7 February 2011 Asia-Pacific Rates Strategy

Trade idea abc

Global Research

Korea CCS curve to re-steepen

 Recent CCS curve flattening is an opportunity to re-establish
steepening positions in 5-2yr segment

 Less attractive levels for arbitrage flows reduce front-end

pay interest; exporter hedging to generate receiving interest

 Upcoming dollar bond issuance is likely to produce paying

interest at the long-end

Trade idea
Weight Entry (date) Target Stop Current Rationale
Pay USD100m Korea 5yr KRW CCS 62bp 100bp 40bp 62bp Reduced arbitrage-related pay-interest
Rec USD100m Korea 2yr KRW CCS (7-Feb) at front-end, liability flows at long-end
Source: HSBC

HSBC FI Research recommends steepening positions in the 5-2yr segment of the KRW
cross-currency swap (CCS) curve. Entry levels are attractive after recent curve flattening
during the past month (Figure 1), which was for the most part attributed to renewed
paying interest from arbitrage trades by foreign bank branches (FBBs) at the front-end as
well as atypical liability-swap flows (from the 5yr USD700m Hyundai Capital dollar
issue) at the front-end. Whilst liability-swap flows are typically seen at the long-end
(steepening the KRW CCS curve), the previously steep CCS curve encouraged paying
Ki Yong Seong
interest associated with these flows to the front-end rather than the long-end.
Strategist
The Hongkong and Shanghai Banking
After CCS curve flattening, however, these arbitrage and liability-swap flows in the front-
Corporation Limited
+852 2822 4277 end have become less attractive and in turn are expected to decline, which will reduce
kiyongseong@hsbc.com.hk upward pressure at the 2-1yr points of the CCS curve. All else equal – and helped by
Virgil F Esguerra continued receiving interest from exporters hedging overseas proceeds – this is expected
Strategist to place downward pressure at the front-end of the CCS curve. The 5-year point, by
The Hongkong and Shanghai Banking
Corporation Limited contrast, is expected to see paying interest from upcoming dollar issues – keeping the
+852 2822 4665 long-end of the CCS curve under pressure, supporting steepening trades (Figure 2).
virgilesguerra@habs.com.hk
View HSBC Global Research at:
http://www.research.hsbc.com
Figure 1. KRW CCS curve to re-steepen Figure 2. Flattening in the KRW CCS may revert
Issuer of report: The Hongkong and
Shanghai Banking 4.0 125 170 (100)
Corporation Limited
3.5
140 (130)
Disclaimer & 3.0 100
Change (bp)

Spread (bp )

B asis (b p)

110 (160)
Disclosures 2.5
%

This report must be read 2.0 75 80 (190)

with the disclosures and 1.5

50 (220)

the analyst certifications in 1.0 50

20 (250)
1y 2y 3y 4y 5y 6y 7y 8y 9y 10y
the Disclosure appendix, Change (bp, RHS) May 10 Jul 10 Sep 10 Nov 10 Jan 11
and with the Disclaimer, KRW CCS Feb 2011 (LHS)
KRW CCS Dec 2010 (LHS)
KRW CCS 2s5s (LHS) 2yr KRW swap basis (RHS)

which forms part of it Source: HSBC Source: HSBC, Bloomberg

 Korea CCS curve to re-steepen
Trade idea abc
7 February 2011

Arbitrage flows less attractive at current valuations, reducing paying interest at front-end CCS
A reduction in arbitrage flows from Thai investors and foreign bank branches (FBBs) is anticipated and
this would make the front-end of the CCS curve more sensitive to renewed receiving interest from
exporter hedging activities as well as asset-swap flows (ie Korean investors with overseas positions to
hedge FX risk by receiving KRW CCS rates), accelerating CCS curve steepening.

Investment returns for Thailand-based kimchi funds in FX-hedged short-term Korean debt – typically
long Monetary Stabilisation Bonds (MSBs), pay 1yr CCS – have become less attractive due to rising Thai
Government yields and reduced KRW swap basis (IRS minus CCS) (Figure 3). Excess return versus 1yr
THB fixed income instruments has declined to 20-30bp (vs. 130bp at the height of the Yeonpyung island
shelling incident in November). Current valuations imply reduced kimchi-fund flows and hence removal
of a previously consistent source of paying interest in front-end CCS. Sizeable MSB redemptions in
February (KRW11trn) and March (KRW12trn) are likely to be accompanied with repatriation flows to
Thailand to reflect reduced attractiveness of arbitrage trades.

Upward pressure on the front-end of the KRW CCS curve may be contained as similar arbitrage flows by
FBBs (long bond, pay 1yr CCS) are unlikely to be active as previously. In last December, FBBs were
positioned at around 110% in anticipation of tighter macro prudential measures. A 200% position limit
signalled by the MoSF in January spurred FBBs to re-establish arbitrage positions. Nevertheless, this
round of arbitrage investments by FBBs is expected to be temporary given less attractive valuations and
potentially tighter regulations.

Paying interest from liability swap flows set to target the long-end of the CCS curve
Liability swap flows to the KRW CCS curve are expected to continue, but as the curve has flattened
significantly, paying interest by dollar bond issuers are likely to be concentrated at the long-end of the
curve (ie 5-year). The next dollar-denominated issue may be an estimated USD500-700m 5-7yr bond to
be issued by Lotte in the coming weeks, as reported by Bloomberg. The potential flurry of Korean dollar
bond issuance in the coming months – given sizeable dollar bond maturities (Figure 4) – would lead to
additional liability swap flows at the long-end given that dollar issuance is typically concentrated in the 5-
7yr curve segment.

Figure 3. Excess returns for Thai “kimchi” investors declined Figure 4. Sizeable Korean dollar bond maturities

5.0 300 1.8

4.5 1.6
250
4.0 1.4
200 1.2
3.5
Basis (bp)

USDbn

3.0 150 1.0

%

2.5 0.8
100
2.0 0.6
50 0.4
1.5
1.0 0 0.2
0.0
Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11
Oct

Dec
Jul
Mar
Apr
Jan
Feb

Jun

Aug
Sep
May

Nov

Kimchi 1yr arbitrage rate (LHS)

ThaiGB 1yr (LHS)
Excess return vs. ThaiGB (RHS) Redemption schedule of USD denominated Korean debt

Source: HSBC, Bloomberg Source: HSBC, Bloomberg

2
 Korea CCS curve to re-steepen
Trade idea abc
7 February 2011

Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the
opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their
personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Ki Yong Seong and Virgil Esguerra

Important Disclosures
This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the
clients of HSBC and is not for publication to other persons, whether through the press or by other means.

This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer
to buy the securities or other investment products mentioned in it and/or to participate in any trading strategy. Advice in this
document is general and should not be construed as personal advice, given it has been prepared without taking account of the
objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice,
consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. If necessary, seek
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Certain investment products mentioned in this document may not be eligible for sale in some states or countries, and they may
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Additional disclosures
1 This report is dated as at 07 February 2011.
2 All market data included in this report are dated as at close 06 February 2011, unless otherwise indicated in the report.
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 Korea CCS curve to re-steepen
Trade idea abc
7 February 2011

Disclaimer
* Legal entities as at 31 January 2010 Issuer of report
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The Hongkong and Shanghai Banking
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4
 abc
Global Fixed Income Research Team
Steven Major, CFA
Global Head of Fixed Income Research
+44 20 7991 5980 steven.j.major@hsbcib.com
Rates Credit
Europe Europe
Keerthi Angammana, CFA Ben Ashby
+44 20 7991 6701 keerthisri.angammana@hsbcib.com Head of Credit Research, Europe
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Subhrajit Banerjee
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Asia
André de Silva, CFA Ksenia Mishankina
Head of Rates Research, Asia-Pacific +44 20 7992 3703 ksenia.mishankina@hsbcib.com
+852 2822 2217 andre.de.silva@hsbcib.com
Remus Negoita
Virgil Esguerra +44 20 7991 5975 remus.negoita@hsbcib.com
+852 2822 4665 virgilesguerra@hsbc.com.hk
Rodolphe Ranouil, CFA
Ki Yong Seong +44 20 7991 6855 rodolphe.ranouil@hsbcgroup.com
+852 2822 4277 kiyongseong@hsbc.com.hk
Peng Sun, CFA
Americas +44 20 7991 5427 peng.sun@hsbcib.com
Larry Dyer
Asia
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Pablo Goldberg Head of Global Research, Asia-Pacific
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Zhiming Zhang
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Van Hesser
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