Asia Volatility Supply Shrinks as Korea's Callable Bonds Vanish

  • Accounting rule changes, FX risks are big drivers of slowdown
  • Volatility gauges across globe have been tumbling this year

Call it the curious case of South Korea’s callable bonds.

Investors in Asia’s No. 4 economy are souring on the debt, prompting issuers to cut back on sales of the securities that can be repaid after set time periods -- sending the average monthly pace of issuance this year to less than half of what it was in 2016. At a time when volatility is vanishing across the globe, the dwindling supply of the volatility-rich options that underpin such debt can have an outsized impact on markets.

Korean callables are “the most important potential source of expanded USD volatility supply among major Asian economies,” JPMorgan Chase & Co. fixed income strategists including Joshua Younger wrote in a note. Because the bonds are usually of relatively long maturity, price changes for options on them lead to large changes in expectations for further changes in price.

Implied and actual price swings have plunged across asset classes this year, generating angst among traders who rely on volatility to boost earnings and spurring some investors to fret that markets will be caught napping if any seismic shift occurs. The CBOE Volatility Index slid to a 23-year low last month, while currency volatility is dropping at the fastest pace since 2012 and expectations for price swings in Treasuries are also collapsing.

Big banks are suffering from the global market calm; read more here

As with many markets since the global financial crisis, regulatory changes are key when it comes to the Korean situation. Callable bonds typically don’t provide interest payments in South Korea. And zero coupons may be designated as a type of derivative in new international rules coming into force in South Korea -- making them less attractive for insurers, a key investor class for fixed-income assets.

Starting next year, publicly traded companies across the world will have to adopt the revised standards, known as IFRS 9, and with it may come “some constraints” that would damp demand for zero-coupon callable notes. Zero-coupon securities account for a big part of the country’s callable market, say market makers.

“We believe there is renewed concern that zero coupon structures may be treated as derivatives,” the JPMorgan analysts noted. Bank-owned insurers, in particular, are likely to stay away from callable bonds, they wrote.

Sales of such bonds also generate options that supply what is known as “vega” -- or securities whose prices are highly sensitive to changes in expectations for market fluctuations. And vega is what investors need to buy if they want to benefit from a spike in volatility.

The dearth of Korean callables -- and its impact on volatility -- comes at a time when fears are on the rise that investors are too complacent across a range of asset classes.

Mohamed El-Erian, Allianz SE’s chief economic adviser, said last month that investors lulled by rising stock prices have been adding risk that may come back to burn them. And Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, said in the past week that the dropoff in U.S. bond volatility means that “even a modest fundamental shift could trigger an outsized response in the Treasury market.”

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