Abstract
The paper discusses potential output, the output gap, and inflation in Korea. The paper explores the information content of potential leading indicators of inflation. A broadly balanced current account has been the suggested norm for Korea over the medium term. The challenge is to help build a more robust bond market that prices risk appropriately. The features of pension schemes in Korea and the problems they face are outlined. The paper reviews pension reform, banking sector, corporate sector, and foreign exchange crises with respect to Korea.
IV. Developments in the Corporate Bond Market1
Financing pressures in the corporate bond market grew through 2000 and are expected to remain substantial through 2001. These pressures reflect the coincidence of greater investor sensitivity to credit risk, the decline of those institutions that historically were the major buyers of corporate bonds, and the upcoming maturity of the large stock of 3-year bonds issued in 1998. The authorities have taken several steps to reduce the liquidity crunch associated with the debt rollovers. The challenge for the authorities will be to ensure that the measures they adopt keep distortions to a minimum, and help build a more robust bond market that prices risk appropriately. In addition, it will be important to maintain momentum in corporate restructuring and the exit of nonviable firms.
A. Background
1. Korea has a fairly active bond market, with the second largest corporate bond and asset-backed securities market in Asia (after Japan). The corporate bond market began to grow in the early 1970s following the passage of the Capital Markets Promotion Act of 1968. Most corporate bonds—about 85 percent immediately prior to the crisis—carried guarantees from banks, securities companies, or guarantee funds. With little issuance of government debt until recently, the three-year corporate bond was considered the benchmark bond yield. Foreign investment in the market was fully closed until 1994, when nonresidents were permitted to buy non-guaranteed convertible bonds issued by small and medium sized companies. Some further liberalization occurred in 1996 in conjunction with OECD membership, but complete liberalization of access by nonresidents did not occur until December 1997.
2. The bond market has changed substantially in the aftermath of the crisis. The development of the market has been stimulated by measures taken both by the authorities and the industry group (the Korea Securities Dealers Association). There are now several domestic rating agencies, some with links to the major international agencies. Since the crisis, the proportion of guaranteed bonds has fallen rapidly—in 1998, this proportion fell to about 30 percent, and it is now only about 3 percent, increasing the importance of credit rating agencies and credit risk assessment by investors. The implementation of mark-to-market accounting was completed in July 2000, and there are now several bond indices published. Finally, there has been very strong growth in government issuance, and a concerted attempt to improve the functioning of the government bond market, including by the implementation of a primary dealer system, a bond futures contract, deli very-versus-payment (DVP), and an inter-dealer broker system. The government yield curve was also extended substantially during 2000, via the first issues of ten-year government bonds.
3. The primary investors in the corporate bond market have traditionally been the investment trust companies (ITCs). These institutions were established in the 1970s and are similar to unit trusts or mutual funds in other countries (except that ITCs may undertake proprietary trading activity). As discussed below, there was a sharp increase in funds managed by ITCs in the aftermath of the crisis, reflecting the high interest rates offered on their products. Problems in the ITC industry became apparent in the wake of the Daewoo collapse, as losses by ITCs and uncertainty over the true value of funds prompted large redemptions by investors.2 The authorities have moved to tighten the regulation of ITCs to ensure improved investment, sales and management practices. In addition, several of the smaller ITCs have been closed and the larger ones have been recapitalized by major shareholders and the injection of public funds. Overall, the industry is far smaller than in mid-1999.
4. As of mid-2000, corporate bonds accounted for about 45 percent of outstanding bond issues in Korea, but a much smaller proportion of secondary market turnover. While there has been a sharp increase in overall secondary market turnover in recent years, most of this growth has been in government rather than corporate bonds. Indeed, market estimates now put corporate bond turnover at about only 7 percent of total secondary market turnover, down from more than 50 percent of turnover 2 years ago.
B. Recent Developments
5. Corporate bond issuance surged in the wake of the crisis. There was substantial corporate bond issuance in 1998 and early 1999, primarily of three-year bonds but also of some shorter maturity bonds. With only modest amounts of bonds maturing in 1998, net financing from corporate bonds in 1998 was W 33 trillion, even as companies lost bank financing.
Inssuance of Corporate bonds
(In trillions of won)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Inssuance of Corporate bonds
(In trillions of won)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Inssuance of Corporate bonds
(In trillions of won)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
6. Financing has been difficult in the corporate bond market since the collapse of Daewoo and the ITC problems of mid-1999. Following the collapse of Daewoo in mid-1999, ITCs—which held a large proportion of the stock of corporate bonds-experienced large losses and large outflows. With limited demand from other investors, new issuance of corporate bonds has been weak since mid-1999, and issuers—especially those with weak profitability—are encountering problems as the bonds issued in 1998 are maturing. Issuance of corporate bonds (excluding ABS) fell by about 33 percent in 2000 to a level that was only one-third of the issuance in 1998. Further, maturities on newly issued bonds have tended to shorten, with three-year financing now available only to the strongest companies.
Outstanding stock of Corporate Bonds
(In trillion, of won)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Outstanding stock of Corporate Bonds
(In trillion, of won)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Outstanding stock of Corporate Bonds
(In trillion, of won)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
7. About half of the existing stock of corporate bonds will mature in 2001. Although there is a substantial amount maturing in the first quarter of 2001, there will be a far greater amount maturing in the final quarter, implying further financing pressures at that point. About 80 percent of the rated debt maturing in 2001 carries credit ratings above the cutoff for a Korean investment grade rating from Korean rating agencies, i.e. above BBB minus. The companies accounting for the remaining 20 percent of debt will presumably encounter substantial difficulty in rolling over their debt without some form of credit enhancement, or arrangement with investors and creditor banks.
Maiming Corporals Bonds
(In trillions of won)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Maiming Corporals Bonds
(In trillions of won)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Maiming Corporals Bonds
(In trillions of won)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Korea: Credit Ratings of Debt Maturing in 2001
(in percent of total debt) 1/
Excludes the debt of workout companies and privately placed bonds.
Korea: Credit Ratings of Debt Maturing in 2001
(in percent of total debt) 1/
| A rating and above | 39.2 |
| BBB rating | 41.1 |
| BB rating and below | 16.4 |
| Unrated | 3.3 |
Excludes the debt of workout companies and privately placed bonds.
Korea: Credit Ratings of Debt Maturing in 2001
(in percent of total debt) 1/
| A rating and above | 39.2 |
| BBB rating | 41.1 |
| BB rating and below | 16.4 |
| Unrated | 3.3 |
Excludes the debt of workout companies and privately placed bonds.
8. The problems in the bond market are being exacerbated by difficulties in obtaining financing from other sources. Banks have historically not been major holders of corporate bonds, so modest recent increases in their bond holdings have done little to offset the withdrawal of other investors. Further, although (nonsecuritized) lending by banks has expanded, the desire to improve their asset quality has made banks reluctant to take on increased exposures to riskier borrowers. There has also been little interest by foreign investors in corporate bonds, presumably largely reflecting the low liquidity of the market, the poor health of many issuers, and the 27.5 percent withholding tax levied on fixed income products. Finally, although the equity market remained a source of financing into the first half of 2000, it has since dried up for most issuers.
9. The problems in the corporate bond market have prompted numerous measures by the authorities. The authorities’ response to the initial problems in mid-1999 was two-pronged, involving reforms and support to the ITC industry as well as encouragement for the establishment of a bond market stabilization fund. The fund was financed mainly with contributions from commercial banks and government-owned banks and its goal was to overcome the disruption caused by redemptions by ITC investors and keep the benchmark three-year corporate yield below 10 percent. By most accounts it was successful in achieving its goals, bringing down the benchmark yield from 11 percent to 9-9½ percent, and reportedly yielding profits to its contributors when it was dissolved in March 2000.
10. The difficulties experienced by low-rated and smaller firms in obtaining financing prompted a further set of measures in mid-2000. These measures included the establishment of a W10 trillion bond fund, in which about 15 banks and other financial institutions were encouraged to participate, for the purchase of corporate bonds or collateralized bond obligations (CBOs). In addition, two state-owned guarantee funds (the Korea Credit Guarantee Fund in particular) were to provide partial guarantees for subinvestment grade bonds that were included in CBOs. By encouraging risk-pooling via CBOs and by providing guarantees on low-rated bonds, the authorities hoped to increase the amount of bond financing going to low-rated and smaller companies. This measure has been reasonably successful, and about W 7½ trillion of primary CBOs (CBOs consisting of newly issued bonds) were issued in the second half of 2000, accounting for about one-third of all corporate bonds issued in this period. About one-third of the bonds in the first nine CBO issues carried credit guarantees, and about 40 percent of the firms raising money in these CBOs were subinvestment grade (BB rated) firms. The primary CBOs have been structured in a way that is broadly consistent with market principles. On average, about 35 companies have been pooled in each CBO. Companies participating in the CBOs pay a yield that is supposedly appropriate for their risk, and the amount by which these yields exceed the yield on the senior tranche of the CBO has provided a buffer which is expected to cover most losses, with the KCGF covering any further defaults.
11. As financing pressures in the corporate bond market worsened in late 2000, some further support measures for the bond market were announced. A second W10 trillion bond fund was established, with similar goals to the first fund, with contributions from a smaller number of banks and in addition from post office deposits and pension funds. A further measure announced at the end of December 2000, was reportedly designed to provide funding to allow the rollover of bonds of larger firms described as having temporary liquidity problems but good prospects of survival. If firms are deemed viable (by a committee consisting of the Korea Development Bank, creditor banks, and the KCGF, they would be allowed to participate if they repay 20 percent of their maturing bonds and present credible rehabilitation plans. The KDB would then act as underwriter for the rollover of the remaining 80 percent of maturing bonds at yields given by the average secondary market yield for similarly rated bonds, plus a margin for the use of the facility. The KDB would then resell the bonds via partially state-guaranteed CBOs (70 percent) and to main creditor banks (20 percent), and would hold the remainder itself. Details of this scheme continue to be refined.
12. The growing use of CBOs has both positive and negative aspects. The government’s support of CBOs has the potential to jump-start an active private market for CBOs to allow risk pooling and provide both a new investment product for investors and increased financing to firms. Of course, risk pooling in principle can be provided directly by institutions such as ITCs which give small investors access to a portfolio of bonds from a large number of issuers. However, in current conditions of limited confidence in nonbank financial institutions, government encouragement of CBOs may have been necessary to boost investor demand for pooled investment vehicles. Interestingly, however, the CBOs have been purchased primarily by large institutional investors such as banks and ITCs, the very type of investors that have the capacity to create their own diversified portfolios. Hence, the attraction of the CBOs may be largely due to the government-backed guarantee on the lower-rated bonds included in the CBO. This raises questions as to whether the low-rated companies benefiting from guarantees are priced appropriately and whether there could be substantial contingent liabilities for the government. Another potential shortcoming is that the bonds included in the primary CBOs are not issued in the open market like other bonds, but carry a yield set by the sponsors of the CBO. Hence, there is a risk that the use of CBOs undermines the development of markets and blunts the effectiveness of the price signals provided by the usual market mechanism that applies when companies come to the market to issue bonds. Finally, there are issues about whether loss-sharing rules are clearly spelled out and whether holders of the residual or subordinated tranches of CBOs—known colloquially in U.S. bond markets as the “toxic waste” of CBOs—are valuing (or provisioning for) them appropriately.
13. The growth of CBOs has been an element of a broader expansion in issuance of asset backed securities (ABS). The growth in ABS issuance has been allowed by the passage of a law on ABS in 1998 and changes to the taxation of asset securitization, and spurred by the securitization activity of KAMCO. In addition to bonds (discussed above), there has also been securitization of loans (both performing and nonperforming), real estate, auto receivables, lease receivables, mortgages and credit card receivables. Indeed, while issuance of standard corporate bonds has fallen, there has been substantial growth in ABS issuance, from about W5 trillion in 1999 to W41 trillion in 2000. In addition to being used to clean up the balance sheets of banks and ITCs, securitization has in many cases been a response to difficulties in obtaining financing. Senior tranches with AAA or AA ratings have accounted for about three quarters of all ABS, and these have found strong demand. However, the junior tranches are typically held by the originating firm, and these have often carried very low ratings and are far less likely to be repaid, and may already be nonperforming.
C. The Causes of the Recent Problems
14. The heightened recent problems in the corporate bond market are a reflection of a bunching in maturities and a greater sensitivity to credit risk. There have been pressures in the corporate bond market since mid-1999 as funds have flowed out of ITCs, and this pressure has been reflected in sharply reduced new issuance since mid-1999. However, the bunching of maturities going into 2001 and the need for companies to repay or roll over a large stock of issuance from 1998 is what has recently made the problems far more pressing.
15. The lack of attention—until recently—to credit risk in the corporate bond market had its genesis in the system of guarantees that existed prior to the crisis. As a result of these guarantees, and a system where losses from corporate failure were relatively rare, it was not particularly important for investors to be aware of the credit risk of the companies issuing bonds. Following the crisis, most bonds were no longer guaranteed and purchasers of bonds were now subject to credit risk, so one might have expected to see substantially greater awareness of credit risk. Hence it is puzzling that issuance of corporate bonds surged so dramatically in 1998 in an atmosphere where the credit risk of issuing companies had likely increased. The explanation appears to be that there was a massive surge in deposits at ITCs—traditionally the major investors in corporate bonds. This surge was presumably a reflection of the low interest rates offered by banks in the aftermath of the crisis, and the high interest rates offered by the poorly managed and less heavily supervised ITCs. There may have also been some elements of moral hazard as portfolio managers in ITCs continued to invest in the expectation that companies would never default—or be allowed to default—on their bond issues. In addition, some chaebol may have found that they could rely on ITCs affiliated with their groups to buy their bonds regardless of risk. These factors together may explain why so much financing went to companies that are now unable to obtain fresh financing or to repay their bondholders.
16. The collapse of Daewoo in mid-1999 was a major shock to the corporate bondmarket. First, it provided a major wake-up call about credit risk and the lack of reliability of financial disclosure of firms—Daewoo Corporation had continued to issue corporate bonds in the lead-up to its default, and had been assessed by some domestic agencies as investment grade (BBB minus) until early in June 1999 (despite a foreign currency debt rating from international agencies of B minus, with a negative watch). Perhaps, more importantly it signaled the beginning of the revelation of problems in the ITCs, and the outflows of funds from these institutions. As investors shifted funds to banks, which historically have not been major purchasers of bonds, there was an outflow of funds from the bond market. This was reflected in an immediate sharp decline in new bond issuance and an ongoing steady decline in the outstanding stock. With a large bunching in maturities from the fourth quarter of 2000, the decline in the stock of bonds would seem set to accelerate.
Korea: Balance Sheets of ITCs
(in trillions of won)
Korea: Balance Sheets of ITCs
(in trillions of won)
| Dec. | June | Aug. | ||
|---|---|---|---|---|
| 1997 | 1999 | 2000 | ||
| Total assets | 102.4 | 268.6 | 159.5 | |
| Holdings of bonds | 64.8 | 154.8 | 81.7 | |
| (percent change) | 138.9% | -47.2% | ||
Korea: Balance Sheets of ITCs
(in trillions of won)
| Dec. | June | Aug. | ||
|---|---|---|---|---|
| 1997 | 1999 | 2000 | ||
| Total assets | 102.4 | 268.6 | 159.5 | |
| Holdings of bonds | 64.8 | 154.8 | 81.7 | |
| (percent change) | 138.9% | -47.2% | ||
17. Not surprisingly, the tightening of market access has hit lower rated borrowers hardest. Aggregate net debt issuance in 2000 was negative, with substantial discrimination in market access across credit categories. Higher-rated companies (with domestic ratings of A and above) accounted for 38 percent of maturing bonds, but obtained 64 percent of new financing (excluding via primary CBOs). By contrast, the lowest rated companies (those rated BB and below) accounted for 25 percent of maturing bonds but obtained only 8 percent of new financing, thereby experiencing substantially negative net financing. Mid-rated companies also saw significantly negative net financing. More generally, the problems experienced by so many borrowers may not be especially surprising in light of the fact about 37 percent of issuers of corporate bonds had subinvestment grade credit ratings (BB or below) from domestic rating agencies, and a further 39 percent were in the lowest investment grade category (of BBB).3 Among the lead companies for the 14 largest chaebol, only 5 now have domestic ratings of A or better.
Korea: Issuance and Maturity of Corporate Bonds by Credit Rating, 2000 1/
(In trillions of won)
Includes all firms for which ratings data were available.
Korea: Issuance and Maturity of Corporate Bonds by Credit Rating, 2000 1/
(In trillions of won)
| Creditrating of firms | A and above | B B B | B B and below | All firms |
|---|---|---|---|---|
| Issuance | 10.2 | 4.6 | 1.3 | 16.1 |
| percent of total | 63.6% | 28.5% | 7.9% | |
| Maturing bonds | 12.2 | 12.1 | 8.2 | 32.6 |
| Percent of total | 37.5% | 37.2% | 25.2% | |
| Net issuance | -2.0 | -7.5 | -7.0 | -16.5 |
Includes all firms for which ratings data were available.
Korea: Issuance and Maturity of Corporate Bonds by Credit Rating, 2000 1/
(In trillions of won)
| Creditrating of firms | A and above | B B B | B B and below | All firms |
|---|---|---|---|---|
| Issuance | 10.2 | 4.6 | 1.3 | 16.1 |
| percent of total | 63.6% | 28.5% | 7.9% | |
| Maturing bonds | 12.2 | 12.1 | 8.2 | 32.6 |
| Percent of total | 37.5% | 37.2% | 25.2% | |
| Net issuance | -2.0 | -7.5 | -7.0 | -16.5 |
Includes all firms for which ratings data were available.
Korea: Domestic Credit Ratings of Korean Bond Issuers, October 2000
Korea: Domestic Credit Ratings of Korean Bond Issuers, October 2000
| Credit rating | AAA | AA | A | BBB | BB | B | CCC or below |
|---|---|---|---|---|---|---|---|
| Number of firms | 10 | 21 | 51 | 136 | 101 | 12 | 15 |
| Percent of total | 2.9% | 6.1% | 14.7% | 39.3% | 29.2% | 3.5% | 4.3% |
Korea: Domestic Credit Ratings of Korean Bond Issuers, October 2000
| Credit rating | AAA | AA | A | BBB | BB | B | CCC or below |
|---|---|---|---|---|---|---|---|
| Number of firms | 10 | 21 | 51 | 136 | 101 | 12 | 15 |
| Percent of total | 2.9% | 6.1% | 14.7% | 39.3% | 29.2% | 3.5% | 4.3% |
Bond Yields
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Bond Yields
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Bond Yields
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Secondary Market Spread by Credit Rating, December 2000
(2-3 year corporate bands; spreads over Treasury bonds)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Secondary Market Spread by Credit Rating, December 2000
(2-3 year corporate bands; spreads over Treasury bonds)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
Secondary Market Spread by Credit Rating, December 2000
(2-3 year corporate bands; spreads over Treasury bonds)
Citation: IMF Staff Country Reports 2001, 101; 10.5089/9781451822052.002.A004
18. Despite investors’ reluctance to buy low-rated corporate bonds, there have been only relatively modest increases in yields on such bonds. Data on secondary market yields for subinvestment grade bonds (domestic ratings of BB and below) are not available, but yields on BBB rated bonds show credit spreads that seem quite low by the international standards. For example, the spread between BBB and AA rated issuers had widened only modestly, to about 2.7 percentage points at end-2000. In the U.S. bond market, the spread between AA and BBB rated bonds at end-2000 was similar at about 2.5 percentage points, although a more relevant comparison might be the spread in the U.S. between A and BB rated bonds which was about 5.5 percentage points. The latter comparison would suggest that credit spreads in Korea remain lower than might have been expected, perhaps offering a clue as to why the market has been reluctant to absorb issuance by lower rated borrowers. It is, however, difficult to explain why (secondary market) yields might not have risen to market clearing levels—the extreme illiquidity of lower-rated bonds is presumably a contributing factor.
D. Conclusion
19. The recent developments in the corporate bond market appear to reflect the fact that the market is now paying far more attention to credit risk, and the sudden impact of this is causing substantial pain. Standard and Poor’s has indeed noted that the fact that the authorities have been forced to intervene is an indication of their success in curtailing the “risk-blind investment decisions” by the private sector that prevailed in previous years. Further, the liquidity pressures in the bond market are a sign of the need for deeper corporate restructuring—principally deleveraging through asset sales and the exit of nonviable firms.
20. The question arises as to whether the greater attention to risk has gone so far as to be excessive and as to whether there is a “credit crunch.” On the one hand, it appears that the better companies—both large and small—still have access to funds at reasonable rates, and that the increase in bond yields that has been seen for lower grade borrowers is not inappropriate. Indeed, a Bank of Korea survey in October 2000 indicated a continuing loosening of lending activity and enhanced competition for lending to highly rated borrowers, accompanied—not surprisingly—by tightened credit conditions for lower-rated companies. Nonetheless, the decline of the ITCs, the risk aversion of banks and the bunching of maturities has resulted in conditions where rollover problems threaten to extend beyond those firms that probably do not deserve financing and to affect viable ones as well. The challenge for the authorities will be to ensure that any measures they adopt keep distortions to a minimum, and help build a more robust bond market that prices risk appropriately. As noted above, it will be important to maintain momentum in corporate restructuring and the exit of nonviable firms.
21. For companies, one primary lesson from the current crisis is the perils of balance sheets with high debt/equity ratios and short debt maturities. These factors mean that companies have to approach the market for fresh financing on a nearly continual basis, leaving them extremely vulnerable to changes in sentiment and reduced market access—the recent trend towards shorter maturities will exacerbate this further. In addition, there may well be questions as to whether short- and medium-term bond financing is the most appropriate type of financing for lower-rated companies. In mature economies, risk and informational factors combine to result in riskier borrowers typically relying mainly on equity financing such as venture capital, or bank lending with banks safeguarding their investment through collateral and close monitoring of cash flows and management behavior. Thus, the problems in the bond market may also be signaling that market participants do not view further bond financing as the appropriate form of financing for some companies.
This chapter was prepared by Anthony Richards.
Further details on the ITC industry are provided in Chapter VI of “Republic of Korea: Economic and Policy Developments” (IMF Staff Country Report No 00/11, February 2000).
It should be noted that these ratings are from a leading domestic rating agency. A much smaller number of Korean companies have ratings from international agencies, and these international ratings tend to be substantially lower that the ratings from domestic agencies.
