Understanding the Types of Interest Rates for Bond Investing

In our last installment, we discussed the credit risk and credit ratings of bonds.

In our last installment, we discussed the credit risk and credit ratings of bonds. If a bond has even a slight risk of default, it should offer a higher interest rate compared to a risk-free bond as compensation for that risk.

We previously explained that government bonds are considered virtually default-free. So, how is the interest rate on government bonds determined? And how much higher should corporate bond rates be compared to government bonds?

In this session, we’ll explain the Bank of Korea's base rate, government bond rates, and corporate bond rates—what they are and how they are formed.

The Fundamental Base Rate

In Korea, the base rate is the interest rate applied when transactions occur between the Bank of Korea and financial institutions.*

*More precisely, it is the 7-day repo rate, which is the rate applied to repurchase agreements between financial institutions as published by the Bank of Korea. However, for simplicity, this explanation is sufficient.

Banks occasionally face short-term cash shortages. To address this, financial institutions typically lend money to each other for one day to a week without the need to solicit deposits or issue bonds. If financial institutions struggle to borrow from each other, the Bank of Korea steps in to provide the necessary funds directly.

The short-term loans between financial institutions are highly secure due to the nature of the transaction and the use of government bonds as collateral. Since government bonds are extremely secure and the loan term is very short, the base rate represents the interest rate on the safest cash available.

How Is the Base Rate Decided?

The Bank of Korea's Monetary Policy Committee (MPC), which includes the governor of the Bank of Korea, meets every six weeks to decide on the base rate. The MPC holds eight meetings per year, and as of August 2024, the base rate is 3.50%.

Unlike bond rates, which are determined by transactions between buyers and sellers, the base rate is set by the MPC based on factors such as inflation, employment, and financial market conditions.

Short-term loan rates between banks can fluctuate from the base rate depending on market conditions. If banks need funds, short-term lending rates may exceed the base rate. In such cases, the Bank of Korea intervenes by providing loans at the base rate to stabilize the market. Conversely, if banks have excess funds and are not borrowing, the Bank of Korea borrows money at the base rate to align short-term rates with the base rate.

Government Bond Rates

The base rate significantly influences government bond rates. Since government bonds are repaid in full at maturity, their rates tend to converge with the base rate as maturity approaches. Generally, government bond rates are higher than the base rate.

Why are government bond rates typically higher than the base rate despite both being default-risk-free? Government bonds have longer maturities, so higher rates are needed to compensate for the extended time.

The Korean government issues bonds with maturities ranging from 2 to 50 years. For a 50-year bond, it takes 50 years to return the principal. Although bonds can be sold before maturity, market conditions may lead to valuation losses. Thus, longer-term bonds often have higher rates to compensate for liquidity risks compared to shorter-term bonds.

A "yield curve" represents interest rates across different maturities for bonds with the same credit rating. In May 2022, Korea's government bond yield curve displayed a typical upward slope, indicating that longer-term bonds offer higher interest rates than shorter-term ones.

The Bank of Korea influences overall market interest rates by adjusting the base rate. When the base rate rises, the shortest and safest rates increase, often causing longer-term government bond rates to rise as well. Conversely, if the base rate falls, government bond rates generally decrease too.

However, note that the base rate and government bond rates do not always move in tandem. Sometimes, government bond rates might fall immediately after a base rate increase as market participants anticipate future base rate changes.

Why Are Government Bond Rates Lower Than the Base Rate Now?

Although longer maturities usually lead to higher rates due to liquidity risks, as of August 2024, all government bond rates are lower than the base rate. For instance, with the base rate at 3.5%, the 3-year government bond rate is only around 2.90%.

This situation arises because the Bank of Korea is expected to lower the base rate in the future, causing government bond rates to preemptively drop in anticipation. As a result, government bond rates may not decrease even if the base rate is lowered.

When government bond rates are lower than the base rate, it is known as an inversion of the yield curve. Such inversions often occur when a base rate cut is anticipated and can be seen as a potential sign of an economic downturn, warranting caution.

Corporate Bond Spreads

Interest rates on bonds with default risk are set by adding a spread to the government bond rate. Corporate bonds, issued by private firms, generally have lower liquidity and higher default risk than government bonds, requiring higher rates.

As of August 7, 2024, the 3-year government bond rate is 2.93%, while the AA- 3-year corporate bond rate is 3.40%, resulting in a spread of 0.47%. The A+ 3-year corporate bond rate is 3.815%, with a spread of 0.78%. The spread reflects the additional risk premium required over government bond rates based on credit risk.

Spreads vary over time and are intuitive. During stable periods, spreads are lower, but they increase sharply during economic downturns and financial crises due to higher anticipated defaults and decreased market liquidity. This characteristic applies to all types of spreads.

When investing in corporate bonds, it's important to pay attention to the spread. Paradoxically, higher spreads occur during times of increased default risk, making corporate bonds more attractive. Conversely, during favorable economic conditions, spreads narrow, reducing investment yields.

For example, in November 2022, continuous base rate hikes and liquidity strains in the corporate bond market caused AA- rated bond spreads to reach 1.80%. Purchasing corporate bonds during such times can yield high returns. Currently, as of August 2024, spreads are about 0.47%, indicating it is not an optimal time for corporate bond investments. Remember, investing in corporate bonds is more favorable when spreads are higher than usual.