[Challenge Bond Ant] ③ Must Watch Interest Rates and Corporate Credit Ratings Trends

Checking the Continuation of the 'Austerity Policy' in the War Against Inflation
Interest Income Tax and Fees Also Key Variables in Investment Returns

[Asia Economy Reporter Lim Jeong-su] Bond investors this year need to closely monitor the macroeconomic conditions in the United States and South Korea. This is because bond yields are likely to fluctuate according to the global interest rate trend. It is necessary to flexibly adjust bond investment strategies based on interest rate forecasts. Additionally, concerns about corporate credit rating downgrades are growing due to the economic recession, so investing in corporate bonds of companies with a high possibility of credit rating decline should be approached with caution. Interest income tax and transaction fees, which significantly affect the real returns on bond investments, should also be considered as variables.

This year, bond investors should carefully observe how long the monetary authorities in the US and South Korea will maintain their tightening stance. Experts expect the US Federal Open Market Committee (FOMC) to raise interest rates at the end of January and early February, and foresee the benchmark interest rate peak to be formed around 5% within the first half of the year. While some predict a quick shift to an interest rate cut policy after reaching the peak, others believe that a high interest rate environment will be maintained for a long period.

The Bank of Korea is also unlikely to rule out the possibility of continuing to raise the benchmark interest rate following the US. On the 13th, the Bank of Korea raised the benchmark rate by 25 basis points (1bp = 0.01 percentage points) to 3.50%, causing both spot and futures prices of government bonds to rise simultaneously. Although the Consumer Price Index (CPI) inflation rate has dropped significantly to around 5%, it remains above the monetary authorities' target. It is difficult to expect interest rates to be lowered again in the short term.

When the benchmark interest rate rises, the absolute level of bond yields increases. In this case, unrealized losses occur on held bonds. Especially, holders of long-term bonds with longer maturities may face larger unrealized losses. Bond investors who purchase long-term bonds aiming for capital gains should consider a longer investment horizon, waiting for an interest rate decline, or adopt a hold-to-maturity (carry) strategy rather than expecting short-term capital gains.

There is also a forecast that the US and South Korean monetary authorities will find it difficult to maintain a tightening stance for a long time. This is because an economic recession is expected this year and inflation is visibly on a downward trend. With the rapid decline in US inflation and growing concerns about recession, there is an expectation that the US Federal Reserve (Fed) will begin lowering interest rates again within the year.

Many Companies with Negative Rating Outlooks and Downgrade Reviews

Even if interest rates peak, if a long-term downward stabilization trend is maintained, bond investors can steadily earn both valuation gains and interest rate gains. Generally, when market interest rates fall below the bond issuance rate (coupon rate), valuation gains occur, and the opposite situation causes valuation losses. The greater the difference, the larger the gains and losses.

Investment in corporate bonds of companies with a high likelihood of credit rating deterioration should be avoided. When a company's credit rating falls, the spread between government bond yields and corporate bond yields issued by that company widens, causing the corporate bond yield to rise. In this case, even if government bond yields remain stable, corporate bond yields increase, potentially causing losses to bond investors.

According to NICE Credit Rating, as of the end of last year, 28 companies were assigned a 'positive' rating outlook, while 40 companies were given a negative rating outlook or placed under downgrade watch, showing a predominance of negative outlooks. Hyung-wook Choi, a researcher at Korea Ratings, predicted, "With signs of economic contraction appearing in multiple economic indicators, there is a high possibility of overall credit spread widening and an increase in corporate bond default rates."

Nevertheless, investors seeking high returns by investing in high-risk bonds must carefully examine risk factors. Bonds related to construction companies, project financing (PF), or securitized products (ABS, ABCP, etc.) have significantly high yields due to default concerns, but if default risk rises and spreads widen, valuation losses may occur.

If supported by risk analysis capabilities, PF-related securitized products are considered better than corporate bonds issued by construction companies. A bond market insider said, "In the case of PF securitized products, many have high yields despite lower default risk compared to construction companies," adding, "Senior tranche securitized products generally have relatively low default risk."

Interest income tax and fees, which individual investors often overlook when investing in bonds, should also be considered as variables. There is a significant tax difference depending on whether interest income tax is subject to separate taxation or aggregate taxation. When combined financial income from interest and dividends is less than 20 million KRW, separate taxation applies, and investors pay 15.4% (including local tax) on interest income. For a bond with a 5% coupon rate, this corresponds to 0.77 percentage points. When financial income exceeds 20 million KRW, the amount exceeding 20 million KRW is aggregated with other income and taxed progressively, potentially increasing the interest income tax by more than 1 percentage point.

Must Determine Whether Separate or Aggregate Taxation Applies

Experts advise that when the investment amount is large, buying long-term government and public bonds with lower coupon rates may yield better returns than those with higher coupon rates. Kim Hyung-ho, CEO of Korea Bond Investment Advisory, said, "Since there is no tax on capital gains from bonds, when aiming for long-term capital gains, it is better to choose bonds with lower coupon rates."

Fees are also an important variable to consider. When trading bonds on the exchange, transaction fees are much higher than those for stocks, significantly affecting bond yields. Since fees vary depending on remaining maturity and securities firms, it is advantageous to use HTS (Home Trading System) or MTS (Mobile Trading System), which have lower fee burdens, for trading.