ADVERTISEMENT

Korea Hedge Funds Are Binging on Risky Bonds Without Ratings

Korean Hedge Funds Are Binging on Risky Bonds Without Ratings

(Bloomberg) -- Burgeoning hedge fund demand is pushing convertible bond sales in Korea toward a record year, a spree that’s also sowing concern that too much risk will end up in unsophisticated hands.

Unlike elsewhere, many end-investors in Korean hedge funds are individuals who have shifted out of traditional mutual funds in search of higher returns. It’s a fact that sits uncomfortably with observers who worry what will happen if they force redemptions on funds holding relatively illiquid securities.

Sales of convertibles, which pay low coupons and let investors convert into stock if the issuer’s shares rise enough, totaled about 3.1 trillion won ($2.5 billion) through July, compared with a record 4.1 trillion won in all of 2018, according to data from Korea Capital Market Institute. Local hedge funds are the main buyers of the bonds, which are usually sold by small- and medium-sized firms without credit ratings.

The boom was helped by government measures to support younger firms and bolster the flagging economy, which is forecast to expand at the weakest pace in a decade this year. Authorities have been encouraging hedge funds to buy bonds from smaller companies as a way to provide funding. The move has added vibrancy to the market but also leaves it dominated by firms with unproven finances.

“What investors should consider before buying Korean CBs is whether the firms have indeed achieved the skills or technologies to drive potential growth,” said Kim Pil-kyu, senior research fellow at Korea Capital Market Institute in Seoul. “If some firms go bankrupt, that may freeze sentiment in the entire CB market.”

Korea Hedge Funds Are Binging on Risky Bonds Without Ratings

In 2018, policy makers introduced so-called “Kosdaq venture funds” that offer preferential access to initial public offerings of stock and tax incentives to money managers in return for them investing in shares (including CBs) of developing companies. In the stock market, concerns about the viability of younger companies have pushed the start-up-heavy Kosdaq index down 10% in 2019 to become one of the worst performers in Asia.

Despite near-zero coupon payouts for most of the securities, investors are lured by a “refixing” clause that is unique to Korean convertibles. The term allows a reduction of almost 30% from the initial conversion price if the underlying stock falls.

South Korea’s three-year Treasury yield hit a record low in August as global appetite for bonds remains strong. The Bank of Korea left its key policy rate unchanged at 1.5% Friday after a cut in July.

Korea Hedge Funds Are Binging on Risky Bonds Without Ratings

Regulators are already worried about retail investors owning things they don’t understand. They’re planning a probe into sales of derivative products that carry the risk of losing all their value depending on moves in overseas market rates. The Financial Supervisory Service declined to comment for this story.

While Korea needs to encourage financing for smaller firms given that there’s almost no junk bond market in the nation, markets must still be kept safe, KCMI’s Kim said. Precautions could include a rule to let only qualified institutional buyers trade the securities, like the 144A rule in the U.S., and requiring issuers to get a rating from at least one credit agency, he said.

“The problem with the CB market in Korea is it has grown so fast,” said Jeon Kyung-Dae, chief investment officer for equities at Macquarie Investment Management Korea. “Some Korean companies tend to issue CBs excessively. The market may face liquidity risk if something goes wrong, such as a fund run.”

--With assistance from Ken McCallum.

To contact the reporters on this story: Heejin Kim in Seoul at hkim579@bloomberg.net;Kyungji Cho in Seoul at kcho54@bloomberg.net

To contact the editors responsible for this story: Lianting Tu at ltu4@bloomberg.net, ;Andrew Monahan at amonahan@bloomberg.net, Chris Nagi

©2019 Bloomberg L.P.