June 15, 2017 10:44 pm JST

Taiwan tightens Formosa bond rules as interest rates stay low

But insurers seeking yield will continue to fuel the boom

Chris Horton, Contributing writer

Global investment banks and U.S. corporations, such as telecoms company Verizon, have been flocking to Taiwan to issue Formosa bonds.

TAIPEI -- Taiwan has announced new rules on locally issued foreign currency-denominated bonds, although analysts say the tighter regulation is unlikely to dampen appetite for these so-called Formosa bonds.

On Wednesday, the Insurance Bureau of the Financial Supervisory Commission quietly announced on its website that Formosa bonds will now only be callable or redeemable after five years, from no limit before. The Insurance Bureau had signaled for months that such a rule was in the works, leading to a surge of issuance in the first quarter as companies tried to get in ahead of the regulation.

The new rules also extend to Formosa bonds traded in the secondary market, which would now not be redeemable or callable for at least three years.

Global investment banks and U.S. companies, including industry leaders such as telecoms companies Verizon and AT&T, Apple and pharmaceutical company Pfizer, issued $24.5 billion of bonds in Taiwan in the year to June 5, almost all denominated in U.S. dollars. In total, there were 68 issues in that period.

These Formosa bonds, which account for nearly a-third of the island's 12 trillion New Taiwan dollar ($395.6 billion) corporate bond market, were created to provide more investment options for life insurers. At present, insurance companies can invest no more than 45% of their portfolio in international bonds.

In a low interest rate environment, many insurers are facing negative spreads largely due to legacy policies sold during a time of much higher interest rates. As such, many insurers have been pushed overseas in search of yield.

But Formosa bonds allow insurers the overseas exposure without breaking the 45% cap on international bonds as they are listed locally and hence, deemed to be domestic investments. This means that insurers can invest as much as they want without limit.

This allows for "a more controlled way for the government to further increase the exposure that insurance could have to international debt," said Lorna Greene, director of debt syndicate and origination at National Australia Bank in Hong Kong.

More than 90% of Formosa bond issues are 30-year callable bonds with zero coupons. Issuance year-to-date is slightly slower than the first half of 2016 -- currently down by about 7% -- with three weeks remaining.

The insurance bureau had previously considered limiting the call period to at least three years before finally deciding on five, said Chen Te-hsiang, bond department manager at Taipei Exchange.

Reinvestment risk

Insurance regulators have expressed concerns that Taiwanese insurers were investing too heavily in Formosa bonds, Chen said, exposing them to reinvestment risk when issuers call the deals. "Last year when the interest rate was low, issuers redeemed and then issued new notes -- the insurers buy again and their profit earnings end up relatively low."

NAB's Greene said: "In the lower rate environment seen in 2015 and 2016, a lot of these calls were exercised, the issuers redeemed the bonds. The insurers then had to find adequate new investments for these funds."

Among the issuers who rushed to market in the first quarter was Verizon in February. The telecommunications company issued a $1.475 billion, 30-year zero coupon note callable after 3 years and every year thereafter, with a yield of 4.95%. AT&T issued a $1.43 billion deal in March, as did Apple, Comcast and Pfizer with billion-dollar transactions.

After the first-quarter rush, the market softened in April and May. Greene said this was due to the high issuance in the first three months and tighter regulations on broker commissions enacted in late March. But she said the market had been "normalizing" since May.

New regulations aside, insurers are also keeping an eye on the New Taiwan dollar's appreciation against the greenback, which has reached 6% this year. The FSC said that the country recorded net capital inflows of $9.28 billion in the first quarter which underpinned the currency's strength.

In April, the FSC called on insurance companies to adjust their foreign exchange hedging to offset the impact of the rising local currency against the U.S. dollar.

Indeed, S&P Global Ratings sounded a note of warning in a June 1 paper. It said that the ratio of insurers' total foreign currency investments to total invested assets reached a record high of 64% in March 2017, after hitting 62.7% in 2016 and only 50% in 2014.

"We believe that insurers in our rated pool should be able to manage their forex risk exposure in a relatively stable manner," the note said. "Moreover, we believe other sources of investment income are capable of absorbing the forex losses so far."

The appreciation in the local currency has also hit Taiwanese insurers' profitability, said Frank Yuen, assistant vice president and analyst at Moody's Investors Service in Hong Kong, but in some cases losses have been offset by a higher realized gains on investment.

"If the New Taiwan dollar remains at its current strength, we will probably see weaker profitability in the second half," he said.

Yuen is expecting Taiwanese insurers to remain interested in foreign currency-issued debt. Formosa bonds in particular will be attractive to insurers who have already filled their 45% overseas debt quota, he said.

NAB's Greene said that Formosa bonds still offer good value. "From the investor's perspective, buying these callable zero structures, regardless of the call frequency, still provides them with better return than regular plain vanilla 30-year issuance," she said.

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