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Attracting Huge Attention
Korean government offers more benefits on bond investments, including inflation-indexed bonds and Brazilian tax-free government bonds
Attracting Huge Attention
  • By matthew
  • March 9, 2012, 16:04
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The bond is widely known as a relatively safe financial product. This has contributed to the formation of many bond buyers among conservative, wealthy people. However, the investment portfolios of ordinary people reveal that bond proportion, especially in regards to long-term bonds, is relatively small.

However, things are expected to change this year. Ordinary people are expected to increase their investments in long-term bonds. With the Ministry of Strategy and Finance (MOSF) announcing on January 18 that it will issue 30-year treasury bonds worth 1.6 trillion won beginning this September, expectations regarding bond investments are rising. The MOSF is expected to lower the bid unit price for treasury bond investments from the current one million won to 100,000 won. The MOSF is also considering income tax interest cuts for individuals who invest in treasury bonds for more than 10 years. These moves mean it will become much easier for an individual to invest in long-term bonds.

Long-term Bond Investments Become Simpler and Easier

The main reason why rich people buy bonds is that they reduce tax payments. Bond interest yields are mostly tax-free. Government bonds are the safest among all bonds. Government bonds refer to assets that depend on the potential growth of a nation, if this falls, the price of government bonds rises, causing interest rates on government bonds to drop. As of today, the interest rate of Japanese government bonds is close to zero, while those on 10-year US and Germany government bonds are two percent, and those of Singapore, Taiwan, and Thailand at the three percent level.

From a long-term perspective, the more mature the capitalist system becomes, the further interest rates on government bonds fall. This automatically leads to a rise in the prices of government bonds. Bond king Bill Gross once said, “Among those who invested in stocks, some have gone bankrupt, but among those who invested in bonds (national bonds), no one has gone bankrupt.”

The same applies to South Korea. South Korea is now following in the footsteps of Japan. The interest rate on Japanese bonds was in the 3 to 4 percent range in the late 1980s. The Japanese government once dramatically increased the issuance of government bonds in the name of implementing austerity policies. As a result, the interest rate on 10-year government bonds soared to the 6 to 7 percent range in the early 1990s. For 10 years since then, the interest rate has continued to fall, with it currently standing at zero percent. Through this process, asset prices, such as those of real estate and stocks, dropped to almost one-third or one-fourth their previous level. However, the prices of Japanese government bonds increased, with investors holding these assets now seeing benefits. Against this backdrop, government bonds are the best asset for Korean investors to avoid the brunt of the economic recession.

Foreign Investment Throng into Korean Government Bonds

The chances are high that the Korean bond market will expand. While foreign investment in the Korean stock market reaches 400 trillion won, the proportion of foreign ownership of Korean government bonds hovers around the 70 trillion won level.

Foreign investment has recently flown into Korean government bonds from China's sovereign wealth fund. Japanese funds are also highly likely to flock to Korean government bonds. Government bond investments are most likely to flow into nations with strong industries. The reason is that the future of a nation’s economy cannot be guaranteed if corporate competitiveness does not prop up the nation's economy. Look around anywhere in the world, there are few nations with companies showing as strong performance as those in Korea. On the other hand, the stock market is also raising concerns that “the prices of Korean government bonds have been overheated.” However, it must be remembered that the Korean government basically guarantees more than four percent of the added value of its government bonds for the next 20 years.

Both interest yields and profit margins can be expected from bond investments. The government bond is safer than any other kind of bond, but has the lowest interest rate. Public corporation bonds have higher interest rates than government bonds and are safe. Seoul Metropolitan Rapid Transit Corporation bonds and Kyungki Provincial Development bonds are the most popular. The recently released Korea Land Development Corporation bond is a 20-year public corporation bond offering a monthly interest rate of 4.38 percent. The interest yield of this bond is in the five percent range when adjusted for reinvestment. This sort of bond is highly safe because they are regarded as being almost government bonds.

High-income earners who want to avoid the so-called Buffet tax -- a tax rule under which a composite income tax rate of 41.8 percent is levied upon income exceeding 300 million won -- need to look at separate tax instruments and low coupon rate bonds. With prices being the main topic of conversation, inflation-indexed securities (IIS) have recently been attracting the most attention from bond buyers. As for IIS, the government guarantees a coupon rate of 1.5 percent, along with the principal. IIS interest is calculated by adding the coupon rate of 1.5 percent to the IIS interest rate of the trading day, and by reflecting inflation on the principal. When the inflation rate is three percent, IIS interest is exempted from taxation and qualifies for separate taxation. In this case, IIS interest is paid by adding coupon interest yields to the inflation rate of three percent.

This yield structure produces higher returns than those of ordinary bond investment. It is mind-boggling why the government issues such good bonds, not to mention guaranteeing the principal. The government is now offering good conditions in order to develop the bond investment market, yet these conditions are highly likely to deteriorate over the next few years. In other words, the government may issue inflation-indexed securities at a lower coupon interest rate.

Inflation hedge is important when investing a large chunk of money, including retirement money, in bonds. The reason is that a fall in the value of money drags down the value of financial yields paid on fixed interest rates. As many countries printed plenty of money, they are highly likely to pay for inflation in the future. These countries have enjoyed the Goldilocks economy of high growth and low inflation for the past 10 years. However, it is highly likely that they will face the Goldilocks economy in reverse; slow growth and high inflation, for the next 10 years. Considering various factors, such as recent trends in the price, supply and demand of global energy, the growing trend of service fees such as labor costs, China’s inflation resulting from the yuan's appreciation, and China’s wage growth rate (an annual 20 percent increase), inflation-indexed securities are expected to function as the best tax-free investment in the coming years. As of now, it appears okay to invest more than 30 percent of a portfolio’s assets in inflation-indexed securities.

Following the Path of Japan

Brazilian government bonds are a good investment. Unlike other foreign bonds, Brazilian government bonds are tax-free. Thus, even though Tobin taxes (six percent) -- taxes on currency trades across borders -- are levied, the bonds yield an annual return of 8.5 percent. This is attributed to the sweeping non-taxation agreement between South Korea and Brazil. South Korea has struck the deal to promote trade and investment with Brazil. The interest on Brazilian government bonds is paid to bondholders every six months. If the Brazilian government decides to attract more dollars, it will possibly lower Tobin taxes further. When this happens, the relative yields on the bonds will possibly increase further. Brazilian tax-free government bonds guarantee the bondholders in the highest composite income tax bracket the same yields as those of taxable bank deposits that offer a 15 percent interest rate.

It seems that the world is now following the path of Japan. In South Korea, there is a growing trend of using long-term government bonds as basic assets similar to insurance policies in terms of asset management. The Japanese have approximately 95 percent of Japanese government bonds. This contributes to the stability of Japan’s foreign exchange market. Like Japan, South Korea is considering tax credits for long-term investors in the government bond market in order to secure the stability of the won.