Korea to introduce high-yield bond funds

South Korea’s National Assembly is hurrying through a bill to allow investment trust management companies offer high-yield fixed-income funds to investors. The legislation was initially slated to pass by July 1, but last-minute wrangling with the tax authorities means it will not be passed for another two or three weeks.

The government is keen to offer a broader product range to retail and institutional investors and deepen the domestic capital markets. Fund managers are wary of the details buried in the legislation, however, and fear it is merely a way to help fund companies saddled with unwanted paper fob it off to investors.

The law requires high-yield bond funds contain a minimum exposure to bonds rated less than investment grade of 30%. The funds will also be closed for the first year, and redeem after three. Fund managers expect these funds could see trillions of won invested during the initial subscription period. There is a finite amount of corporate high-yield issuance in Korea, so this demand is likely to drive prices up.

Given the short time horizons of virtually all Korean investors, once the funds’ value has risen as the prices of junk bonds go up, punters will sell once the funds open after their first year. Fund managers will have to pay off some of their liquid investment-grade paper to be able to meet redemptions. The 30% rule means this will have to be matched by somehow offloading junk bonds as well, and could lead to a collapse in high-yield bond prices.

It is not clear whether distributors or fund managers will eat the costs of such a downturn.

Fund managers complain that regulators at the Ministry of Finance and Economy are impatient to jumpstart the market and have not thought through the implications of the details. Nor are they interested in amending the bill for reasons of ‘face’. Some market participants believe only local investment trust management companies now stuck holding bad assets will be interested in these high-yield bond funds as a means to unload their undesirable paper. Other fund managers will view such funds as too dangerous.