South Korea’s National Pension Service, the world’s third largest retirement fund, aims to remove all the dollar hedges on its foreign bond investments – and other domestic investors may follow suit, according to ANZ research.

Such moves could well raise the cost of hedging offshore assets back into won, as Korean investors increase their foreign allocations, said the Australian bank in a note published yesterday.

For dollar/won spot, buying pressure will increase over time as a higher percentage of assets is allocated offshore on an unhedged basis, it noted. “The effects will be magnified if the wider asset management industry in South Korea follows suit.”

The banks said there were two main reasons why fund managers and asset owners in Korea may follow NPS’s lead towards an FX-unhedged policy.

The first is the need to meet higher return targets in an environment where interest rates will likely stay relatively low globally in the foreseeable future.

The second is a sustained fall in dollar/won forward points, which turned negative in 2016 (see figure below). As a result, FX hedging now carries a cost, which will erode returns.

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Moves by local asset managers to reduce dollar/won hedging would have a much bigger impact than those by pension funds other than NPS.And the cost of FX hedging via currency forwards may well increase further, said the ANZ note. “With the US Federal Reserve on track to hike the Fed funds rate further in the coming year, while the Bank of Korea will likely be on hold, the forward points could go deeper into discount,” it said.

According to the Korea Financial Investment Association, domestic fund houses have a total AUM of some $230 billion. The country’s other main retirement schemes include Government Employees Pension Service and Korea Teachers Pension Fund, each with an AUM of around $14 billion.

NPS hedge reduction moves

In December 2015, NPS had announced it would reduce its currency-hedging target rate for overseas fixed income to 50% by the end of 2017 and 0% by the end of 2018. The fund had already reduced its hedging of overseas equities and alternative investments to 0% in 2014.

In 2009, the fund’s FX hedging target for overseas equities and alternative investments had been 50% and for overseas fixed income 100%.

Meanwhile NPS’s offshore allocation is steadily rising. It had W570 trillion ($510 billion) of assets under management (AUM) as of end-March, 26.6% of which is invested offshore, noted ANZ. That figure has climbed from 16.4% in 2012 and is heading towards a target of 29.3% by the end of 2018 and 40% by 2022, said the bank.

Foreign fixed income accounts for 4% of NPS’s total AUM. To meet the end-2018 target, the fund will need to remove the hedges for this portfolio, which amounted to W22.7 trillion in March 2017.

Until recently NPS’s overseas fixed income portfolio was still 100% hedged. To wind down the hedges over a period of 18 months, noted ANZ, the fund may either buy back dollar/won forwards or allow the forwards to mature and buy spot at the same time, of some $50 million daily.