The closed-end bond fund craze

It is not that it is good or bad, but sometimes I wish our financial market operated more in tune with the rest of the world.

After more than a decade of studying and working in one of the biggest bond fund-management companies in the US, I came back to Thailand and learned something new.

The closed-end domestic bond funds were in vogue. They are simple to understand because they function pretty much like long-term deposits.

They are like a no-brainer sort of product, both for asset-management companies and customers.

Asset managers buy bonds with a certain maturity and hold them for the full period, charging customers a fee. Customers, on the other hand, get what they want, that is, a fixed-term deposit-like investment.

During the past few months, however, domestic short-term interest rates have been trending down and have remained low.

Oh, what do we do now?

It does not feel right to roll over those maturing short-term closed-end funds at lower yields. Not to worry. Historically, even though we have not been one of the world's strongest nations, please don't discount us when it comes to survival skills.

One or two fund-management companies came out with short-term foreign bond funds that do not hedge currency risks.

These, I think, are risky as a gain or loss from currency fluctuations can overtake the returns from the bonds by multiple amounts.

Then along came the Korean bonds to the rescue.

After hedging for currency risk and paying for all the transaction costs, Korean bonds managed to pay higher yields than Thai bonds, at least at this point in time.

The Korean bond market is generally not easily accessible, and this is perhaps why this "arbitrage opportunity" exists. (Arbitrage means making excess returns from a risk-less investment opportunity.)

Quite a few people have asked me, is it true that there is no risk in this investment scheme? I do not know the details of these deals, but from the idea of it, the only risk is the default of the South Korean government during the life of these short-term funds, which is very unlikely.

What, then, might be the adverse effects of these closed-end funds?

One obvious adverse effect is it could raise borrowing costs for the government, the Bank of Thailand, and corporations in Thailand.

As these closed-end bond funds have short maturities, they compete directly with short-term bonds issued in baht for available funds.

So far the adverse effect is probably minimal, partly because the customers of closed-end bond funds tend to be individual investors, while those of the bonds issued by the Bank of Thailand, the government and corporations tend to be institutions.

However, if the Korean bond sensation goes on for much longer and the client base expands, this could lead to higher deficits for the government and slow down our economy through higher borrowing costs.

This is the first part of a series by Kate Hathirat, the head of fixed income at Aberdeen Asset Management.