It is a familiar conundrum to bond investors the world over: how to generate yield without ramping up risk in a low interest rate environment.
For the past two decades, Taiwan has faced the biggest problem of all. The island not only houses an outsized insurance sector but one long forced to invest in offshore assets to try and generate returns that are higher than its onshore liabilities.
This underlying mismatch has led to a constant game of cat and mouse between the industry and its regulator, the Financial Supervisory Commission (FSC). The insurers need offshore assets to maintain their profitability, while the regulator remains understandably concerned that foreign exchange and interest rate risk will create a trap that snaps shut if the US dollar changes course from its current high path.
It’s clearly a systemic risk for Taiwan given that its insurance industry now represents 150.9% of GDP thanks in large part to ultra-low domestic interest rates, which has pushed the country's citizens into insurance products rather than bank deposits. At the end of the first quarter, the insurance industry had $889 billion in assets under management (AUM) compared with Taiwan's $589 billion 2018 GDP.
The commercial-regulatory push-pull has shown no sign of abating during 2019. In fact, it has become all the more intense as US Treasury yields and many credit spreads have ground ever tighter, with insurers locked into paying out on legacy guaranteed products that carry yields of up to 6%.
All that has happened is that the industry's overseas investment focus has switched to a new piece of cheese. Where once it was Formosa bonds (US dollar-denominated bonds listed in Taiwan), it is now bond exchange-traded funds (ETFs), which are denominated in New Taiwan dollars but invest in US dollar assets.
In many ways, the switch shows how successful the FSC has been at minimising Formosa bond risks over the past two years. In March 2017, for instance, it curtailed the issuance of structured long-dated bonds with short-dated call options since they only "optically" matched insurers’ long-dated liabilities.
Then in November 2018, it told insurers that they needed to categorise Formosa bonds within their foreign investment portfolios, which at that point were capped at 40% to 45% of total AUM.
As Moody’s analyst Kelvin Kwok explains, “The overall foreign investment cap was lifted by 145 percentage points to accommodate Formosa bonds. The cap varies from insurer to insurer, but averages 60% to 65%.”
Many insurers are now close to their limits, although they are able to expand it if they can sell more US dollar insurance products to citizens back home. In 2018, 37% of first-year premiums were dollar-denominated, although Kwok says the figure has dropped this year because of the weakening Taiwanese currency.
He estimates that roughly 15% to 20% of the major lifers' AUM is dollar-denominated.
Taiwanese investment bankers agree that insurers will remain cautious about getting too close to the foreign investment limit. This has led to a correspondingly sharp decline in Formosa bond issuance, but a large spike in ETF bond investment, which are currently not classified as foreign investments.
BOND ETF GROWTH
As table 1 shows, outstandings of Taipei-listed bond ETFs amounted to just NT$35.21 billion ($1.15 billion) in January 2018. By September 2019, the figure had grown to NT$1.135 trillion ($37.05 billion) – roughly 4.6% of the global total.
If outstandings carry on growing by 10% per month the figure will be up to $50 billion by the end of the year.
Table 1: Taiwan Bond ETF Issuance
|Date||AUM NT$ bn||MOM % Growth||New issues||EM ex China||China||High Yield|
Another reason Taiwanese insurers love ETFs is because they only need to get one approval per fund rather than one per bond were they to individually purchase the latter from the primary bond market in the form of a Formosa, or standard Reg S/144a deal.
This allows insurers to creep further down the credit curve to pick up yield since many funds span a wide ratings spectrum. As such, one of the most striking growth figures has been in emerging market bond ETFs, particularly those specialising in Chinese credit.
According to local bankers, a total of $10.58 billion is invested in emerging market bond ETFs, of which pure China exposure amounts to $5.79 billion and a further $650 million comprises high yield.
The two biggest emerging markets ETFs are the Capital ICE 15+ year US Emerging Markets External Sovereign Bond ETF and the KGI 10+ Emerging Markets US dollar investment grade bond ETF, both listed in Taipei. As of mid-October, the former had AUM of NT$36.64 billion ($1.2 billion) and the latter NT$31.48 billion ($1.03 billion).
This AUM has quickly shot them up the rankings of global ETF providers alongside iShares, VanEck, Invesco, Vanguard and SPDR Barclays Capital.
When it comes to China's onshore bond market, the Cathay FTSE Policy Bank Bond 5+ year ETF has NT$36.97 billion ($1.21 billion) outstanding.
The FSC is back in catch-up mode as it tries to contain these risks. It sprang back into action in March when it clamped down on concentration risk by ruling that one single investor could no longer account for more than 50% of a bond ETF’s AUM, down from 80% previously. This ratio is set to fall again to 30% at the end of 2020.
More recently, it has announced a review of the insurance industry’s risk-based capital ratio (RBC), so there is a higher buffer against adverse FX movements. “The bond ETF charge was previously 8.1% but the regulator is planning to add a further 6.1 percentage points to capture foreign exchange risk,” Kwok told FinanceAsia.
The FSC is also toying with plans to impose a credit charge so that there is a clear differentiation between the costs of investing in a developed market ETF versus an emerging markets one.
Kwok expects formal confirmation of the changes by the end of November. He forecasts that the pace of ETF bond growth will then slow but not stop.
Investment bankers agree. Alvin Yang, executive vice president at KGI securities, points out that the regulations allow insurers to invest up to 10% of their AUM in bond ETFs.
“There’s still lots of room before they hit this,” he said. “The ETF bond market has room to grow to about $60 billion based on current AUM. It’s still the winning product as far as insurers are concerned.”
So what does this mean for the Formosa bond market? At the end of September, outstandings stood at $170.5 billion, nearly five times the level of bond ETFs.
On the surface, issuance appears to be holding up (see table 2). But the Dealogic figures are flattered by outsized deals from Qatar, which became the first sovereign issuer to list a deal in Taipei in 2018.
It raised $12 billion in 2018 and another $12 billion in March 2019. The combination of an Aa3/AA-/AA- credit rating and 4.817% coupon on the sovereign's $6 billion 30-year tranche should be a winning one for the insurance industry.
About 20% of the longer-dated tranche was placed with Taiwanese insurers.
Table 2: Formosa Bond Volumes
|Priced Year||Deal Value USD (m) (Proceeds)||No.|
However, the available investor pool has shrunk from more than a dozen institutions at the market’s height in 2016 to about five this year as even the biggest investors are close to their regulatory limits for foreign investments.
Take Fubon Financial. Its second quarter results revealed a 64.5% foreign investment ratio for its life insurance unit. This figure does not include “domestic” bond investments such as ETFs, which accounted for a further 12%.
As a result, Taipei-based bankers do not believe that Formosa bond issuance will hit the highs of 2016 again when US corporates poured into the market with structured zero coupon deals that had 30-year maturities with one- to two-year call options.
But they are still optimistic that issuance will pick up again in 2020.
“We should bounce back from 2019 lows, although the growth rate won’t be dramatic,” said a spokesperson from Yuanta Securities's fixed income department.
Yuanta argues that increased redemptions should drive additional supply. The securities firm believes that if US interest rates continue declining, then more issuers will be tempted to trigger the call options on their existing Formosa bonds and try to re-finance at tighter levels.
So far redemptions have been relatively slow, particularly when it comes to the spate of zero-coupon callable deals issued at the market's height. “It was noticeable that very few issuers called their bonds when yields really tightened during the third quarter,” KGI’s Yang said. "But the number could jump a lot during the first quarter of 2020."
Re-financing these deals is complicated by the fact that insurers have not lowered their investment hurdles in tandem with tightening bond yields.
“This is the big issue,” Jenny Hsu, head of debt capital markets at Cathay United Bank, said. “Investors don’t have that much flexibility to drop their investment hurdles because of the payout commitments on their legacy products.”
But they do have some flexibility as legacy products become a progressively smaller percentage of insurers’ AUM.
According to Yang, the average liability costs of Taiwanese insurers was 4.1% to 4.2% about three years ago. Today it stands at 3.7% and next year, Yang thinks it is likely to be slightly lower again.
Hedging costs are becoming more favourable too, he reckons. In the fourth quarter of 2018, they averaged about 2.8%. “Right now, the level’s around 2%,” Yang said. “If the US Fed keeps cutting interest rates, then it should drop to about 1.5% in 2020.”
Over the past few years, insurers have turned to proxy hedging to keep their hedging costs and FX risk under control. This is an FX insurance product for insurers based on currency baskets that is cheaper than traditional derivatives.
Moody’s Kwok estimates that the major insurers are currently hedging 50% to 60% of their foreign currency portfolios with traditional derivatives, then a further 10% to 20% with proxy hedges.
Fubon’s results bear this trend out. At the end of the second quarter, its life unit had hedged 92.4% of its official foreign currency exposure compared with 75% three years ago.
Lower hedging costs theoretically mean that insurers can buy higher-rated, lower yielding credits and still hit the same investment return hurdles as before. They have historically dropped their returns for credits they place a high value on – such as Japanese and Singaporean banks.
LARGER AND LONGER
The extent to which lower hedging costs will bring a wider range of credits into play will be one of the key issues for 2020.
The market’s sweet spot has typically revolved around issuers that have an all-in funding cost of about 100 basis points over Libor or above, which is where the Middle Eastern names fall. South Korean banks come in at around the 65bp level.
One new way that fixed income bankers are trying to help issuers hit their all-in funding costs and enable investors to meet their return thresholds is by going extra mature: stretching maturities from 30 to 40 years.
Yuanta Securities says this is a very promising development; a win-win for issuers and investors.
The market's first 40-year Formosa was issued by Electricite de France (EDF) back in 2016 and carried a 4.99% coupon. But the maturity did not really catch on until this year when the structure morphed into a zero-coupon format.
So far there have been four 40-year deals for: Bank of America, JP Morgan (twice) and Santander. The zero-coupon Santander deal was a relatively small $60 million deal with a 4.2% internal rate of return (IRR).
Bankers believe the next tasty morsel for the market could be its first 50-year deals based on soundings by A- rated EDF. A first Formosa sukuk is also expected before year-end too.
Insurers are also pushing issuers to embrace longer-dated call options to avoid bunching. In addition to the new market-standard 30-year non-call five deals, there have also been some 30-year non-call eight ones in the private placement market, according to local bankers.
Most of these zero-coupon callable deals are fairly small ($100 million to $150 million) and have been placed with insurance funds.
However, Taiwan’s other big investor base – commercial banks and securities companies – desire liquidity, which has helped drive the trend towards larger transactions that are dual-listed in Taiwan and typically either London or Singapore.
In recent years, the two mainstays have been Korean banks ($300 million to $500 million issue sizes) and Middle Eastern banks ($500 million to $1 billion). More recently there has been growing interest from Southeast Asia in line with the government’s Go South policy to reduce Taiwan’s economic reliance on China.
“There has been a noticeable uptick from Asean, which has really helped to diversify the issuer base,” said Cathay’s Hsu. “Banks from this part of the world definitely see the benefit of issuing offshore while US interest rates are so low.”
In late September, for example, A3/A- rated CIMB Bank Berhad issued a $680 million five-year sustainable development goals floating rate note (FRN) that was dual listed in Malaysia and Taiwan. It follows Maybank, which executed an $850 million deal in March.
The net result is that the Formosa market has switched from a structured to a more vanilla bond market dominated by financial rather than corporate issuers. So far this year, bankers say that 29 of the 100 issues have taken an FRN format.
BOOSTING DOMESTIC INVESTMENTS
Clearly one solution to the insurance industry’s investment dilemma would be more higher-yielding Taiwan dollar-denominated products. Recent moves in this direction include a relaxation on foreign borrowers if the proceeds are used for Taiwanese investments and incentives to invest in sectors that require long-term funding such as infrastructure and healthcare.
Ageing demographics, for example, are prompting more care homes. Insurers that invest in them are now allowed to appoint directors to sit on their boards.
Renewables have also come into focus given the government is phasing out nuclear energy in favour of offshore wind. Plans for a debut New Taiwan dollar bond by Denmark’s Orsted is at an advanced stage.
At up to $500 million in size, the deal should be fairly large by local standards according to one Hong Kong-based banker. However, the mooted 1.5% coupon on the prospective 15-year tranche, only serves to emphasise why insurers are forced offshore.
As Moody’s Kwok concludes: “the investment pool is still fairly limited so it’s going to be difficult for insurers to shift their assets back onshore.”
But he also believes that while “the foreign exchange risks are still there, the regulator and industry have done a good job to make sure they remain manageable.”
So does that make the cat and mouse analogy a bad one? Perhaps. However, one thing the Tom and Jerry cartoons always reveal is a much larger truth: the cat and the mouse may spend an awfully large amount of time trying to outwit each other, but at the end of the day they work together when it counts.