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Formosa Bonds: Looking at the Options

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Formosa Bonds: Looking at the Options VIEWPOINT November 2016 Formosa Bonds: Looking at the Options AUTHORS 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 Mohit Mittal companies, facing low local yields and high liabilities Managing Director from legacy products, have been investing in the bonds Portfolio Manager 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 Rick Chan investment return and reinvestment rates for investors will be lower. Even at today’s yields, Executive Vice President investors may not be adequately compensated for the call risk in the bonds. Portfolio Manager 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 At the same time, recognizing the challenges life insurance companies are facing in the low Account Manager 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 November 2016 Viewpoint With this change, the FSC aimed to Comparing yields: Formosa bonds versus U.S. Treasury zero-coupon spur foreign companies with bonds and U.S. credit branches in Taiwan to issue Formosa bonds on the Taipei Security Yield Exchange and encourage financial 30-year zero coupon U.S. Treasury rate 2.65% innovation by Asian institutions in Generic investment grade corporate spread 1.80% the region. 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 Value difference (between 30-year nc 5 callable zero and Formosa bond yields) ~0.90% are generally less favorable now for Source: Bloomberg, based on PIMCO calculations as of 31 October 2016 investors than for issuers. Even Recently, Taiwanese regulators have though the securities often have WHAT ARE THE ALTERNATIVES TO contemplated pushing out the FORMOSA BONDS? yields similar to or higher than earliest call date for new Formosa corresponding debt with bullet Even as spreads have tightened in issues to at least three years. This maturities, most Formosa bonds the credit markets over the last few change seems likely since many (about $70 billion) are callable, and months, we find long maturity U.S. older Formosa bonds with shorter the call option is often investment grade credit is still an call periods have recently been undervalued, in our view. attractive opportunity. Credit called and therefore have not spreads remain wide relative to Investment grade 30-year zero- provided enough duration to long-term averages, while coupon accreting callable bonds, insurers’ portfolios. In the first nine fundamentals and technicals are the most common Formosa bond months of 2016, 25 bonds totaling very supportive. structure, typically have accretion $6.8 billion were called, compared yields north of 4% today, compared with $2 billion in 2015. Another $3 Currently, investors could build a to 2.65% for equivalent U.S. billion–$4 billion is expected to be portfolio of diversified U.S. Treasury zero-coupon bonds called in the coming months. investment grade corporate bonds (see table). The higher yields on with a potential yield above 4%. If Looking further ahead, the Formosa bonds should compensate an investor also sells a call option introduction of a new international the investor for both higher credit on the U.S. rates to match the accounting standard in 2018, risk and call risk; however, a payout profile of Formosa bonds at IFRS 9, could complicate investing diversified investment grade bond a cost of 75 basis points‒80 basis in Formosa bonds because bonds portfolio without embedded calls points (bps) per annum, the with call options would not meet often has a comparable yield to portfolio could potentially yield the “Solely Payments of Principal callable Formosa bonds. Thus, we 5%, which is about 75 bps above and Interest” test and would believe Formosa bonds significantly the average Formosa bond yield. therefore be classified as fair undervalue (or even ignore) the call Additionally, a skilled active value investments. option, which can be worth almost manager can aim to enhance as much as the credit component, return above the base yield of by our calculations. around 5% through potential alpha from credit selection and options management, with similar risks to those in Formosa bonds. November 2016 Viewpoint 3 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.” 1 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. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, Newport Beach Headquarters issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. 650 Newport Center Drive Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond Newport Beach, CA 92660 prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond +1 949.720.6000 counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with Amsterdam managing the strategy. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount Hong Kong invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors London should consult their investment professional prior to making an investment decision. References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, Milan sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included. Munich This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been New York distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Rio de Janeiro PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where Singapore unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), Sydney PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company
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