The search for yield is not a new phenomenon, even if it has intensified under QE. For years, the big Japanese Life companies in particular were prone to allocating to strategies that offered high nominal yields in foreign currencies, before running them increasingly unhedged and then getting hit hard by a currency crisis, a crisis they then intensified by rapidly withdrawing their funds. Indeed we could go as far as to suggest that a major contributory factor in several emerging market boom bust cycles was precisely this sort of behaviour. As such we should always be alert for evidence of unhedged carry trades as a source of risk, and it looks like we have one appearing funded by Taiwanese Life Companies. This time however, it is not in emerging market debt, but in US Investment Grade Bonds. With the prospect of a Trade agreement and an appreciation of the Tawianese $, it could unwind very quickly in ‘a flight from quality.’ It merits watching closely.
Currently Taiwanese investors are aggressively chasing locally issued ETFs investing in US investment grade debt, creating a classic bubble warning signal as well as providing a strong bid for US corporate debt markets. This local market has grown by almost 70% this year in terms of size, according to Bloomberg and is forecast to hit $100bn. However, our concern should not be simply the speed of growth – although this is always a warning signal of potential capital misallocation- or that this is largely unhedged carry trading, but rather that this is a clear case of regulatory arbitrage and could, indeed should, attract regulatory attention and thus disappear as quickly as it came, even if the currency doesn’t trigger an unwind first.
The popularity of this new trade follows a recent regulatory crackdown on so called Formosa Bonds – Bonds issued in $US by multi national corporations and sold onshore in Taiwan. These used to be very popular in Taiwan as they were exempt from any cap on foreign assets, and the market grew dramatically over the last five years to over $125bn. Of course the problem here was that the old story that the high(er) yields the bonds were offering were completely eliminated if the clients hedged the currency risk – and so largely they didn’t, similar to the Japanese Life companies of old, ignoring the fact that there really is no such thing as a free lunch. When the Taiwanese currency strengthened against the US$ during 2016 and 2017, the unhedged bond positions registered double digit losses and accordingly last year, local regulators, worried by currency losses, imposed a cap, effectively killing (the growth in) the market.
As is often the way, around the same time, the Taiwan$ peaked against the US$ and began to weaken, largely driven by the Trade War fears that have dominated over the last 18 months. In order to play this currency trade again, and in response to the regulatory crackdown on Formosa Bonds, the Taiwanese insurers have instead issued Formosa ETFs, essentially working around the restriction to create local ETFs that invest in US investment grade bonds. This is of course regulatory arbitrage rather than a new investment strategy. The bond is ‘investment grade’ for capital requirement and is also deemed ‘local currency’, but the return is essentially the same ‘bet’ and is effectively an unhedged foreign currency carry trade. It does of course have the further twist of large counterparty and liquidity risk with the underlying issuer.
As such, I believe we should be watching the Taiwanese $ exchange rate extremely carefully. Between March 2018 and August this year, the Taiwan currency weakened by almost 9% against the US$, largely driven by Trade War concerns, but of course adding a nice enhanced return in local currency terms for the Taiwanese insurers long US Investment Grade Bonds. In fact in the 18 months from March 2018 to September this year, the Trade War play of being long unhedged US Investment Grade Bonds would have returned around 16% in local currency, hence its popularity. Indeed, it can be significantly more than this; to pick just one fund, the Cathay Bloomberg Barclays US Corporate A- and above 10+ years liquid ETF has TWD55bn of assets and is up 24% in local terms over the last year.
Since the peak in August, however, the Taiwan $ has now rallied by around 3.5% and completed a near exact 50% Fibonacci reversal of its Trade War sell off. The risk therefore is that a further rally in the TWD associated with trade war tensions easing and/or a new regulatory crackdown on Formosa ETFs could rapidly reverse the flows into US Investment Grade bond markets. Watch out for that butterfly effect as they say.
