"Bond yields have been falling for the past two years, spreads between corporate and government paper have been narrowing, there is tremendous demand for paper among cashed up institutions and domestic underwriters have been bidding aggressively to win mandates from companies in a falling rate environment."
This snapshot of the market comes from Terran Liang, a senior officer at Grand Cathay Securities, one of the dominant players in Taiwan's domestic bond market.
Commercial banks have traditionally accounted for more than 70% of all funding in Taiwan, although that is gradually declining. The banks' share of the market is even higher if all of the corporate bond issues guaranteed by the banks - which are most of them - are included.
The regulators and senior bankers would all like to see a more flourishing capital market in order to diversify more of the corporate risk away from the banking sector.
The banks and insurance companies dominate investment in government paper, which accounts for two-thirds of all bonds outstanding. The same buyers, as well as mutual funds, tend to buy the supranational paper - local currency bonds issued by triple-A multilateral agencies. The bond funds, with around NT$900bn in funds under management, dominate the corporate market.
In recent years, money has flowed ever more vigorously into the approximately 50 bond funds because investors are enticed by the tax regime. Retail investors and other institutions put their money into the funds because of the combination of tax free capital gains and no dividend tax liability - all dividends are reinvested by the funds.
When Grand Cathay's Liang spoke to EuroWeek in late April, the investment house had just launched a multi-tranche New Taiwan dollar (NT$) issue in the local market on behalf of the perennial Asian currency issuer Inter-American Development Bank (IADB).
The unusual transaction comprised tranches, each of NT$1bn, on maturities of 18, 19, 20, 21 and 24 months with coupons between 4.01% and 4.05%.
Banks in Taipei estimate that the IADB deal was priced below government spreads and they presume that allowed IADB to hit its target funding costs after swap.
"Supranationals tend to offer investors spreads of between 5bp and 10bp above the government curve," says Juno Chou, head of fixed income at Salomon Smith Barney in Taipei. "There is plenty of demand for the paper at these levels, especially as the government has this year been issuing only at the long end of the yield curve, from 10 to 20 years."
The IADB transaction was the first supranational issue of calendar 2001. "The supranationals target at least 20bp under Libor after the swap," says John Li, head of financial markets for Citibank in Taipei. "However, the currency swap market has not been favourable for some months as there are not enough Taiwanese companies borrowing dollars and swapping back to local currency liabilities."
As in most other Asian countries, it is not the lack of funds that is holding back the domestic capital markets, but rather the lack of supply.
From Japan to Thailand, fund managers, banks and other financial institutions and retail investors are flush with cash. The same is true in Taiwan, where investors, like their regional counterparts, are hungry for return but are risk averse. The miserable performance of the stock market since early 2000 has further fuelled bond market liquidity - the leading stock index attained recent highs of over 11,000 early last year but fell below 5,000 in late 2000 and was languishing around 5,500 in April 2001.
Like other countries in the region, there is a slowdown of capital expenditure among leading firms, especially those such as Taiwan Semiconductor Manufacturing Corporation (TSMC) or United Microelectronics Corporation (UMC), which compete in the capital intensive semiconductor sector.
However, the bond market has to compete with the onshore bank market and the offshore equity and debt markets.
As often as possible since late 1999, Taiwan's leading companies have looked to raise equity capital in the offshore markets, through either American Depositary Receipts (ADRs) or by issuing convertible bonds.
One-to-one bank finance and syndicated lending are also enticing sources of funds for Taiwan's corporate elite. Banks are flush with cash and the private sector banks in particular are well capitalised and well managed.
These banks, and some of the better state linked banks, are only too eager to offer funding to compete with rates and terms available in the bond market.
But while government bond issuance has continued to rise steadily year-on-year, primary market activity by banks and corporates is nowhere near enough to absorb the enormous excess supply of capital.
Primary corporate issuance hit a peak of US$7.45bn (equivalent) in 1998, then fell back to US$4.2bn in 1999 and recovered slightly to US$5bn in 2000, according to figures from Salomon Smith Barney. The market had until 1999 been growing steadily since 1992, except in 1997 when the financial crisis hit Asia.
A key factor that has held back the market was the January 1, 1999 law enacted by the Securities & Future Commission that demanded all unsecured corporate issues either to be rated by Taiwan Credit Rating Corporation (a local joint venture with Standard & Poor's) or to have a bank guarantee.
However, this did not hold back the market for too long, as corporates and underwriters soon found alternatives such as bonds backed by collateral of one form or another, either fixed assets or marketable securities.
"There was and still is a real caution among corporates in opening their books to the rating agencies for fear that they will reveal more than they want and that they will not achieve the ratings that they would like," explains Chou.
This in fact turned out to be the case as a handful of the leading names applied for ratings in 1999 only to receive less than flattering testimonials. "This dissuaded several other leading names and lower tier credits from testing the waters," says Liang.
As of April, Salomon Smith Barney notes that about eight corporates, 16 banks, four bill finance houses, five insurance companies and three securities houses have garnered credit ratings.
"For the moment, only blue chip names would apply for the credit rating first, as for other middle or small names, purchasing bank guarantees is still the most cost effective and efficient way to raise funding from the local bond market. Many companies that apply for ratings do not make the results public."
There is some evidence that Taiwan's companies are gradually overcoming their aversion to opening their books to the ratings companies. "The companies cannot imagine that they can forever live in the times of old where names and relationships secured funds," reports one banker. "We firmly believe that companies will continue to migrate towards the capital market and will prefer not to take on too much foreign exchange risk unless they can match those liabilities against their assets."
Another factor that has held back the corporate market was the mini financial sector crisis that Taiwan suffered in 1998. Most analysts initially thought that Taiwan's banks had avoided the contagious non-performing loan disease that hit Asia in 1997. While it was true that Taiwan did not suffer such a virulent attack, the markets discovered in 1998 that Taiwan was nevertheless touched by the illness.
This caused the banks to become reluctant to offer the bank guarantees on corporate bond issues that they had traditionally offered at next to no price. Recognising at last the contingent liability, as well as the weakening creditworthiness of corporate Taiwan, the banks demanded much higher fees for the guarantees, or withdrew from the market entirely for certain credits other than the top names.
The banks now offer guarantees at around 50bp-70bp per annum, depending on the credit and whether the borrower provides collateral.
The deteriorating state of some of the banks' balance sheets also forced investors to recognise that bank guarantees did not, in reality, offer insulation from corporate default. "Due to sharply rising NPL (non-performing loans) ratios at some of the local banks, investors have become far more cautious about the guarantor banks' credit quality," says Chou.
This year, the market is expected to turn around due to the large amount of bonds maturing that require refinancing. However, the first quarter proved rather dull - a mere NT$19.4bn of public and private sector corporate issuance.
"The first quarter in Taiwan is traditionally quiet as most issuers tend to wait until their March 31 results are out," explains Li. "This means that the high levels of corporate issuance we anticipate should commence around May."
The lack of supply since 1999, combined with massive domestic liquidity, has lead to a narrowing of the spreads between government and corporate paper. In May 1999, a company such as Taipower, rated AA by Standard & Poor's and AAA by Taiwan Ratings, paid around 40bp-60bp more for its new issues than the government. By April this year this spread for new issues had plummeted to between 0bp and 5bp.
China Steel, also rated AA, in early April even managed to issue below theoretical government spreads at five years, when the state controlled company secured funds at 4.27%.
"The bond funds have so much money and they do not like putting their money into government paper because those bonds are actively traded and therefore have secondary market prices," says Li.
Bond funds do not like any paper that they might have to mark to market. If they take a corporate issue that has been sliced into many totally illiquid tranches they can effectively control secondary market prices and thus ensure they control the potential volatility of their portfolio.
Lower rated credits have also enjoyed a similar spread narrowing. "Triple-B companies are issuing at around 30bp over the government curve, which is extremely tight compared with levels several years ago," says Chou. "Although investors are generally more cognisant of credit worthiness, the spreads of lower rated companies have tightened because top tier credit spreads are now so thin."
Local bond funds have around NT$900bn under management, which is huge in proportion to the total bond market that Salomon Smith Barney estimates was worth NT$2,349bn as of January 31.
"It is not surprising that corporate spreads are so low," explains Chou. "Total non-government paper outstanding is only around one-third of total paper in the market, which means less than the money the bond funds have at their disposal."
"Competition among underwriters has become ever more intense," says Li. "Most companies select underwriters following Dutch auctions and that has also conspired to push spreads down."
The dominance of the bond funds as buyers has meant that the secondary market has been held back because of their aversion to secondary market prices.
Aside from the mark-to-market concerns, another problem for the secondary market, and long a bone of contention between the market participants and regulators, is the 0.1% transaction tax on all non-government and non-supranational paper trades.
The market is somewhat divided as to whether the abolition of the transaction tax would enhance the liquidity of corporate paper. "The bond funds dominate the corporate bond market and with their buy and hold preferences are unlikely to change in the near term, even if regulations are introduced to encourage more secondary market activity," says Liang.
Secondary market trading of corporate paper in 2000 was NT$220.6bn, compared with total market outstandings of NT$7,989bn.
Investors, such as the insurance companies and banks, prefer the zero risk sovereign stock. The bank sector, flush with cash, has been investing ever more actively in government stock as surrogate regulatory capital.
Even the government market tends towards buy and hold, partly because the banks like to hold zero risk weighted assets and partly because there is no hedging available as short selling of bonds is not permitted.
There is also, as yet, no bond futures market and no immediate likelihood that the regulators will allow such a development.
However, market participants expect the government to eventually bow to the logic that the ability to hedge will draw local and foreign institutions into the market - entities that have so far stayed largely on the sidelines.
As a result of these impediments, some 90% of secondary market transactions are not that at all, they are repurchase (repo) transactions that the banks and bond funds carry out for short term liquidity and redemption needs.
The underwriters of new issues have recognised that there is no sense in trying to beat the market's momentum. New corporate issues are increasingly packaged into numerous tranches in order that one bond fund can take all of a particular tranche and thereby avoid the possibility that a secondary market trade could whittle away the value of its holdings.
To counter this trend, the Securities and Futures Commission (SFC) introduced a new regulation in May 2000 that a minimum tranche size of NT$200m is required. The SFC was concerned that issuance activity was becoming absurd, with some new deals comprising as many as 38 separate tranches.
The Taiwanese bond market has most of the vital ingredients that should encourage rapid growth in the coming years.
Corporate and government bond yields have both fallen since 1999 and the immediate outlook is for more interest rate cuts in the US. As the New Taiwan dollar is so closely linked to the US dollar, market participants believe there is further room for rate cuts by the Bank of China, the country's central bank.
"Falling yields should lead to greater corporate issuance activity as companies seek to lock in their medium term cost of funds at what are relatively low and therefore attractive rates," says Liang. "With competition among underwriters so intense and so much additional demand over supply, we can anticipate some good years ahead for the market." *