RPT-Amid doubts over N.Korean threat, investors seek protection


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By Vidya Ranganathan

SINGAPORE, April 4 (Reuters) - Unable to decide if Pyongyang's military threats are real or mere rhetoric, some fund managers and other investors exposed to South Korean stocks and bonds are buying financial protection in the form of cheap options and credit insurance.

Financial markets have rarely reacted to North Korea's frequent bursts of bellicose rhetoric. This time though, the scale of provocation from the reclusive nation and investors' lack of familiarity with its new leader, Kim Jong-un, have made markets slightly wary.

Nearly two months since Pyongyang's nuclear test on Feb. 12, some investors have begun to show signs of nervousness in reaction to a series of North Korean threats that have included waging war on the neighbouring South and putting nuclear missiles on standby.

South Korean sovereign credit default swaps - the cost of insuring five-year sovereign debt - have widened to 83 basis points, their highest in six months. The won has fallen nearly 5 percent against the dollar this year, half of the losses coming after the North's Feb. 12 nuclear test.

South Korea's main stock market index is down 2 percent this week but had been under pressure even before the escalation of North Korean threats.

"International investors have always been used to North Korea making noises, but the scale of the current crisis is a little bit unprecedented and that is putting people off," said Gary Dugan, chief investment officer for Asia and the Middle East at Coutts.

Still, market moves suggest domestic Korean investors are more sanguine than their overseas counterparts, some of whom are following conservative risk strategies to hedge portfolios.

Many domestic investors remain convinced that North Korea's threats to attack the South or even more distant U.S. military bases are merely bluster, despite the fact that Pyongyang has surprised in the past with nuclear tests in 2006 and 2009, and a deadly attack on a South Korean island in 2010.

"We as Korean citizens are familiar with this kind of a situation," said a hedge fund manager who has invested in the market for more than a decade.

He said he had seen no sign of investors facing margin calls or scrambling to buy out-of-the money put options to hedge against a possible sharp downturn in local securities.


Credit default swaps and cross-currency swaps , the two markets used by foreign investors to hedge risk and to convert their currencies into won, have shown the most stress.

"Foreigners are seen intensifying 'sell Korea' with the North Korea issue, so the cross-currency swap has room to fall further until the problems are resolved," said one broker in Seoul.

In the CDS markets, it wasn't merely fund managers with holdings in South Korea that were seen buying protection. Many bids were also from banks and institutions that had exposure to the won and government bonds, owing to the large volumes of credit linked notes (CLN) they had sold, traders said.

These won-denominated credit-linked notes, which are structured investment products that give buyers an attractive debt-like return and indirect exposure to a company's debt, had been hugely popular in South Korea over the past few years.

Issuers of CLNs onshore would also have bought dollar bonds issued either by the Korean government or by Korean companies offshore, in order to square their exposure and earn a spread.

Now, with the won weakening and Korea's credit standing deemed riskier, some feel they need to hedge those holdings.

"Exposure to Korean corporates and financials has grown through issuance of CLNs in the last few years," said Krishna Hegde, a credit strategist at Barclays. Hegde estimated that as much as $1 billion of CLNs that were linked to the Korean sovereign bond were issued in 2012 alone.

"Given the recent increase in geopolitical headlines, such exposures will need to be hedged," Hegde said.


One simple reason investors found hedging a good idea has been the extremely low volatility in most asset classes, which is a result of the exceptional rally in equity markets since the beginning of the year and loose monetary policies in developed economies. A low future-implied volatility keeps the cost of hedging instruments, such as options, low.

"We have been, and are, maintaining tail event options in the precious metals sector," said Stephen Quan of Quan Holdings LLC, a Chicago-based asset management and financial consulting firm. Quan, however, is among those who think the North Korean situation could turn worse and is positioning for that outcome.

In terms of market moves, however, the spike in CDS was the exceptional event this week.

While foreigners were seen selling Korean stock futures, domestic retail investors and institutions turned buyers.

"People onshore are not as worried as offshore players," said Minsoo Kim, a hedge fund manager at Sparx Asia Investment Advisors in Hong Kong. "I can see another one to maybe two days of nervousness, but I am looking at probably at some point early next week to be more bullish," he said.

Even so, foreigners were still buying won bonds, Korea Financial Investment Association data showed. Foreign investors bought a combined net 6.9 trillion won ($6.17 billion) in listed bonds between Feb. 12 and April 3.

Over the Feb. 12-April 4 period, they sold a net 1.7 trillion won in stocks on Seoul's main exchange, Korea Exchange data showed. ($1 = 1117.6000 Korean won) (Additional reporting by Jongwoo Cheon and Melanie Burton in Singapore, Vincent Se Young Lee in Seoul, Nishant Kumar in Hong Kong; Editing by Ken Wills)

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