Closed-end bond mania and its consequences: Part II

In the first article, I explained how the higher yield of Korean bonds, even after hedging for currency risks, could drive up borrowing costs for the Thai government and local corporations.

Because of limited space for that article, I failed to mention that these bonds do not trouble me.

After all, in the world of free flowing capital, money goes where it is needed most, and this is reflected in the price of money, in terms of interest rates or yields.

To help stem the rise of the baht, monetary authorities are now allowing Thais to invest abroad.

This policy should lower the cost of capital in other countries at the expense of local borrowers.

But again that is how global capital markets work.

Likewise, foreign investors in our markets help lower our cost of capital against their own markets too.

What I do care about, however,

 is that development of the local bond market could be affected.

In particular, I do not want locals to think of bonds, or fixed income asset class, merely as deposits.

Even though they can be seen that way, as closed-end funds have more than emphasised the point, fixed income can do much more for investors.

In more developed financial markets, bonds are reasonably liquid in the secondary market.

When that is the case, there is no need for investors to hold bonds until they reach maturity.

That is, their money is not locked up for a certain period of time.

Moreover, they have the opportunity for capital gains, as well as losses, when they sell the bonds before maturity.

Also, as longer-dated bonds generally have higher yields than short-dated bonds, by investing only in short-dated bonds, investors lose the ability to earn higher yields. In short, investors in closed-end short-term bond funds give up liquidity and the chance to earn higher returns for predictable, lower returns.

This is not good or bad in itself; it is just that investors would be better off if there were more open-end fixed income products available, whether they are domestic or foreign funds.

That is because bonds play a crucial role in portfolio diversification.

A weak economy is generally not good for stocks because corporate earnings are not so strong.

On the other hand, it leads central banks to cut interest rates, which is very good for bonds because bond prices move in opposite direction to interest rates. Hence, including bonds in anyone's portfolio helps to reduce the volatility of that portfolio and hence makes for more stable returns.

But if investors hold these closed-end bond funds, rather than bonds or open-ended bond funds, the value of the closed-end bond portion cannot rise to compensate for the losses on the equity portion of the portfolio.