Deutsche strip bond starts Taiwan fund cleanup

The regulators indicate asset securitization is also in the works.

Deutsche Bank has completed Taiwan's first strip bond transaction in a move designed to avoid a potential crisis in the country's bond fund industry. Yesterday (February 3) the investment bank stripped NT$2.6 billion ($82 million) worth of principal obligations (PO) in structured bond funds away from the interest obligations (IO), allowing it to sell back the PO in the form of zero-coupon bonds to the counterparty, a domestic securities investment trust company.

Although Deutsche would not comment on the counterparty, it is believed to be Fubon Securities Investment Trust. Neither party would discuss the size of the premium being paid to the bank for issuing strip bonds, which will vary depending on the structured notes and the desperation of the fund manager.

This is the result of months of groundwork with the Taiwan Central Depository and GreTai Securities Market (the OTC market) that included converting the physical structured bonds into scripless form - the first time Taiwan's secondary market ever saw scripless trading, says Cynthia Chan, head of global markets at Deutsche in Taipei. Deutsche also had to work out a new tax regime with the Ministry of Finance and help the regulators adopt new documentation for the strip bonds. Other fund houses are now contacting Deutsche and regulators expect more activity after Chinese New Year.

Deutsche will retain the IO and eventually sell that on to other investment banks, or institutional investors globally that have a corporate-bond trading license in Taiwan, as per GreTai rules.

Kong Jaw-sheng, chairman of the Financial Supervisory Commission, says the deal was finalized with the Ministry of Finance only 10 days ago.

The key issue is to maintain bond funds' liquidity and high yields, says FSC commissioner Lee Shyan-yuan. Bond funds in Taiwan are actually hybrids that invest roughly 50% in bonds, and 50% in liquidity instruments - half of which are structured bonds that involve inverse interest-rate floaters.

The underlying credit risk is very low but with rising interest rates, there is a liquidity problem. The FSC has undertaken moves in the past six months to boost liquidity, such as allowing fund managers to use their portfolios as collateral in the repo market. Also, the pressure on the New Taiwan dollar to appreciate has providentially led to a capital inflow from abroad. So liquidity has been maintained.

This left the FSC with the problem of resolving the mass exposure to derivative structures in bond funds. Last autumn, the FSC asked investment banks to suggest ideas. Most banks, including Chinatrust, HSBC, Lehman Brothers, Taishin Bank and UBS, provided variations on the same idea, namely securitizing the assets. But the regulator was uneasy with the idea of creating an equity component in what are supposed to be bond funds.

Deutsche was the only one to suggest a strip bond, says the FSC's Lee. "This could be immediately implemented and investment trusts are comfortable with the idea," he says.

Although strip bonds will not fully resolve the risks in the bond fund market, it does let an investment trust divest itself of the interest rate risk to an investment bank that has means of hedging it.

The bond fund gets back a zero-coupon bond and this gives the solution a certain elegance. "This opens new business for investment trusts," says Lee. "They can use the PO as a component in a principal-protected or capital-stable fund. They can use it to create liquidity products and earn a liquidity premium from their customers."

The next step is to graduate these hybrid bond funds to an environment where their NAVs are transparent and regularly updated. At present, these illiquid structured notes mean there is no secondary market for bond fund trading and fund managers do not mark them to market. The threat of a declining NAV would be enough to spark another run on the market, as happened last summer following a credit event.

Lee would not outline the steps to getting toward a healthy, transparent NAV environment, but says his goal is to have all NAVs updated daily by a neutral third party such as a custodian bank. "We must adopt international practice and remove all doubts about NAVs," he says.

To reach this goal will require both continued liquidity, to offset any potential market panic and allow stronger fund houses to take a loss on the structured notes; and to remove the interest-rate risk from structured notes in bond funds - whether via strip bonds, or, in the future, asset securitization. Lee says the FSC is still working with other investment banks to find a way to securitize these structured notes, and he expects to see deals occur later this year.