Formosa swaptions trade under pressure from new Taiwan rules

Limit on investment by insurers is hitting issuance of Formosa bonds and related options

Taipei formosa

Dealers say a new regulatory restriction on Taiwanese insurers is depressing demand for callable Taipei-listed US dollar bonds known as Formosas, threatening a once highly lucrative options trade.

A collapse in Formosa issuance, driven by expectations of the rule change, has reduced the supply of Bermudan-style US dollar swaptions – exercisable on a given date per year and embedded in Formosas – that had kept long-end rates volatility low.

Issuers like Formosa bonds because they result in lower all-in funding costs compared with vanilla floating-rate debt. To do this, the issuer executes a package trade, entering into a receive-fixed interest rate swap and simultaneously selling a Bermudan-style receiver swaption. The swaption matches the optionality embedded in the Formosa, and the premium reduces the effective all-in floating rate payable by the issuer.

“The size of the [Formosa-linked] swap market has dropped dramatically,” says the markets head for Taiwan at a European bank. “So far in August we’ve seen barely anything.”

Pacey Formosa issuance gave banks’ interest rate trading desks a cheap supply of Bermudan swaptions. They hedged these by selling more liquid – and more expensive – European-style swaptions, profiting from the basis between the products to the tune of as much as $200 million a year according to one senior rates trader.

That started changing in June when Taiwan’s Financial Supervisory Commission put out a proposal to re-define Formosas as a foreign asset, leading to an announcement on August 14 that Formosa bonds would now count towards insurers’ overseas investment limits. Regulation puts a ceiling of 65.25% of total assets under management on overseas investments.

In June, seven 30-year zero-coupon Formosa bonds were issued totalling roughly $1.5 billion, according to listings published on the website of Taipei Exchange. The number of issues plunged to three in July, with a combined value of just $160 million. So far this month, only one bank – Morgan Stanley – has printed a 30-year zero-coupon bond, for a mere $5 million. 

Debt capital markets analysts say the proximity of some insurance companies to the overseas investment cap now affecting Formosas is the key reason issuance was subdued in July. 

“Some Taiwanese insurers – it’s mainly the lifers – now have very limited allocation for Formosa bonds because, historically, they have been quite aggressive and so they are close to the new limits,” says Andy Chan, an analyst at Taiwan Ratings, a subsidiary of S&P Global Ratings.

Although there was some issuance by local banks in July, it included five-year floating-coupon bonds rather than the longer tenors favoured by investors in the insurance sector.

“Traditionally, the local banks’ 30-year callable bond has made up about two-thirds of the total [Formosa] issuance,” says a Taipei-based markets head at another European bank. “But because of this regulatory change, that issuance is going to disappear because the insurance companies will no longer buy those.”

Chain reaction

Dealers say the dramatic fall in Formosa issuance is already having an impact on the US dollar swaptions market. Albert Lin, head of Americas structured rates trading at Barclays in New York, says there has been a noticeable lack of long-dated Bermudan swaption supply in recent months, as visible from the absence of downward movements in long-dated volatility – which would happen if dealers were hedging Formosa issuance.

“You would normally see [an effect] from the way dealers are axed to move vol; you see it if vol levels spike lower,” he says, adding that long-dated vega, or volatility exposure, is not as pressured as it used to be.

The European bank’s Taipei-based markets head agrees: “Previously, when there was a Formosa issue you would see a selldown of the long-dated vol. Today the flow becomes less and less. I would expect there to be less balance in the long-dated volatility because of this regulation.”

The slower supply of Bermudans has also narrowed the basis between these swaptions and their European-style counterparts. In the past, a European swaption might trade at 60 volatility points per year, with a Bermudan at 45 points, leaving a basis of 15 points that can be earnt over the life of the trade. According to Lin, since the start of the year, a five-year Bermudan option on a 30-year interest rate swap has increased by 3.5 annualised volatility points compared with its European-style counterpart, narrowing that basis considerably.

One senior fixed income source at a European bank says it may be the end of the “easy” trade that has been very lucrative for banks over the past few years, but he argues it may allow for more structural innovation in the country going forward.

Even those firms that are not close to the foreign investment ceiling could decide Formosas are a less attractive investment proposition due to the impact of recent foreign exchange movements on their hedging costs: since the beginning of 2016, the US dollar has fallen nearly 9% against the Taiwan dollar.

“In 2016, when the foreign exchange rate was more favourable to lifers, the hedging cost was less than 100 basis points,” says Chan at Taiwan Ratings. “But in the second half of 2017, some lifers saw hedging costs between 150–250bp. If your investment yield is 4 or 5%, and your hedging costs rise by 50bp or 100bp, then your overall return declines by 0.5–1%. That’s quite significant.”

A yield of at least 4% is typical for Formosas.

Kelvin Kwok, an insurance sector analyst at Moody’s in Hong Kong, agrees there is more behind life insurers’ waning appetite for Formosas than just the regulatory change.

“Some of the bigger players actually retain some buffer below the cap and therefore still have some capacity to invest in the bonds,” Kwok says.  “But they are also looking to compare the yield and return between the Formosa bonds and direct overseas bond investments.”

Additional reporting by Lukas Becker

Editing by Olesya Dmitracova

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