Over the eight trading days around the 1st, when Korean government bonds were officially added to the World Government Bond Index (WGBI·World Government Bond Index), foreign investors recorded net purchases of 6.8 trillion won in Korean government bonds. The inflow of foreign funds also produced some stabilizing effect on Treasury yields. However, some expect the exchange-rate stabilization effect to be limited depending on the extent of currency hedging by foreign investors.

The Ministry of Economy and Finance said on the 9th that foreigners’ net purchases of government bonds amounted to 6.8 trillion won over the eight trading days from the 30th of last month through the 8th. The WGBI is a representative developed-market bond index calculated by the United Kingdom’s Financial Times Stock Exchange (FTSE) Russell; once included, large pension funds and other overseas institutions are required to buy Korean government bonds in a specified proportion.

Foreign investors had been net sellers of 107.8 billion won over the previous seven trading days (March 19~27) but shifted to net buying starting on the 30th of last month, just before inclusion. In particular, they net-bought 3.628 trillion won on the 31st, the day before inclusion. That was the largest daily net purchase on record.

The government believes the late-March surge in foreign net buying occurred because ‘passive funds’ that mechanically track the index came in first. To maximize interest income accruing immediately after inclusion on April 1, it is advantageous for institutions to complete purchases and set their portfolios in advance by the previous day.

The government expects that increased foreign demand for government bonds due to WGBI inclusion will help stabilize yields. When demand to buy government bonds rises, bond prices go up and, conversely, yields fall.

Indeed, on the first day of inclusion, the 1st, Treasury yields fell across the board. The 10-year yield plunged 19 bp (1 bp = 0.01 percentage points) to 3.689% from the previous day, while the 3-year and 5-year fell 18.2 bp and 21 bp, respectively. Gong Dong-rak, a researcher at Daishin Securities, wrote in a report on the 2nd that “Korea’s bond market, alongside the end-of-war mood regarding Iran, saw the favorable supply-demand factor of WGBI inclusion further amplify the decline in yields.”

However, the expected stabilizing effect on the won·dollar exchange rate from WGBI inclusion remains uncertain. When foreign funds enter the bond market, dollar supply increases in the domestic FX market, creating downward pressure on the rate. But if those funds bought bonds with currency hedges that fix the exchange rate, a decline would be hard to expect.

According to minutes of the Monetary Policy Board released by the Bank of Korea in February, a BOK official said, “Between April and November this year, about USD 50 billion to USD 60 billion in passive funds related to WGBI inclusion will flow in, improving FX supply-demand conditions in the second and third quarters,” but added that “the effect could be limited depending on whether the inflows are currency-hedged.”

In the market, exchange-rate hedging is seen as having a high weight among exchange-traded funds (ETFs) and index funds run by private asset managers, whereas it is relatively low for public pension funds and central-bank money. In particular, whether Japan-affiliated fundswhich account for about 30% of all WGBI-tracking assetshedge currencies could be a swing factor. The BOK noted, “Passive funds are generally known to flow in without currency hedging, but for Japan-affiliated money, the share of hedged passive funds is also high.”