Download Formosa Bonds

VIEWPOINT
November 2016
AUTHORS
Mohit Mittal
Managing Director
Portfolio Manager
Rick Chan
Executive Vice President
Portfolio Manager
Formosa Bonds:
Looking at the Options
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.
Justin Tang
Account Manager
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.
2
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.
November 2016 Viewpoint
Comparing yields: Formosa bonds versus U.S. Treasury zero-coupon
bonds and U.S. credit
Security
Yield
30-year zero coupon U.S. Treasury rate
2.65%
Generic investment grade corporate spread
1.80%
Callable option value
1.00%
30-year non-call 5 callable zero
5.40%
VALUATION OF FORMOSA BONDS
Formosa bond yields
~4.50%
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.
Value difference (between 30-year nc 5 callable zero and Formosa bond yields)
~0.90%
Investment grade 30-year zerocoupon 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.
Source: Bloomberg, based on PIMCO calculations as of 31 October 2016
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.
November 2016 Viewpoint
INVESTMENT TAKEAWAY
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.
“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.”
3
Also known as international bonds in Taiwan. Some investors use a narrower definition that refers only to international bonds listed
in Taipei and denominated in Chinese yuan.
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