New investments in structured products by South Korea’s institutional investors remain subdued due to their recent sluggish performances coupled with the rising interest rates environment.

One of the most widely sought products by institutions are those linked to interest rates, mainly curve accrual notes. With these products, investors can accrue interest at a fixed annual rate but only during the periods when the underlying rate curve is within a specific range. Most of the range accruals invested by the institutions in South Korea track the Constant Maturity Swap (CMS) curve such as the USD 30-year CMS rate minus USD 2-year CMS rate.

“Just a few years ago, local insurance companies and mutual benefit associations were actively funnelling their funds to the long-term interest rate-linked products but they are currently not being called [to enter into new products],” said Kyungho Kim, head of retail derivatives solution and distribution team at Mirae Asset Daewoo, the largest securities house in South Korea by market cap.

All callable securities have an embedded ‘call’ provisions allowing the issuer to redeem the security at a specific date. This means that if the rates drop and create a more favourable environment for the issuer to issue a new note, the products will get called. In an interest rate rising environment, on the other hand, issuing a new note will become more expensive than before.

“In the past couple of years – when rates were very low – the products were called and rolled over,” said a South Korea sales head at a European bank in Hong Kong. “The rates were intentionally kept low since Lehman, so it was easy. Starting last year, when we had more aggressive rate hikes, the calls no longer worked. So, the sales for institutional investors, which rely on turnover, is not happening.”

While the institutions might also be missing better entry points for a new product or new investment opportunities as their funds are ‘locked-in,’ they still have annual coupons guaranteed.

“From the clients’ perspective, I don’t think the damage is that critical,” said the banker. “It’s more of the banks' issue where you don’t see the tradable volumes anymore.”

Sluggish performance

Apart from the rate-linked products, the country’s institutions also favoured structured products tracking strategy indices around five years ago, according to industry sources. The excitement, however, died down in recent years due to their weak performances.

“We have not made any new investments in structured products using strategy indices in the past couple of years,” said Chanwoo Lee, portfolio manager at Public Officials Benefit Association (POBA) – an institution that manages KRW11.9 trillion (US$10.6 billion) worth of funds and invests 8% of the total amount in structured products, mainly range accruals.

“Investing in structured products, maybe 5 or 6 years ago, using strategy indices was a trade-off for us as we gave up the low but guaranteed yields, expecting the strategy index to perform as the investment bank – which sold the product – anticipated,” said Lee. “The index worked well at the point when we decided to invest but not afterwards, as nobody really knows how the market will fluctuate. Since then, the kind of products vanished in the market.”

Like many other institutional investors which tend to give up higher yields for a principal protection feature, POBA also invested in products that guarantee the capital at maturity.

The sales volume of structured products for institutional investors in South Korea is also taking a hit from the introduction of accounting standards called the International Financial Reporting Standard (IFRS) 9. “Local insurance companies are downsizing their assets invested in structured products as holding such notes will increase earnings volatility due to the new regulation,” said Gyun Jun, an analyst at Samsung Securities in Seoul.

The standards were introduced as a new requirement to all insurance companies in Korea this year.