Warren Buffett said “only when the tide goes out do you discover who’s been swimming naked”.

If the Federal Reserve’s recent move to possibly lower interest rates results in weakness in the U.S. dollar, yield-hungry life insurance companies in Japan and Taiwan that bought dollar-denominated bonds without hedging for currency volatility might want to keep that investing maxim in mind.

Despite their conservative reputations, analysts say Asian life insurers ran up great risks in their search for income through their sizable “naked” bond positions, setting them up for pain when the greenback loses altitude.

Market expectations for the U.S. central bank to embark on four interest rate cuts in the next 12 months has analysts speculating that the dollar could finally stumble from its high perch as the Fed’s monetary policy joins the easier stances of other major central banks like the European Central Bank.

The dollar is off its highs against Asian currencies since the June Fed meeting, but has recovered some of its losses in recent sessions after signs of the U.S. labor market’s resilience in last Friday’s jobs data. The New Taiwanese Dollar

TWDUSD, +0.025658%

   is down 0.9% year-to-date against the greenback at 31.172, while the Japanese yen

USDJPY, +0.15%

  is up 1.4% over the same period against the U.S. dollar at 108.765.

The ICE U.S. dollar index

DXY, +0.12%

  is still up 1.4% in 2019, though off around 1% from its year-to-date highs, FactSet data shows.

See: Why Trump’s tweets about the U.S. dollar might soon pack a lot more punch

Foreign life insurance companies are big buyers of U.S. investment-grade corporate bonds. The Taiwan Insurance Institute reported the country’s life insurers held around $550 billion of foreign assets in March, around 70% of its total assets. The Life Insurance Association of Japan reported Japanese life insurers owned more than $860 billion of foreign assets in April.

This stockpile of foreign securities is mostly parked in dollar-denominated Treasurys, corporate debt and other highly rated fixed-income like securities.

“Besides the U.S., there’s very few places where you can find a 4 to 5 percent yield,” said Brad Setser, a fellow at the Council of Foreign Relations, a specialist in capital flows.


Low interest rates in Japan and a relatively small domestic bond market in Taiwan have forced financial institutions from both Asian economies to trawl abroad for higher-yielding investments.

Taiwanese life insurers have been particularly aggressive in their accumulation of foreign bond holdings. Many have pushed their holdings of foreign assets past the 45% maximum level that regulatory ceilings allow, sometimes circumventing these limits through the purchase of Taiwan-listed exchange-traded funds that are linked to U.S. corporate bond indexes but denominated in dollars.

However, their push for overseas income has meant many are forced to contend with fluctuations in currencies, which can swiftly erase the extra income earned from abroad. To mitigate that risk, life insurance companies will typically hedge against sharp fluctuations in exchange rates through three-month currency forward contracts, in effect, selling the greenback and buying the domestic currency at an advanced date.

But the vast differentials in short-term interest rates between the U.S. and other developed markets in the last few years have raised the costs of currency hedging for foreign investors buying dollar assets, wiping out the gains earned from plying U.S. corporate bond markets, said Thomas Graff, head of fixed-income for Brown Advisory, in an interview with MarketWatch.

That has led a growing number of life insurers to take increased currency risk in the hope that the dollar will remained at its elevated levels seen since mid-2018.

So-called naked investing, or buying assets without hedging against currency movements, was on the rise last year as the Fed’s hawkish stance and the U.S.’s relative economic strength versus the world helped to prop up the greenback. A stronger greenback can deliver a fillip to foreign holders of U.S. dollar-denominated bonds.

“The implied cost of hedging has been negative for asset managers in places like Japan, the eurozone for some time now so it doesn’t surprise us that life insurers may be under-hedged,” said Bipan Rai, North American head of FX strategy at CIBC Capital Markets, in e-mailed comments.

Cost of hedging against dollar movements remain elevated

But as a result life insurance companies, often highly leveraged, may also be exposed to hefty losses if the dollar weakens.

Daniel Sorid, head of U.S. investment-grade credit strategy at Citibank estimates that around a fifth of Taiwan’s life insurers’ bond investments took place without some mitigating hedge.

In Japan, Nippon Life Insurance Co., the largest life insurer in Japan, reported that around 40% of its investments were unhedged.

Setser says a sharp slide in the greenback could force back-pedaling life insurers to “cover” their unhedged bond positions through currency swaps or forwards, which has the net effect of strengthening the local currency. That, in turn, could amplify the pain from the depreciating dollar.

It’s an acute risk, he said, in Taiwan where the investment strategies of life insurance companies could swing the country’s exchange rate. Taiwan central bank governor Yang Chin-long said the island’s financial system was sensitive to sudden market movements in the currency in response to overseas turbulence.

“There’s clearly a risk absent intervention by Taiwan’s central bank. The need to hedge could amplify a market move,” said Setser, who added the Taiwanese central bank has historically tried to smooth currency volatility to aid its exporters.

Steven Oh, global head of credit and fixed income at PineBridge Investments, said the influence of hedging activity on vast and liquid currency markets such as the Japanese yen tended to be marginal.

But he said for relatively illiquid currencies such as the South Korean won and the New Taiwanese dollar, they could temporarily lead to material changes in the exchange rate, especially when life insurers moved in concert.

On the flipside, market participants say the Fed’s dovish policy shift would also narrow interest-rate differentials between the U.S. and the rest of the world, thus bringing down currency-hedging costs and drawing foreign bond buyers back to U.S. shores.

Investors have saidhttps://www.insure.com/health-insurance/medicare-how-it-works-with-other-insurance European debt yields on a post-hedged basis have been much richer than their U.S. peers in the last few years, but if interest-rate differentials narrow, Japanese and Taiwanese insurers may ramp up their allocations to U.S. corporate bonds and Treasurys.

“If the Fed, for example, delivers a 50 basis point rate cut over the remainder of this year, then actually the economics of hedging could shift back in favor of U.S. assets,” David Riley, chief investment strategist at Bluebay Asset Management, said in an interview with MarketWatch.

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