South Korean institutions are facing the common problem of duration mismatch, with both the National Pension Service (NPS) and Korea Post looking to increasingly invest abroad to try to resolve this issue.
The duration of the liabilities of Korea’s biggest pension fund, the $350 billion NPS, is 20 years longer than its assets, says Song In-kyu, executive managing director for PwC’s deal business division. Korea Post’s insurance arm faces a similar mismatch, as the duration of its liabilities is 10 years more than its assets.
(Song took up his current role in April, advising institutional investors on asset allocation, having previously worked as Korea Post’s head of global real estate in the postal insurance asset management bureau.)
“Both Korea Post and life insurance companies are facing the same problem, that while they want to extend the duration of their assets within the domestic markets, these markets do not provide that opportunity, as there are very few investment opportunities that have long tenors,” says Song, who was speaking at AsianInvestor's Asian Investment Summit in Hong Kong last week.
Korea Post has two investment arms, one for its savings division and one for the insurance division, which manage $50 billion and $40 billion, respectively.
Duration mismatch makes a financial institution that has an interest to ensure that the timing of their cash inflow matches with cash outflows vulnerable to changes in interest rates. Duration measures the change in value of a fixed income instrument to every 1% change in interest rate. The higher the duration, the more the price will drop as interest rates rise.
If the duration on the liabilities side is longer than the duration of the firm’s assets, the impact from a rate cut would raise the value of the firm’s liabilities more than its assets.
Bank of Korea, the $50 billion Korea Investment Corporation and domestic insurers (which have an aggregate $400 billion in AUM) are also investing overseas. A low interest rate environment in Korea, and a bond market lacking in longer-tenor issuance (say, 20 years-plus), have combined to make Korean fixed income unattractive for these investors.
But by investing offshore, these institutional investors face foreign exchange risks due to their domestic currency liabilities, making FX hedging solutions necessary. These investors normally hedge up to 100% of their FX exposure stemming from their offshore fixed-income investments.
Meanwhile, Song says Korean pension funds and insurers also invest in alternatives. While both NPS and Korea Post would buy assets that have at least a domestic triple-B rating, in practice, their allocation into alternative assets is based on different benchmarks. This lack of a harmonised benchmarking approach presents “a major challenge for [allocation] into alternative assets”.
Traditionally, Korean investors have associated “alternative assets” with private equity investments, or shares in companies acquired through leveraged buy-out deals.
Instead of these risky equity investments, Song says he is currently advising clients that there are other, more attractive assets that lie between equity and fixed income along a corporate capital structure. For example, corporate senior loans or mezzanine loans provide attractive, yet less risky returns than private equity. He is also suggesting Korea pension funds look into investment opportunities in real estate and infrastructure.
Today around 80% of Korea Post investment is in fixed income. Currently the institution offers mostly retail saving products; on the insurance side, it offers health, accident, home and scholarship insurance products.