FinanceAsia’s first local debt conference in Taiwan proved timely. The importance of the bond market is growing. Chin Lung Tseng, senior executive vice president of China Securities pointed out during his speech that the bond market’s outstanding issuance stood at NT$1.8 trillion ($60 billion) in July this year, compared to NT$200 billion 10 years ago. That is larger than the Hong Kong local debt market, which had outstandings of $54 billion in July this year. The difference, however lies in the fact that the Hong Kong bond market has three times as much outstanding corporate debt to government debt, whereas in Taiwan, that ratio is reversed.
While most attention in Taiwan is fixed on the stockmarket, the trading volume of the bond market has exceeded that of the stock market since 1995. Several speakers at the conference said that it is high time for the financial community to alter its emphasis on the stock market and focus on the bond market. The two instruments were likened to the ‘legs’ of the financial market, and it was stated that using only one is akin to hobbling the economy. The stock market has hitherto received a lot of attention since that is where the majority of retail of investors are clustered.
Although the island appeared to escape relatively unscathed from the 1997 Asian Financial Crisis, the consequences for Taiwan have not yet been fully worked out. But this is changing. President Chen Shui-Bian’s decision to attack the nexus between politics and business is causing confidence to falter, because an anti-corruption crusade could cause shockwaves throughout the economy.
The banking sector is especially vulnerable, due to the large number of state-owned, or recently privatized, banks and its high level of non-performing loans. Consequently, the Taiwanese bond market is attracting a great deal of scrutiny as the financial community edges away from its erstwhile reliance on banks.
Banks have historically dominated the financial system by lending to companies, and although the proportion is declining, it still accounts for 70% of total financing needs. And banks also influence the bond market thanks to the popularity of bank guaranteed bonds.
Banking sector out of favour
But banks are not exactly flavour of the month on the island. The talk in Taiwan now is even about preventing another financial crisis by having the kind of bond market which forces issuers to be transparent and enables the accurate pricing of risk by investors. There are concerns that banks, with non-performing assets on average in the 7% to 10% range, are not on a sound footing. The recently privatized state banks are considered especially vulnerable. Many banks are finding themselves sidestepped by the biggest and best Taiwanese companies, which can access the bond markets.
Some government regulations, such as the tax-free gains from the bond market, are also distorting the market. Retail investors can pour their saving into bond funds without the tax burden of bank deposits. Institutions see the combination of tax-free capital gains and no dividend payments as the basis for using the bond fund as the ideal instrument for managing their cashflow cycles.
Consequently, bond funds are the biggest single buyers of corporate bonds in the market. The total size of the Taiwan fund market is over NT$1 trillion, of which 67% is invested in bond funds. Out of 228 mutual funds, 50 are bond funds. The desire of bond fund investors to access a stable earnings flow means that bonds are not traded. The bond funds simply buy and hold. By doing this they also conveniently forego the need to mark the corporate bonds to market, thereby maintaining a level of unreal, or perhaps surreal, predictability on the value of the bonds. This predictability aids in the marketing of the bonds, because their tenor and yield can be compared to the prevailing bank deposit rates.
Unnatural preference
Ironically, this has proved to be an ideal solution for Taiwan. Issuers are encouraged to issue. And their creditworthiness does not come under scrutiny by their outstanding bonds, since they are not being marked to market. And investors get tax-free yields. The result has been that corporate bonds get as good, or better pricing than government bonds. This unnatural preference for corporate bonds due to their tax advantages means that poorer quality issuers do not necessarily pay the appropriate risk premium, and that investors are taking on more risk than they are aware of.
It also means that the bond market it is not performing its crucial function of valuing capital. The lack of liquidity in the market is exacerbated by the 0.1% transaction tax levied on the trading of corporate bonds. And the absence of trading means that the value of a company’s credit is unknown.
This situation is made worse on the government side by the lack of a fully-formed yield curve. Although government bonds are marked to market by law, they are not heavily traded. And the government issues bonds on an ad hoc basis, meaning that choosing a benchmark is not as easy as it would be with a more predictable and better managed issue flow.
Banks are the biggest buyers of government bonds as they can use them to improve their capital adequacy ratios, and therefore buy and hold. The lack of hedging instruments - for example, traders are not allowed to short bonds - also acts as a deterrent to trading.
As a consequence of these problems, some 90% of transactions on the bond market are not bonds being bought and sold but repo transactions that the banks and bond funds carry out for short term liquidity and redemption needs.
Credit risk analysis is still the skill the market needs to develop. Companies are reluctant to expose their inner workings to the prying eyes of investors and ratings agencies. Dr Chung Hsing Chen, president and CEO of Taiwan Ratings - a joint venture with Standard & Poors on the island - pointed out that of the 90 credit ratings analyses he has done in the past two years, only 54 have been made public.
With so many issues to discuss, the conference proved an interesting forum. The presence of officials from the Securities and Futures Commission, such as Chi-Hsien Lee, and Chen Chung, a vice-minister at the Ministry of Finance ensured that the necessary decision makers were on hand to listen to what the market participants are saying.
The conference was sponsored by China Securities, the China Times and Taiwan Credit Ratings and took place on September 1.
