A potentially calamitous fall in the value of structured bonds in Taiwan could be solved through CBO issuance, say Asian ABS bankers. The question is whether regulators will give full backing to a surge of issuance that could reach between NT$160 billion and NT$800 billion ($4.75 billion and $23.7 billion) over the next year.
The crux of the situation that between early 2000 and late last year, Taiwan operated in a declining interest rate environment. Consequently, bond funds - which account for 70% of investments - spent heavily on products such as inverse floaters and range accruals, which offered greater returns than bank deposits.
With structured bonds a major part of their portfolios, assets owned by bond funds peaked in May 2004 at NT$2.4 trillion. Yet a rise in the Bank of Taiwan's one-year deposit rate from 1.4% to 1.9% in September 2004 caused the returns of structured bonds - and consequently bond funds - to plummet. The total value of these funds has now dropped to NT$1.6 trillion.
The situation was exacerbated when a default by Procomp Industries caused a NT$200 billion bond sell off by investors, resulting in the insolvency of fund manager, United Securities Investment Trust.
Matters have been worsened by too many participants - there are 47 bond funds - an almost non-existent secondary trading market and unclear regulations on structured bond pricing. This, bankers say, caused fund managers to set bond prices artificially high and overvalue the net asset values of their portfolios. The rate increase triggered fears of a redemption crisis with bond funds unable to make payments, possibly sparking a financial slump.
Taiwan's regulators have ordered bond funds to rid themselves by the end of the year of structured products whose value drops when interest rates rise. Reportedly, they will deny applications for future products from fund managers who fail to comply.
However, regulators have concerns other managers could follow in the footsteps of United Securities, which has told regulators that it can not take losses on its deteriorating portfolios.
That would seem impossible given the bonds in question trade substantially below par. One solution to limit the damage has been to package the structured bonds into CBOs. The process started this summer with deals by Capital Securities Corp. and Yuanta Core Pacific Securities. Yet with adverse publicity surrounding the collateral, bankers questioned how attractive an investment the CBOs would be unless the underlying bonds were bought at heavy discounts.
Several foreign investment banks were invited to devise solutions, working in tandem with local commercial bonds that had acquired portfolios from funds. UBS came up with a unique structure on a NT$18 billion CBO issued by Chinatrust Commercial Bank, a deal that was completed at the end of September.
In order to enhance returns and entice investors, UBS's idea was to package half of its NT$-denominated bonds with 50% of triple-A rated U.S. dollar-denominated zero-coupon bonds.
"The solution has been to convert these inverse floaters into a fixed security and combine them with a U.S. dollar-denominated CDO," explained Gilbert Ong, associate director in Fitch Ratings' Asian structured finance group. "You take that combined security and issue it as a domestic CDO. The pricing is relatively in line with the coupon, so you might get say 4% from your U.S. bond and 0.25% from the inverse floater, which is then bought at a rate over the CP index."
"Whether this truly resolves the issue effectively is a question only time will tell, but we are going to see several more of these transactions in the next six months," Ong added.
UBS' plan seemed to work. The NT$9 billion triple-A rated senior piece, with a 3.1-year average life, priced at 20 basis points over the commercial paper index, going primarily by commercial banks. Additionally, the NT$9 billion triple-B minus rated junior tranche, callable after five-years, offered a fixed rate return of 3.1% and was bought in its entirety by a local insurance company.
Banks involved in innovative transactions are not usually averse to talking them up. However, UBS is fiercely guarding the precise structural features, even requesting that Fitch not release the presale report to the public. With rival houses - including ABN AMRO, BNP Paribas, Calyon Securities, E-Sun Commercial Bank, HSBC Securities and Lehman Brothers (advising Taishin International Bank) - known to be working on deals, UBS wants to keep its blueprint private as it seeks follow-up transactions.
The snag, at least for UBS' rivals, is the conflicting attitude of regulators. Despite having ordered funds to sell structured assets, regulators seem reluctant to approve other CBOs that have been filed recently. Cathay Life Insurance, for example, abandoned its own CBO plans after interminable delays in the approval process.
"We are very confused about the regulatory attitude, as are others in the market," confessed one head of Asian ABS.
Clearly UBS found a way to appease the strict criteria of the regulators on valuing the domestic bonds, although how remains a mystery. "Banks are being low key about their plans because the success rate may be low," added another banker. "These deals are tough to do because the underlying bonds are hard to price and the U.S. collateral prices move."
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