to government bonds, the figure was estimated at 44.3 trillion won, below the projected inflow." In September alone, foreign investors were net sellers of 2.1 trillion won worth of bonds.
Lim Jae-gyun of KB Securities noted, "GPIF holds government bonds of major markets, including the United States and Europe, at weightings generally similar to their benchmark allocations, but it has maintained a lower weighting for Korean bonds than the benchmark." 
Japanese funds are generally known to track WGBI mechanically, while ETFs are also understood to replicate their underlying indexes to a significant extent. Even so, some major funds have allocated less to Korean bonds than the benchmark. 
Lim attributed weaker-than-expected foreign purchases of Korean bonds to diminished incentives for arbitrage trades. Since the end of last year, market expectations that the Bank of Korea (BOK) rate-cut cycle had ended and that a policy rate hike was possible have sharply reduced foreign investors' incentives to pursue short-term bond arbitrage. As recently as April last year, a dollar-based investor could have expected a return roughly 100 basis points higher than that on one-year U.S. Treasuries by hedging the won exposure and investing in one-year Korean government bonds. The gap has steadily narrowed since then. He explained that around the U.S. Federal Open Market Committee (FOMC) meeting last September, there were also periods when investing in U.S. Treasuries was more advantageous than investing in Korean government bonds. 
Meanwhile, declining demand from insurers for bond forwards has also been cited as a factor weakening foreign purchases of ultra-long-term bonds. Insurers have used bond forwards to manage their Korean Insurance Capital Standard (K-ICS) ratios, and foreign investors often held the bonds until they were delivered to the insurers. Analysts say that related transactions have declined as rising interest rates recently reduced insurers' need to purchase ultra-long-term bonds.
 

[email protected] Kim Hyun-jung Reporter