Formosa bond issuance has been hit by tightening regulations

Taiwan’s giant insurance industry has found a way to satisfy its hunger for higher returns and circumvent a crackdown on risky overseas bets, with implications far beyond the country’s shores.

The trade is buying locally listed exchange traded funds that purchase overseas, dollar-denominated corporate and sovereign bonds. The funds are denominated in the Taiwan dollar, providing a way around recently imposed regulatory restrictions on foreign assets.

For the country’s life insurers, which manage some $750bn in assets, it is an elegant solution to a problem created when authorities last year stamped down on “Formosa bonds” — dollar-denominated securities issued locally by the likes of Verizon, AT&T, Apple and Toyota.

But the boom raises questions about the currency risks that insurers are taking on, and the outsized role Taiwan’s insurance companies play in the global debt market.

“What is unique about Taiwan is that they are both the most speculative investors in the world and the most conservative,” says Krishna Memani, chief investment officer at OppenheimerFunds. “They’re significant players in the US corporate bond market, especially the long end.”

Taiwan’s insurers represent the biggest investment industry in the world relative to the domestic economy, meaning they often have to head overseas to find investable assets. They have snapped up an estimated $500bn of debt globally — at one point owning a third of 30-year debt issued by the biggest US telecoms companies, according to Citi estimates.

Formosa bonds were especially popular as they were exempt from regulatory caps on foreign assets. However, last year Taiwan’s Financial Supervisory Commission — spooked by a rash of currency losses — moved to set a cap for Formosa bonds ownership, effectively strangling the market’s growth.

Taiwan insurers started ramping up their “Formosa ETF” purchases last year, when the market expanded by $9bn, according to JPMorgan. But growth has exploded in 2019, and the Formosa ETF market is expanding at about 30 per cent a month, according to Daniel Sorid, a Citi analyst in New York.

“The US corporate bond market is witnessing the development of a new investment vehicle situated 8,000 miles away that could grow to well above $40bn in assets, and potentially as large as $80bn,” he writes in a recent report. “The last time Taiwan life insurers drove the development of a new market category, it grew over four years into the $125bn Formosa bond behemoth.”

Cathay Securities Investment Trust, one of the biggest local ETF issuers with $4.5bn across 25 funds, saw inflows rise 20 per cent last month, building on growth of 240 per cent in 2018, according to Eddie Cheng, who heads the trust’s ETF unit. Taiwan’s life insurers accounted for about 70 per cent of Cathay’s new inflows.

However, this raises the same currency risks as the Formosa bond market did. If the US dollar depreciates strongly against the Taiwan currency, pushing down the value of assets held in ETFs, it could pummel the local insurance industry. Given the sector’s influence on global markets, this could ripple elsewhere — especially as similar dynamics can be seen in other Asian countries.

“The nexus of currency risk and credit risk within the foreign bond portfolios of investors in Taipei, Tokyo and Seoul is an area of systemic fragility,” said Citi’s Mr Sorid. “The maturity mismatch between (short) hedging vehicles and (long) bond investments remains a source of substantial concern for US corporate bond market stability and exposes US credit markets to the risk of outflows triggered by exogenous shocks to Asian financial institutions.”

Taiwan’s life insurers notched a NT$452.6bn, or 29 per cent, gain in investment profits in the first half of 2018 with strong currency gains as the dollar appreciated against the Taiwan currency. But losses on currency hedges of nearly NT$305bn knocked the industry’s first-half profits from continuing operations down to NT$79bn.

Kitty Ching, president of the Taiwan Insurance Institute, an industry body, said that bearing some foreign exchange risk was a “necessary evil most insurers have to endure”, given the cost of insuring fully against forex movements.

“If insurers fully hedge long-term currency risks, the yield pick-up from overseas investment will be meaningless,” said Ms Ching. She added that the industry was “fully aware” of the problem and was trying to find ways to invest more money locally.

“Taiwan insurers in general get returns between 4 per cent and 5 per cent from overseas investments. If they can cap [the currency hedging] cost at 1 per cent, they get juicy returns of 3 to 4 per cent, a lot higher than local investments,” she said.

Taiwan’s Financial Supervisory Commission told the FT it would watch the Formosa ETF market’s development closely, including the potential risk to insurers from currency exposure. But as investment levels are “still low” compared with overall portfolios, the regulator has not proposed any new limits.

Locally, the biggest concern is not risks to financial stability or overseas ramifications, but the lack of investment back home — especially a “tragic” lack of money for early-stage start-ups, said Mark Hsu, a partner at GD1, a Taipei-based venture capital fund.

“The overall sentiment is so risk averse. The future does not bode well — in terms of innovation, overall business sentiment and, unfortunately, social mobility,” Mr Hsu said.

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