[Real Estate Finance] Interest Rates Peak Approaching... Timing for Long-Term Bond Investment

Turning Point Expected in US Interest Rate Hike March
Advice to "Hold Off on Rushing Investments for Now"

The global tightening that has continued since the COVID-19 pandemic is expected to soon reach a turning point. The prevailing view is that market interest rates, which have risen significantly, will soon peak and either stabilize or begin to decline. However, concerns about economic recession, financial sector instability, and the prolonged Russia-Ukraine war continue to create economic uncertainties, preventing the stock market from finding a breakthrough. What investment strategies are effective in such times? The answer lies in the market. Savvy 'big players' have already turned their attention to the bond market since the beginning of the year. In particular, long-term bonds with maturities of 10 years or more, which can yield greater capital gains as interest rates fall, are gaining popularity.

According to the Korea Financial Investment Association on the 12th, individual investors' net purchases of bonds with remaining maturities of 10 years or more in the over-the-counter market in the first quarter of this year amounted to 2.2526 trillion won. This is nearly four times the 576.7 billion won recorded in the previous quarter. Compared to the same period last year (481.9 billion won), the amount has increased about 4.7 times. Early in the year, there was an expectation that the U.S. Federal Reserve (Fed) would reach its terminal rate at the March Federal Open Market Committee (FOMC) meeting and then cut rates within the year, which is interpreted as the reason why investment funds rapidly flowed into the bond market. In the past, bond investment was perceived as the exclusive domain of so-called 'big players,' but now it is becoming more popular as investments can be made with small amounts starting from 1,000 won units.

Although U.S. economic indicators such as employment and inflation have shown stronger-than-expected performance, delaying the Fed's terminal rate timeline somewhat compared to early-year expectations, the enthusiasm for bond investment continues into April. Individual investors have purchased 250 billion won worth of long-term bonds (with remaining maturities of 10 years or more) in just over 10 days this month. This reflects expectations that the Fed's tightening stance will ease due to factors such as the slowdown in U.S. inflation and the unexpected collapse of Silicon Valley Bank (SVB). The Bank of Korea held its base rate steady at 3.50% as of the previous day.

The reason long-term bond investment is popular ahead of a potential rate cut phase is that bond prices move inversely to interest rates. The lower the interest rates, the more bond prices rise. Kim Yong-sun, head of the Suwon WM Center at Daishin Securities, explained, "Long-term government bonds are optimal for investment in the current market situation. If you buy 10-year or 20-year long-term government bonds at the current interest rate level and the rate drops by just 0.5 percentage points after one year, you can expect double-digit annual returns due to bond price appreciation."

Investment value is even higher for long-term bonds issued with coupon rates in the 1% range. Korea's current base rate of 3.5% is the highest level since November 2008 (4.0%), during the global financial crisis. It took only about a year and a half to raise the base rate from 0.5% to the current level, so the gap between the coupon rate of already issued bonds and the market interest rate is larger than ever. A large difference between these two rates means higher expected yields from bonds. Especially, long-term bonds with longer remaining maturities have greater price volatility due to interest rate declines compared to short-term bonds, and the longer period to realize capital gains increases their investment value.

Another attraction of bond investment is 'tax savings.' Taxation on bond investment income is based on the 'coupon rate.' For example, a 20-year government bond issued in 2019 (19-6) was trading at an interest rate level of 3.205% on the previous day in the market, but its coupon rate was only 1.125%. If held until maturity in 16 years, the average yield is estimated to be 3.7%. Kim Yong-sun said, "Assuming the issue price was 10,000 won, the price has dropped to the 7,300 won range due to interest rate hikes. If the interest rate falls by 0.5 percentage points after one year, the selling price will rise to the 8,200 won range, generating investment gains. However, taxes are only paid on interest income based on the coupon rate, so capital gains are effectively tax-free, increasing the real after-tax return."

Additionally, credit specialized financial bonds (yeojeonchae) issued by card companies and others are also being actively purchased by individual investors due to their low coupon rates in the 1-2% range. According to the Korea Financial Investment Association, the total net purchases of bonds by individuals in the first quarter of this year amounted to 8.6554 trillion won, of which other financial bonds (yeojeonchae) accounted for 2.5966 trillion won. This was the second-largest net purchase amount after government bonds (3.0487 trillion won), surpassing corporate bonds (2.0956 trillion won).

Although 'big player' retail investors quickly bought bonds betting on the possibility of rate cuts, doubts remain in the market about the timing of the end of tightening. Even if rate hikes stop, there is significant uncertainty about when the actual rate cuts will begin. Although last month's inflation rate fell to the low 4% range, it is still a long way from the 2% range that can be confidently called 'stable.' The real estate market, where risks from troubled project financing (PF) have not disappeared, is also a variable. Therefore, market experts advise maintaining a wait-and-see stance for the time being rather than rushing into investments.

Im Jae-kyun, a researcher at KB Securities, said, "Due to concerns about inflation from public utility rate hikes, it is judged that rate cuts within the year are difficult. There is also a burden from the inverted yield curve as government bond yields and the base rate have reversed. Even if rate cuts are considered within the year, the market expects them at the end of the year, meaning investors must endure about nine months of inverted carry. Unless government bond yields fall sharply, this remains a burdensome level." He added, "From the perspective of foreigners who have massively entered the Korean bond market after the SVB collapse, the desire to realize profits is expected to increase. Therefore, rather than rushing now, it is advisable to increase exposure after the 3-year government bond yield exceeds 3.6%."

Yoon Yeo-sam, a researcher at Meritz Securities, also pointed out, "Expectations for monetary policy easing within one year are limited to lowering rates to about 3.25%. If cuts do not occur within the first quarter, yields below 3.2% on 3-year government bonds represent an uncomfortable reality due to inverted carry." He added, "If the domestic economic slowdown trend becomes more concrete, confidence will strengthen that rates can be lowered to 2.75% within two years."

This content was produced with the assistance of AI translation services.