The Formosa Bond Market Ignites

FSC Chairman William Ming-chung Tseng, left, and Wu Yuqun, head of China's securities and futures bureau, while meeting in Beijing in December 2014

Taiwan’s offshore RMB bond market is growing rapidly after investment was opened to domestic insurers.  

Taiwan’s Formosa bond market is surging on the back of deregulation measures that have made the renminbi-denominated notes more accessible to the island’s cash-rich insurance firms. In the first quarter of 2015, issuance totaled 11.35 billion yuan, up 132% from 1.5 yuan billion a year earlier, according to Standard Chartered.

Formosa bonds are issued in Taiwan and listed on the Taipei Stock Exchange (formerly the GreTai Securities Market), which provides an over-the-counter system for trading. “We see plenty of room for the Formosa bond market to grow in 2015,” says Tony Phoo, a senior economist at Standard Chartered in Taipei. He forecasts that the regulatory loosening will enable the yuan-denominated market to reach 50-60 billion yuan this year, up from 20.8 billion yuan in 2014.

The upper end of that forecast matches the 60 billion yuan target set by the Financial Supervisory Commission (FSC) in June 2014. If the goal is reached, Taiwan would become the world’s second largest offshore trading market for yuan-denominated bonds, surpassing Singapore, the FSC says.

A broad swath of international banks has been selecting Taiwan as an alternative offshore renminbi-funding destination. Issuers are coming from a number of newly appointed offshore yuan hubs, including France, Germany, the U.K., South Korea, and Malaysia.

The speed of the turnaround in the Formosa bond market is striking. It had been anemic in its first two years of existence, with little primary market issuance and just 21 deals. The catalyst for the market’s takeoff came in May 2014 when the FSC removed onshore foreign-currency bonds from life insurers’ 45% overseas investment ceiling. Under the revised regulation, insurance investors can count a foreign-currency bond listed in Taiwan as a domestic investment even if the issuer is based offshore and the security is cleared outside Taiwan.

Taiwan’s life insurers are flush with cash. Their assets have grown to US$600 billion as annual premium income more than doubled from NT$1.2 trillion in 2003 to NT$2.7 trillion in 2013, according to the FSC. Now the insurers are looking for 3.5-4% returns on those assets in the Formosa bond market, according to Standard Chartered, the second largest underwriter of offshore yuan bonds last year.

“Life insurers are focused on meeting their minimum yield target,” says Wu Soushan, chair of the Taipei Exchange. “They are also concerned about tenor and have a preference for duration.”

Taiwan’s life insurers are flush with cash. Their assets have grown to US$600 billion as annual premium income more than doubled from NT$1.2 trillion in 2003 to NT$2.7 trillion in 2013, according to the FSC.

Swaps and yields

But Taiwan’s life insurers cannot find such high yields in government bonds or other NT$-denominated investment-grade notes. A one-year NT$-denominated government bond offers a coupon rate of about 1.12%, while its five-year benchmark has a yield of 1.62%. Assets in Taiwan’s domestic market have offered poor returns for over a decade as the Central Bank has maintained a low benchmark interest rate (it has stayed at 1.875% since June 2011).

The removal of foreign-currency bonds from life-insurance firms’ overseas investment cap is “super important” for the insurers, says an analyst at a local brokerage, speaking on condition of anonymity. “It’s going to allow them to increase their investment spread significantly,” the analyst says. “The yields of more than 4% on Formosa bonds look very attractive.”

By Taipei-based CTBC Bank’s estimates, the removal of foreign-currency bonds from life insurers’ overseas investment quota could free up between US$12 billion and US$15 billion for Formosa bond purchases in 2015.

The Formosa bond market is also benefiting from attractive cross-currency basis swaps, which allow foreign issuers to price deals within their US dollar funding costs, provided they can find investors. On February 16, the three-year offshore yuan cross-currency swap rose 125 basis points to 4.18%, reaching its highest point in at least four years, according to Bloomberg.

With cross currency basis swaps between the US dollar and renminbi at historical highs, issuers are able to achieve cost savings of 30-40 basis points over their USD funding curve by issuing Formosa bonds and swapping the proceeds into US dollars, according to a  research note in March by Becky Liu, a Hong Kong-based senior rates strategist at Standard Chartered.

Foreign issuers’ appetite for Formosa bonds is growing as converting yuan proceeds into US dollars becomes less costly. Deals have already been priced this year from Air Liquide, the Export-Import Bank of Korea (Kexim), Société Générale, Deutsche Bank, Goldman Sachs, Morgan Stanley, and Maybank. All of the issuances were inaugural except for those coming from Deutsche and Kexim. Japanese and U.K. banks are also considering deals, market insiders say.

Yield rates, meanwhile, have climbed to 4% or higher, as offshore renminbi funding costs have risen amidst fears of further RMB depreciation and tightening liquidity. In January, Kexim issued three-year and seven-year notes, priced at 4.05% and 4.20% respectively, followed by a three-year note with a coupon rate of 4.4% in February. That same month, Morgan Stanley became the first U.S. bank to issue a Formosa bond, selling five-year notes priced at 4%. Then in March, Deutsche Bank, Maybank, and Société Générale debuted in the Formosa market with three-year, five-year, and three-year deals respectively, with coupon rates of 4%, 4.12%, and 4.03%.


Chinese lenders

In a further bid to develop Taiwan’s offshore renminbi market, the FSC in March raised the ceiling of yuan-denominated bonds issued by Chinese banks to 45 billion yuan (US$7.25 billion), boosting the former limit of 25 billion yuan by 80%. Chinese lenders currently have renminbi-denominated notes totaling 23 billion yuan in Taiwan, according to the FSC, and may sell more following the raising of their Formosa-issuance cap, analysts say.

But the FSC has not commented on when it will expand the scope of Chinese firms permitted to issue Formosa bonds. Since March 2013, China-based banks, branches, and subsidiaries of Taiwanese banks operating in China, as well as subsidiaries of China-registered Taiwanese companies, have been permitted to issue the renminbi-denominated notes.

Because of the substantial risks tied to China exposure, the FSC has yet to relax the restrictions for Chinese issuers, market insiders say. “It is difficult for Taiwanese investors to monitor Chinese firms’ credit risk, and they are also exposed to systematic risks brought by China’s economic slowdown and overcapacity,” says an analyst at a local securities house, who spoke on condition of anonymity.

“The fact that not all Chinese firms can issue Formosa bonds is not a big problem right now as the market is still in its infancy,” notes the analyst. “But the regulator will be able to expand the size of the market significantly by allowing more types of Chinese companies to issue the bonds.”

With regard to increasing Chinese participation in the Formosa bond market, the Taipei Exchange “is going step by step,” says Chairman Wu. “We are gradually building a larger offshore RMB center in Taiwan.”


Further liberalization

The FSC also plans to allow retail investors to invest in Formosa bonds issued by Chinese banks, citing the rising demand among retail investors for financial products. During a trip to Beijing in December 2014, FSC Chairman Tseng Ming-chung said that the Commission was likely to allow retail investors to buy Formosa bonds issued by Chinese banks in the first half of 2015. However, once retail investors are permitted to buy the bonds, the FSC expects it will take longer to review each Formosa bond issuer’s application “to provide more protection to retail investors,” Tseng said in Beijing.

Some market players question that approach. “The regulator will ‘protect’ retail investors at any cost,” says an executive with a foreign brokerage, who spoke on condition of anonymity. “Some retail investors complain to Taiwan’s legislators – who control the FSC’s budget  – when their investments do not work out as planned. It would be better if there were more education for retail investors about the securities market than ‘protection.’
The FSC has yet to announce when it will allow retail investors to purchase notes issued by Chinese banks. But Taiwan will launch a yield curve for one to ten-year Formosa bonds on May 25; 10 to 15 financial institutions will be market makers based on their share of the Formosa bond market, according to the Taipei Exchange.

“The curve is very complete,” says Wu of the Taipei Exchange, adding that with pricing reference points and credit ratings for issuers, it “will make the Formosa bond market efficient and more transparent.”

According to Reuters, the financial institutions selected to be market makers are MasterLink Securities, Taipei Fubon Bank, Yuanta Securities, SinoPac Securities, Capital Securities, Bank of Taiwan, Mega Bank, KGI Securities, CTBC Bank, and HSBC (Taiwan).

Further liberalization is important for the Formosa bond market to continue growing, says Phoo of Standard Chartered. “Hong Kong is a preferred offshore renminbi center, but that should not undermine Taiwan’s ambitions,” he says, noting that in the first two months of the year, Taiwan’s RMB-denominated bond market attracted more issuers than Hong Kong’s. But for the Formosa bond market to grow sustainably, he adds, “Taiwan must leverage its current foundation to get more international investors to participate, and not just focus on mainland Chinese and Taiwanese corporates.”