The biggest rally in South Korean government bonds since 2009 drove valuations to the highest level in nine months relative to equities as an economic slowdown prompted investors to favor the safest assets.
Ten-year government notes yielded 3.01 percent on July 25, a record low, while the Kospi index (KOSPI)’s earnings yield, the inverse of its price-earnings ratio, was 11.16 percent, according to data compiled by Bloomberg. The gap of 815 basis points was the widest since October 2011. The difference has since narrowed to 725 basis points amid speculation European leaders will do more to tackle a regional debt crisis.
While the 10-year yield dropped 48 basis points in July, Hanwha Securities Co. and Samsung Asset Management Co. say bonds may advance further as a global slowdown hurts Korean exports. Overseas sales tumbled the most in almost three years in July and inflation was the slowest since 2000, data showed today. South Korea’s economy grew 2.4 percent in the second quarter from a year earlier, the least since 2009.
“In normal economic situations, this valuation gap would’ve signaled it’s time to buy equities,” Choi Seok Won, the head of research in Seoul at Hanwha Securities, one of South Korea’s bond primary dealers, said in a phone interview on July 27. “But at times like this when risk appetite is low, the difference has to be much larger for money to flow quickly into stocks.”
The 10-year yield fell to 3.14 percent yesterday from 3.62 percent at the end of June as the central bank unexpectedly cut its benchmark interest rate for the first time in three years to spur demand at home amid a deteriorating global economy. It was 3.10 percent as of 10:26 a.m. today in Seoul. South Korea’s government debt has handed investors a 4.9 percent return this year, HSBC Holdings Plc data show.
The Bank of Korea lowered its seven-day repurchase rate to 3 percent from 3.25 percent on July 12 and Samsung Asset Management predicts it will be at 2.50 percent before the end of this year. Economic growth is forecast to slow to 2.9 percent this year from 3.6 percent in 2011 and 6.3 percent in 2010, based on the median estimate in a Bloomberg survey.
“It’s not the time to start selling bonds expecting an economic recovery with Europe’s situation continuously evoking nervous reactions in the market,” said Kim Youngsung, head of fixed income in Seoul at Samsung Asset Management, South Korea’s biggest fund manager with 118 trillion won ($104 billion) of assets.
Companies on the Kospi index trade for 9.6 times estimated profit, less than the five-year average of 10.8 times, and compared with the MSCI Emerging Markets Index’s 10.5 times, according to Bloomberg data. The Kospi fell 0.7 percent today, trimming this year’s advance to 2.4 percent.
“Investors’ risk aversion has reached its maximum level, which I think can’t be sustainable, and the relative attraction of stocks is getting bigger,” said Heo Pil Seok, Chief Executive Officer at Seoul-based Midas International Asset Management Ltd., which oversees some $5.1 billion. “I think South Korea’s bonds are now in a bubble phase, with prices already reflecting further rate cuts.”
South Korea’s exports dropped 8.8 percent in July from a year earlier and consumer prices increased 1.5 percent, the government reported today. Economists forecast a 3.7 percent decline in shipments and an inflation rate of 2.0 percent, Bloomberg surveys showed. Industrial output fell 0.4 percent in June from the previous month and manufacturers’ confidence is at a three-year low, according to reports earlier in the week.
Five-year credit-default swaps insuring South Korea’s sovereign debt against default fell six basis points in July to 117, according to data provider CMA, which is owned by McGraw- Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.
Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent if a government or company fails to adhere to its debt agreements. A basis point equals $1,000 annually in a contract protecting $10 million of debt.
European Central Bank council member Ewald Nowotny said in an interview published July 25 that there are arguments in favor of giving Europe’s rescue fund a banking license, which would allow access to European Central Bank lending. ECB President Mario Draghi pledged the next day to do whatever is needed to preserve the euro. The won and the Kospi gained in the four trading days since July 25.
Investors should be wary of viewing the comments as a “permanent cure” to Europe’s crisis, Samsung’s Kim said.