Why Taiwan’s insurers have built big bond ETF positions

This article is adapted from a feature on Taiwanese fixed income ETFs that originally appeared in Asianinvestor's Spring 2020 edition in early March, as the coronavirus was beginning to spread across the world.

Taiwan has long been a key driver of exchange-traded fund (ETF) developments in Asia, often pioneering new types of product. It’s now doing so in the fixed income arena. 

The island’s bond ETF market is already proving a stellar success. In most markets, equity ETFs are the most popular vehicles, but bond ETFs have grown from nothing in 2016 to dominating today.

Last year they truly soared. The asset value of bond ETFs grew a whopping 3.6 times last year to $44.53 billion, outpacing the doubling of assets in the instruments to $71.38 billion across Asia as a whole, according to local consultancy firm Keystone Intelligence and ETFGI.

By comparison, the island’s equity ETF market has grown in a far more subdued manner, from $8.06 billion at the end of 2016 to $10.93 billion at the end of last year.

There’s a simple reason for the rapid bond ETF growth: Taiwan’s insurers. 

The island’s life insurance companies are desperate for offshore exposure and bond ETFs have helped them gain it. Taiwan’s bond ETFs are very institutional-heavy, while the products in other markets are more evenly subscribed by both retail and institutional investors, Jackie Choy, director of ETF research for Asia at Morningstar, told AsianInvestor.

Local fund managers tailor-make the bond ETFs for the specific needs of insurer clients. Indeed, their demand meant that most bond ETFs issued in the last two years were over 90% subscribed by a single insurer, despite the liquidity and other risks involved in such investments, he added. 

In fact, the craving of Taiwanese insurers for bond ETFs reached such a level that Taiwan’s financial watchdog took a set of measures last year to tamp down on insurers’ investments into the products, including limiting their concentration in the instruments and adding a sizable foreign exchange capital charge. 

There are several reasons for the rapacious appetite of Taiwan’s insurers for bond ETFs. By far the most important is the low returns available in the local bond market. 

The new restrictions may have only slowed the tide of supply. Market experts believe Taiwan insurers will keep demanding the ETFs, as they seek out better returns. 

“Their investments in bond ETFs will be more selective and careful ... the growth [of the market] will slow down, but it will keep growing because it is an important tool for insurers’ asset allocation,” Jeff Chang, president of Securities Investment Trust and Consulting Association (Sitca), told AsianInvestor in late February.

GAUGING THE APPEAL

There are several reasons for the rapacious appetite of Taiwan’s insurers for bond ETFs over the past two years. By far the most important is the low returns available in the local bond market. 

The yields for a 10-year government bond stand at just 0.55%, well below the funding rate most insurers require to cover the policies they have sold. In contrast most overseas bonds can deliver returns of more than 3%, making them far more appealing. 

Previously, most insurers relied on Formosa bonds, or locally-placed US dollar debt, to gain more overseas exposure. But these products were grouped as overseas investments starting November 2018, which led insurers to turn their attention to bond ETFs.

While most Taiwan insurers ramped up investments to bond ETFs, the appetite of the largest, Cathay Life, has been particularly notable. The NT$6.26 trillion ($209 billion) insurer raised its exposure fivefold last year, from just 1% of its investable assets at the start of 2019 to about 5% in October, a spokesman told AsianInvestor at the time. 

Cathay Life did not provide an update on its current bond ETF allocation as AsianInvestor magazine went to press, citing its black-out period before announcing its 2019 financial results. However, it has since revealed it had maintained some balance sheet liquidity due to a recent injection of liquidity and high capital buffer, offering it a chance to invest in high quality assets. 

When making its bond ETF investments, the insurer prioritised high quality bonds familiar to the insurer as its underlying assets. That meant it was exposed to transparent assets that can offer stable returns with good levels of liquidity, ensuring that the ETFs don’t carry too much additional investment risk, the spokesman said in October. 

ETFs are also assessed as equity products for accounting purposes in Taiwan, which meant Cathay Life was not required to hedge the associated currency risks and could save some money there too, he added.

In addition, most bond ETFs offer dividends and have lower volatility than equity portfolios, so directly investing in them is more convenient than buying the underlying bonds, said Chang of Sitca. The bond ETFs have a dividend yield of 3% to 5%, on average.

The biggest draw of the bond ETFs is their ability to let Taiwanese insurers to get indirect exposure to offshore bonds without having to report them. as foreign assets. Overseas investments are now capped at 65.25%, Chang said. But the bond ETFs are currently considered to be domestic assets, even though most invest in US dollar debt.