Perpetually wrong? One hopes not

IFR Asia 996 - June 17, 2017
6 min read
Asia

If it looks like a bubble, feels like a bubble… okay, you know how that one goes. These days, I can’t help feeling that this may be an apt metaphor for foreign currency bonds issued in Taiwan’s Formosa bond market. But maybe I’m just too early.

Mind you, I called the Formosa demise early last year, much to my chagrin and embarrassment. The market just chugged on, or should I say exploded, going from a tiddler of just US$2bn of annual issuance in 2013 to around US$100bn last year, according to figures from the Taipei Exchange. Boy, was that a wrong call!

Well, we all make mistakes, but nevertheless, I reckon at some point I will be right. The reason I say that is that the Formosa market essentially depends on demand from one source: the domestic life insurance industry.

And that particular concentration risk centres on the way regulations pan out in Taiwan. Insurance regulation in that country, which relies heavily on external demand, is hostage to a variety of fortunes, not least demographics and capital market prices, principally interest rates and exchange rates.

IT JUST SO happens that the razor-thin yields available in the Taiwan government bond market, where hitherto much of the country’s life insurance industry had parked its funds, have coincided with more generous yields in the US dollar bond markets. That partially explains the Formosa bond boom which has been extant for the past four and a half years or so.

That dynamic, which cried out for the most gargantuan of portfolio switches, was facilitated by the country’s financial authorities – the Financial Stability Board – which decided in its wisdom just over three years ago to classify Formosa bonds as domestic investment.

That shattered the ceiling which had restricted Taiwanese life insurance companies from investing more in “foreign” debt, on which their quotas were full. They were henceforth free to go out and fill their boots in Formosa bonds and that’s exactly what they’ve done.

In the meantime the Formosa bond market has become a venue of choice for the staple issuers of the international debt markets, from large universal banks such as Deutsche and HSBC, to blue-chip corporates such as Apple, Pfizer and Verizon.

THE FORMOSA MARKET’S growth also seems to have had a lot to do with the Asian market’s perennial inability to price options correctly – in this case call options which have tended to be the feature of Formosa issuance in US dollars.

Most of the Formosa bonds which had been issued up until a regulation change by the FSB in March came in 30-year callable format, with the call typically pitched at two to three years.

Then the authorities decided that any calls under five years were unacceptable and so, following the passing of that edict three months ago, the most likely format to emerge from the Formosa market is in 30-year non-call five paper.

What happened in the “good old days” when the short-dated calls were all the rage was that investors in Formosa bonds – principally Taiwanese life insurance companies – were happy to get any kind of yield pick-up versus ordinary three-year bullet paper issued for like-rated names.

And that mispricing by the investor base was music to the ears of issuers, who were over the market like the proverbial cheap suit.

But that was back in the days when US yields were somewhat higher than they are now. Now that the yield pick-up between Taiwan govvies and US govvies is negligible, the optionality might begin to appear like a bagatelle. Or perhaps not. US 10-year governments were looking to close out last week at around 2.15% while 10-year Taiwan govvies were eyeing a level just over 1%. Enough, perhaps, to keep the trade alive for the foreseeable future, assuming that pair doesn’t come unstuck in dramatic fashion.

Another reason why I suspect my bearish call on the Formosa bond market might have been premature is that markets seem to be fully risk-on again, despite some looming risk factors in the form of legal challenges to the Trump administration and geopolitical risk in North Korea.

One clear piece of evidence of that was a recent cheeky trade from Hong Kong’s FWD Group, which managed to print in zero coupon perpetual non-call five format the week before last.

Admittedly the deep discount of the zero coupon format brought in less cash than would have been the case for a bullet issue – US$360m for a nominal US$500m deal – but the deal managed to break the 7% optical barrier which many market observers imagined would be impossible to pull off.

But zero coupon format has been the norm in the Formosa market since that market’s boom took off, and it seems investors are more than willing to load up on the duration kicker presented by zero coupon paper. I reckon the good times can roll a bit longer for this market.

And when I change my mind, I assure you – for what it’s worth – I will let readers of this column know. I can only hope the veracity of that call will not be of the stopped clock variety.

Jonathan Rogers_ifraweb