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2021 Jan/08
Analysis on the Characteristics of Korea’s Strip Bond Market and Plans for Facilitating the Market Research Papers 21-01 PDF
This study aims to analyze the characteristics and economic effects of Korea’s strip bond market in terms of the secondary market and the market’s issuers, investors, and yields, based on which to propose ideas for facilitating the market. A strip bond is a debt obligation which is broken into coupon and principal components and issued as several zero-coupon bonds. Investor can benefit from investing in those bonds as they offer a broader opportunity for long-term, arbitrage investment and eliminate the reinvestment risk a coupon bond usually has. In addition, more information on zero-coupon bonds with diverse maturities in the strip bond market could help complete the yield curve, making the market more comprehensive.
Korea’s strip bond market has been introduced in March 2006 for the purpose of improving the liquidity of benchmark Korea Treasury Bonds, revitalizing the long-term bond market, and effectively responding to market demand for long-term zero-interest bonds. It was 2010 that the issuance of strip bonds began picking up. A more significant increase has been observed around the on-exchange secondary market since 2016.

This paper analyzed the primary and secondary market data to grasp the main characteristics of Korea’s strip bond market. The results confirm the market’s wide-ranging benefits to investors. First, strip bonds have the effect of expanding the supply of long-term duration bonds in response to investors’ demand for long-term assets. With the average maturity of domestic strip bonds continuously on the rise, the proportion of stripped long-term government bonds has been also increasing. The prolonged maturity of those bonds results from two factors. First, the insurance sector increased investment in long-term bonds in response to regulatory changes. Second, institutions holding long-term debt are increasingly using strip bonds for the purpose of duration matching.

The main institutions that invest in strip bonds include insurers, pension funds, asset managers and banks. As a result of analyzing the behavior of major strip bond investors using the trading data of the over-the-counter market, insurers and pension funds tend to invest in long-term strip bonds in order to eliminate maturity mismatches between assets and liabilities. By contrast, asset managers are found to prefer high investment returns, investing in short-term principal strips and coupon strips that have relatively high spreads. Banks act as strip bond providers while investing in various types of strip bonds for higher profitability.

The most notable feature in Korea’s secondary market for strip bonds is the divergence of bond types and market participants between the on-exchange and the over-the exchange markets. The KRX—Korea’s on-exchange market—is a marketplace where principal strips that mature less than one year take up a large proportion of trading, while the OTC market sees a diversity of stripped principal and coupon components changing hands. Recently, liquidity of strip bonds in the KRX has improved significantly, mainly because of the government’s regulatory actions such as introducing a primary dealer system for strip bonds that mandates the dealers to engage in market making for strip bonds with less than one-year maturity. Such a boost in the on-exchange secondary market is certainly viewed positively as it has improved the liquidity of short-term strip bonds, and has helped complete the yield curve of short-term, risk-free bonds. However, its crowding-out effect of contracting trades of longer-term strip bonds is posing a negative aspect.

The introduction of strip bonds provides the effect of improving long-term government bonds and off-the-run bond liquidity. A comparative look at strip bonds with other risk-free bonds, strip bonds’ liquidity is lower than that of short-term KTBs and two-year Monetary Stabilization Bonds, but is higher than long-term KTBs. Stripping long-term KTBs helps boost the liquidity of those otherwise illiquid bonds. 

According to the analysis in this paper, Korea’s strip bonds showed higher excess spreads than government bonds do. The average yield on Korea’s strip bonds was found to be consistently higher than the mark-to-market yield on KTBs with the same maturity. Such a result could have been affected by strip bonds’ higher price sensitivity to interest rate changes, compared to coupon bonds with the same maturity. This paper also compared the yields on principal and coupon strips, and found coupon strips’ spread to be higher than principal strips, which is consistent with previous studies on strip bond prices in other countries. Because stripped interest payments are issued as various small-amount bonds, they are illiquid and serve for investors whose investment purpose and strategy are often different from those investing in stripped principal components. Also noteworthy was strip bonds’ spread varying widely across strip types, maturities, interest rate hikes, and trading venues, all of which suggest diverse factors behind how strip bonds are priced.

For steering Korea’s strip bond market towards sustainable development, several improvements are needed in the areas of issuers, investors, secondary market and market infrastructure. Plans are needed to help the issuers to accurately grasp the demand of strip bonds and to elastically supply them. Investors should refine their strategy, fully reflecting the market’s characteristics. Also necessary is a plan to introduce diverse packaged products based on strip bonds. The secondary market needs improvements in price efficiency, which could be achieved by improved liquidity of strip bonds. Last but not least, it is necessary to promote more information on the strip bond market and the underlying bonds to be analyzed and provided.