Money is flowing out of South Korean bond funds after the Bank of Korea raised its policy rate twice in a row, but ultra-short-term bond funds — the category least sensitive to rate moves — have drawn large inflows. With the prospect of further tightening keeping upward pressure on market yields, investors are shortening maturities to reduce interest rate risk.
Domestic bond funds held 88.6344 trillion won in assets as of the previous day, down 385.1 billion won over the past month, according to financial data provider FnGuide on the 2nd. Bond funds have been losing money this year as expectations for rate cuts faded and market yields rose. In the first half, a rally in domestic equities also weighed on relative performance by making stocks and other risk assets more attractive.
Flows diverged sharply by fund type. Funds that mainly hold government and public-sector bonds saw assets fall 625.5 billion won over the past month, while ultra-short-term bond funds, which invest in bonds with short maturities, took in 648 billion won. Returns diverged as well over longer periods. Government bond funds lost 1.69% over the past three months, while ultra-short-term funds returned 0.80%. Over six months, government bond funds fell 4.63% while ultra-short-term funds gained 1.50%, demonstrating their defensive quality.
Rising market yields are the key reason for the split in performance. The Bank of Korea raised its policy rate by 0.25 percentage point in July, to 2.75% from 2.50%, and lifted it again to 3.00% last month. Bond prices typically move in the opposite direction from yields, and price swings grow larger as maturities lengthen. In a rising-rate environment, long-dated bonds face greater risk of valuation losses, while ultra-short-term bonds are less price-sensitive and mature quickly, making it relatively easy to reinvest at higher yields.
Expectations that the central bank's tightening cycle is not yet over, even after two consecutive hikes, are reinforcing the shift to shorter maturities. The Bank of Korea's own six-month rate outlook also points to further increases. Of the 21 projection points submitted by seven members of the Monetary Policy Board last month, 10 placed the policy rate at 3.25% in six months and six at 3.50%. Only five pointed to the current level of 3.00%.
Hana Securities expects the central bank to hold rates next month before raising them again in November and in February next year, bringing the terminal rate to 3.50%. It said that path is not fully priced into the treasury bond market, and that yields on three-year and 10-year government bonds could climb to peaks of 4.3% and 4.7% this year. "As the semiconductor export cycle gradually spreads through the broader economy, it is also adding to core inflation pressure," said Kim Sang-man, an analyst at Hana Securities, who maintained a recommendation to reduce duration.
Supply is another variable. If net issuance of treasury bonds next year stays near 100 trillion won, similar to this year, the supply burden could add to upward pressure on yields. "Even with expectations of fresh foreign inflows from inclusion in the World Government Bond Index this year, weaker demand amid market conditions has increased the supply burden," said An Ye-ha, an analyst at Kiwoom Securities. "If concerns over expansionary fiscal policy persist, the term premium on domestic yields will stay elevated."
