This story was adapted from the Spring 2020 edition of AsianInvestor, which was published in early March, just as the coronavirus was beginning to spread across the world.
It's hard to exaggerate just how quickly Taiwan has developed its bond ETF market.
Back in 2016 there was not a single such instrument to be found on the island. But the market grew to $1.27 billion by the end of 2017, expanded almost tenfold to $12.22 billion by end-2018 and grew by almost four times to $44.53 billion at the end of last year.
Thirteen of Taiwan’s 39 asset managers have begun issuing foreign bond exchange-trade fund products, to meet the seemingly insatiable demand of local life insurers being starved of local yield.
The growth was so rapid that the Financial Supervisory Commission (FSC) finally stepped in to regulate the investments on multiple fronts.
The regulator began in March 2019, by moving to reduce insurers’ concentration in a single bond ETF. In the past, an insurer was allowed to supply nearly all of the AUM in a single ETF. But the regulator stipulated that insurers could only subscribe for up to 50% of bond ETFs launched in March and afterwards. In addition, this had to drop to 30% after the bond ETF product had been listed for six months.
The reasoning was simple. Bond ETFs are more liquid than bonds but they still carry liquidity risks. And insurers that almost wholly own an ETF would find it next to impossible to dispose of large amounts of the product in the secondary market without offering large price discounts. The new rules can help to reduce such liquidity risks, Kelvin Kwok, analyst for Asia financial institutions group at Moody’s, told AsianInvestor.
The FSC followed in September by verbally discouraging fund houses from issuing two bond ETFs in a row, to curb the supply of the products. Then in October, it revised the risk factors applied to bond ETFs for insurers, placing an additional foreign exchange risk charge of 6.61. This was in addition to the risk charges of 6.33 and 8.35 for developed and emerging market bond ETFs, respectively.
Most bond ETFs invest in US debt but the foreign exchange risks are not fully reflected under the current risk-based capital (RBC) regime, Chang Chuang-chang, vice chairman of the FSC, told AsianInvestor in an interview at the time.
However, demand was still strong in the final months of 2019. To rein in investment risks, the FSC announced in around December that only bonds rated as investment-grade by international rating agencies can become underlying assets in newly issued ETFs.
China onshore bonds aren’t typically rated by the likes of Fitch, Moody’s or Standard & Poor’s, meaning they don’t qualify. As a result Taiwan insurers are no longer allowed to get exposure to mainland bonds through bond ETFs, along with other non-investment grade debt.
The decision to cut high yield or non-rated bonds out of the equation makes sense, argues Kwok. Bond ETFs, like bond funds, have credit risks, but these can be reduced by banning junk bonds from bond indexes and only including higher-quality debt, he said.
INTEREST TO STAY
Despite the new rules, most market experts believe the impact of the regulatory moves will be limited and interest in bond ETFs is here to stay.
There are several reasons for this. First, many insurers’ overseas investments are very close to the regulatory cap of 65.25%, so bond ETFs offer a convenient way to get around the limit. Taiwan insurers can invest up to 10% of the investable assets into bond ETFs, and their current allocations only sat at 4% on average as of end-2019, said Kwok.
The pace of growth has obviously been rapid in Taiwan and allocations to fixed income ETFs are expected to continue, given that a lot of the insurers are not even close to reaching the investment cap, Chris Pigott, head of Hong Kong ETF services at asset servicing firm Brown Brothers Harriman, told AsianInvestor.
Second, the additional risk charge is not a very big burden and most insurers can afford it, Kwok added. It’s possible that insurers with relatively weak levels of risk-based capital may invest less aggressively in these products, but that is unlikely to apply to most of the island’s 23 life insurers.
Taiwan’s regulatory threshold for insurers’ RBC is 200%, and the new 6.61% risk charge has not left any in danger of falling under this level given that their allocations to bond ETFs don’t constitute a major proportion of their portfolios, said Jeff Chang, president of Securities Investment Trust and Consulting Association (Sitca).
Observers believe it is unlikely the regulator will seek to raise capital charges on bond ETFs soon, after having just added a sizeable increase.