[Bond Market Diagnosis] ① Fire Was Quickly Put Out... Corporate Credit Risk Remains

Bond Market Liquidity Tightening Eased Amid Legoland Incident
Only High-Credit Bonds Traded... Companies Rated A or Below Suffer High Interest Rates

The liquidity crunch triggered by the Legoland incident swept through the bond market once. The government-led large-scale liquidity supply to the market put out the urgent fire. However, uncertainties remain. Interest rates are expected to stay high next year, and credit risks are anticipated to increase due to worsening corporate earnings and economic recession. The unsold inventory in the real estate market has expanded alarmingly, remaining a risk factor for the bond market. The bond market is walking on thin ice. How long will the seemingly stabilizing atmosphere last? We diagnose the current situation and risk factors.

[Reporters Hwang Yoon-joo, Lee Min-ji, Lim Jung-soo] The liquidity squeeze in the bond market and short-term financial market, which intensified after the Legoland incident, is easing. Despite the rapid interest rate hikes in the U.S., the possibility of a slowdown in the pace has emerged, leading to a decline in bond yields including Korean government bonds. The corporate bond market, which was unsettled due to the large-scale bond issuance by Korea Electric Power Corporation (KEPCO), the bank bond market where yields surged due to supply-demand concerns, and the asset-backed securities (ABS) market (bonds issued by specialized credit finance companies), which faced funding blockages, have all seen a halt in rising yields and a reopening of funding channels.

However, the bond market is not functioning normally. Although the government is injecting funds to warm the frozen market, only high-credit-quality bonds are barely active. Rising raw material prices, increased funding costs, and deteriorating corporate earnings due to the recession act as negative factors, keeping concerns about corporate credit risk high. It is still considered a long way before the warmth spreads to companies or financial institutions with somewhat lower credit ratings below A grade.

Through Liquidity Support Package... Market Stabilizes Despite U.S. Rate Hikes

Although the U.S. Federal Reserve (Fed) raised interest rates by 50 basis points (1bp=0.01 percentage points) at the December Federal Open Market Committee (FOMC) meeting, Korean government bond yields actually declined and stabilized. On the 17th, the 3-year maturity government bond yield closed at 3.539%. After the U.S. implemented a giant step (a 0.75 percentage point rate hike at once), the same maturity government bond yield had risen to 4.548% earlier this year but recently dropped by more than 1 percentage point. Gong Dong-rak, deputy general manager at Daishin Securities, explained, "There was little change in the U.S. Treasury bonds (TB) 10-year and 2-year yields, and Korean government bonds reversed to a decline in the afternoon," adding, "This means the bond market had preemptively priced in the tightening stance and quickly priced in expectations that the policy stance itself could shift considering the possibility of an economic recession."

The 3-year maturity Korea Electric Power Corporation bond (KEPCO bond), which once traded at mid-6% levels in the secondary market due to supply-demand instability, fell to the 4% range. According to the Korea Securities Depository, the 3-year KEPCO bond issued on the 14th with a scale of 150 billion KRW was issued at 4.550%. KEPCO bonds are top-rated (AAA), but after the Legoland incident, they were issued at higher yields than lower-rated corporate bonds, fueling overall market anxiety. In fact, the 3-year bond yield issued by KEPCO on the 15th of last month (5.800%) was higher than the same-day corporate bond (unsecured 3-year) AA- rating (5.346%).

The decline in KEPCO bond yields is attributed to the operation of the Bond Stabilization Fund (Bond Fund) and diversification of funding sources. The financial authorities have operated the Bond Fund since October 24 to stabilize the bond market, purchasing matured corporate bonds (AA- or higher), asset-backed securities (A+ or higher), commercial paper (CP), and short-term bonds (A1). Additionally, KEPCO was advised to restrain bond issuance and convert to bank loans. This reduced the scale of KEPCO bond issuance that disrupted the bond market and opened a path for funding through partial purchases by the Bond Fund. Hyun Seung-hee, senior researcher at NICE Investors Service, evaluated, "The previous liquidity squeeze in the bond market was due to increased concerns about credit products, which shrank investment demand. The Bond Fund's role in supplying funds in the bond market, including KEPCO bonds, has positively contributed to market stabilization."

The financial authorities plan to complete an additional capital call procedure of 5 trillion KRW for the Bond Fund by January next year. They are also operating a corporate bond and commercial paper (CP) purchase program worth a total of 11 trillion KRW, managed with policy funds. Furthermore, from next year, a 5 trillion KRW Primary Collateralized Bond Obligation (P-CBO) program will be launched to support smooth corporate bond issuance by large, medium, and small enterprises.

Some concerns have been raised that expanding the issuance limit of public corporation bonds such as KEPCO bonds could trigger supply-demand instability again. An investment banking industry official said, "The amendment to the KEPCO Act, which increases the KEPCO bond issuance limit, is likely to pass the National Assembly in March next year," adding, "If KEPCO raises the bonds that have been postponed until the law passes all at once, yields could surge again due to supply-demand instability." The official also predicted, "With Korea Gas Corporation also demanding an increase in issuance limits, the supply of public corporation bonds could suddenly expand."

Non-Investment Grade Bonds Face Chilly Sentiment... Credit Risk Concerns Expand

The corporate bond market is stabilizing mainly around high-grade bonds rated AA or above. According to the Korea Financial Investment Association, on the 16th, the 3-year maturity corporate bond yield for credit rating 'AA-' was 5.265%. After exceeding 5.7% due to the Legoland incident in October, the yield declined due to expectations of a slowdown in Fed rate hikes and the effect of large-scale government liquidity supply such as the Bond Fund. As corporate bond yields fell, the credit spread (the difference between the 3-year corporate bond yield rated 'AA-' and the same maturity government bond yield), an indicator reflecting institutional investors' corporate bond sentiment, also narrowed. This means credit risk has decreased accordingly.

However, investment sentiment is still concentrated only on high-grade ratings. In the secondary market, premium trading occurs mainly for companies with good credit ratings. Bond yields move inversely to prices; as yields fall, bond prices rise. Recently, the 'Hyundai Steel (AA) 120-3' bond maturing in January 2024 traded at a 5.5% yield, about 20 basis points lower than the market average yield (the unique yield evaluated by private bond rating agencies). The 'KB Financial (AAA) 36-2' bond maturing in February of the same year also traded at about 4.7%, approximately 40 basis points lower.

In contrast, the 'SK Rent-a-Car (A+) 50-1' bond maturing in April of the same year traded at 6.1%, 5 basis points higher than the market average yield, and the 'Samyang Packaging (A-) 2' and 'DL Construction (A-) 1-2' bonds maturing in September traded at 6.081% and 6.407%, respectively, 35 and 33 basis points higher than the market average. A-grade companies such as SK Magic, SK Rent-a-Car, and Hansol Paper issued private placement bonds at still high yields in the 7-8% range.

Reflecting the polarization in the bond market, the credit spread (yield difference) between high-credit-quality bonds and lower-rated non-investment grade bonds has risen to an all-time high and has not come down. As of the 16th, the yield difference between AA-rated and A- rated bonds reached about 97 basis points. An investment banking industry official said, "Corporate bonds rated A or below are still trading at considerably high yields," adding, "There are almost no new issuances."

Kim Young-do, senior research fellow at the Korea Institute of Finance, analyzed, "Concerns about credit crises have not disappeared in non-investment grade bonds," adding, "Several risk factors remain, including supply-demand instability and redemption issues due to financial institutions' year-end book closing, the possibility of additional tightening in the short-term funding market, and real estate project financing (PF) instability."