The announcement last Tuesday by Taiwan's Financial Supervisory Commission (FSC), that effective May 2017, Taiwan insurers could only invest in international bonds that have non-callable periods of at least five years in the primary market or at least three years in the secondary market, is credit positive for life insurers, says Moody's Investors Service Hong Kong.
This is because the measure will lengthen the effective durations of the insurers' new international bond investments and improve their asset-liability management. In addition, it will lower their reinvestment risks when interest rates fall.
International bonds are denominated in foreign currencies and listed on the Taipei Exchange (TPEX). Because these bonds are excluded from Taiwan insurers’ overseas investment limit (45% of total investments), life insurers have been adding the bonds to their portfolios to gain additional yield over NT$ bonds. Investment grade corporates or international banks are the major issuers of international bonds, which generally offer higher credit spreads over NT$ bonds, mostly issued by the Taiwan government.
The total of outstanding international bonds in Taiwan was NT$3.4 trillion (US$113 billion) at 30 April 2017, up from NT$9 billion at year-end 2013. This suggests that international bonds could account for roughly 12%-13% of insurers’ investment assets assuming that the life insurers purchased 70%-80% of these bonds. Amid anticipation of this tightening and market expectations of the US rate hike, total issuance of international bonds listed in TPEX jumped 69% on the year to NT$606 billion in the first quarter of 2017.
Issuers usually embed call options in the international bonds so they can redeem the bonds when market interest rates drop. This poses reinvestment risk to Taiwan life insurers and also adds to their challenges in matching asset and liability durations. The new rule should alleviate this risk. Because Taiwan life insurers have been the major buyers in this market, Moody's expects most issuers of these international bonds will lengthen the non-callable period of their new issuance in accordance with the new rule.
The new rule’s potential effect on the offering yields of the international bonds is mixed, since lengthening the bonds’ durations may increase their yields, while the removal of a short-term call option could lower the yields. On balance, Moody's expects that the bonds’ yields will decline from the current 4.5%-5.5% for 30-year international bonds without restrictions on callable periods, but the drop will be mild given a general expectation of a US rate hike.
In spite of the potential yield decrease, Taiwan’s life insurers are expected to continue to invest in international bonds because they will still offer a substantial premium over domestic alternatives. By comparison, the 20-year Taiwan government bond yield was only 1.8% as of 30 April 2017, and generally, insurers are earning an average 2.0% on their domestic corporate bonds.
Regardless of the rule change, the total returns of international bonds will inevitably drop this year owing to increasing hedging cost amid the New Taiwan Dollar strength. Foreign exchange mismatch risk will remain a critical risk to the life insurers’ profitability as they continue to channel their investments to foreign currency denominated assets.