Formosa bonds are growing in popularity. Issued in Taiwan but denominated in currencies other than the New Taiwan dollar, the bonds have become an attractive funding choice for many types of overseas issuers recently.1 And Taiwanese life insurance companies, facing low local yields and high liabilities from legacy products, have been investing in the bonds to meet their need for yield.
Formosa bonds seem to be a good fit for Taiwan’s life insurers: The bonds must be rated triple-B or higher, and yields lately are topping 4%. Indeed, Taiwanese life insurers, with more than US$600 billion in assets, own about 80% of outstanding Formosa bonds. However, as yields have continued to trend lower and more bonds are called, the effective investment return and reinvestment rates for investors will be lower. Even at today’s yields, investors may not be adequately compensated for the call risk in the bonds.
Growth in Formosa bonds
Historically, large global financial institutions have been the dominant issuers in the approximately $80 billion Formosa bond market, particularly those with call features. In the last three years, however, nonfinancial corporations such as Apple, Électricité de France and Anheuser-Busch have used this market for funding purposes, along with large international issuers such as Qatar and National Bank of Abu Dhabi.
At the same time, recognizing the challenges life insurance companies are facing in the low interest rate environment, Taiwan’s Financial Supervisory Commission (FSC) increased the overseas investment limit for life insurers gradually over several years, and in June 2014 removed Formosa bonds from the ceiling altogether. So Formosa bonds are basically now counted as local investments.
With this change, the FSC aimed to spur foreign companies with branches in Taiwan to issue Formosa bonds on the Taipei Exchange and encourage financial innovation by Asian institutions in the region.
Valuation of Formosa bonds
We believe Formosa bond terms are generally less favorable now for investors than for issuers. Even though the securities often have yields similar to or higher than corresponding debt with bullet maturities, most Formosa bonds (about $70 billion) are callable, and the call option is often undervalued, in our view.
Investment grade 30-year zero-coupon accreting callable bonds, the most common Formosa bond structure, typically have accretion yields north of 4% today, compared to 2.65% for equivalent U.S. Treasury zero-coupon bonds (see table). The higher yields on Formosa bonds should compensate the investor for both higher credit risk and call risk; however, a diversified investment grade bond portfolio without embedded calls often has a comparable yield to callable Formosa bonds. Thus, we believe Formosa bonds significantly undervalue (or even ignore) the call option, which can be worth almost as much as the credit component, by our calculations.
Recently, Taiwanese regulators have contemplated pushing out the earliest call date for new Formosa issues to at least three years. This change seems likely since many older Formosa bonds with shorter call periods have recently been called and therefore have not provided enough duration to insurers’ portfolios. In the first nine months of 2016, 25 bonds totaling $6.8 billion were called, compared with $2 billion in 2015. Another $3 billion–$4 billion is expected to be called in the coming months.
Looking further ahead, the introduction of a new international accounting standard in 2018, IFRS 9, could complicate investing in formosa bonds because bonds with call options would not meet the “solely payments of principal and interest” test and would therefore be classified as fair value investments.
What are the alternatives to Formosa bonds?
Even as spreads have tightened in the credit markets over the last few months, we find long maturity U.S. investment grade credit is still an attractive opportunity. Credit spreads remain wide relative to long-term averages, while fundamentals and technicals are very supportive.
Currently, investors could build a portfolio of diversified U.S. investment grade corporate bonds with a potential yield above 4%. If an investor also sells a call option on the U.S. rates to match the payout profile of Formosa bonds at a cost of 75 basis points‒80 basis points (bps) per annum, the portfolio could potentially yield 5%, which is about 75 bps above the average Formosa bond yield. Additionally, a skilled active manager can aim to enhance return above the base yield of around 5% through potential alpha from credit selection and options management, with similar risks to those in Formosa bonds.
In today’s low yield environment, Formosa bonds are here to stay as life insurers in Taiwan treat them as an effective way to deploy and reinvest large amounts of capital in a short time.
However, investors with high concentrations in Formosa bonds and those who do not need the regulatory relief the bonds can offer may want to look at other investment choices, including diversified investment grade credit portfolios with similar yields and less onerous call features. Investors who need additional yield and can take additional risk may also want to consider derivatives-overlay strategies that replicate the callable features of Formosa bonds but at potentially better valuations.