Unhedged FX: Asian life insurers and pension funds (Update June 2, 2025)
June 2, 2025
Note for readers: This essay was written a few days ago, as I scheduled this issue ahead my week of digital screen detox. Apologies if any content becomes out of date.
Good morning, bonds have been in the news recently. So here’s a more topical essay on how bonds work, and how foreign investors may utilize the financial instrument.
Fixed income assets (i.e. bonds) provide a crucial tool in global capital markets.
In its name, bonds’ fixed duration income streams provide a reliable method to match long term liabilities, i.e. life insurance and pensions. But doing so in a volatile foreign currency without hedging creates substantial risk for the bond holder when exchanging back to the home currency.
Traditionally, the US dollar provided a safe haven from large movements in currency exchange, but it is slowly becoming less true for Asian currencies that have seen a very volatile couple of months.
As a reminder, here is how a bond works.
A bond usually has 2 components: (1) a promise to pay the principal amount when the bond matures/comes due, and (2) a promise to pay a coupon (interest) amount regularly. Because both of these components are “fixed” (not changing) after the bond is issued, these are “fixed” income assets.
If you hold the bond to maturity, you will receive the principal and coupon payments, less any risk of the bond issuer defaulting. It is in essence a form of debt between the issuer and the holder. Sovereign nations and corporations are the most common issuers as bonds as a way to raise capital to fund operations or investments.
At the same time, most bonds are marketable. Before a bond matures, a bond holder can sell the paper to a willing buyer and receive a price for the remaining income and principal at maturity. The price is set by the market, which determines the current value of the bond’s remaining income stream, plus any premium demanded for any default risk.
If country A issues a 30-year bond with 5% semi-annual coupon rate and principal of $1,000, the issuer (country A) is promising to:
Every 6 months, pay $25 in interest, for a total of $50 per year.
At the end of the 30 years, pay $1,000.
The price of this bond issue is then determined by an auction.
In this example, if the price (determined by auction) is lower than $1,000, it means the bond has a yield greater than ~5%. The bond purchaser will earn the 5% coupon rate, plus the amount between the price and the principal.
If the price is determined to be greater than $1,000, the bond will have a yield less than ~5%, with a possibility to be negative. As the bond purchaser will pre-pay some amount for the future income stream.
Bond prices move opposite of yield. When yield increases, bond prices fall.
Therefore, bond holders are often in one of 2 buckets: (1) held to maturity bond holders—i.e. the investor fully expects to hold the paper for all remaining income streams, and (2) available-for-sale asset holders—i.e. the investor expects some possibility they may sell the bond before it matures to another buyer.
Life insurers, pension funds, and banking: Some uses of bonds
The goal of life insurance and pension funds is to provide a promise for some “fixed” payout far in the future. This payout may be a lump sum or a recurring fixed payment.
Therefore, in essence, as an intentional over-simplification, pension funds and life insurers simply have to match their future liabilities (obligations) with the current funds and reserves.
Fixed income assets become a perfect tool for this job.
A bond’s future income streams are pre-determined/fixed, and the risk of default for high credit corporations and sovereign nations are low. Sovereign nations can always print money, and high credit corporations like Microsoft or Pfizer have fortress balance sheets with low leverage.
For example, for a pensioner that is soon to retire (with expected life expectancy of 30 years remaining), the fund simply has to buy a 30-year bond that provides sufficient coupon/interest payments to cover the recurring pension payments, then the liability is fully funded.
Beyond insurers and pension funds, some banks also use long dated bonds as a way to generate income (but some would say speculate).
For example, First Republic Bank failed in 2023, they very often used customer deposits to buy long dated US treasuries (i.e. 30-year bonds). Then, the bank claimed they will always hold the treasury to maturity (i.e. they have no intention to sell).
Unfortunately, the bank was forced to sell much of their treasury holdings when there was bank run on their deposits. They were insufficiently capitalized to handle the withdrawals. They did not have enough cash liquidity, because their capital was either locked up in loans to customer (mortgages) or bonds (treasuries).
Taiwanese/Japanese life insurers and sudden currency appreciation
Most recently, amid the trade war uncertainty and volatility, the US dollar weakened significantly against most global currencies.
In particular, Asian currencies appreciated much more quickly than normal.
This means, for foreign investors, like Taiwanese or Japanese life insurers, their US dollar investments suddenly decreased in value relative to their home currencies.
New Taiwan Dollar appreciates ~8% in 1 month
In the case of Taiwanese life insurers, firms recently had to take huge losses.
Over one month, the NT dollar surged more than 8%! They had to keep paying out life insurance policies in Taiwanese dollars, but their portion of US Treasury income suddenly dropped (when converted to NT dollars)!
This is hugely problematic for life insurers that invested their reserves into US treasuries. Taiwan’s life insurers hold 70% invested assets in foreign currency.
After taking into account the currency exchange, the fixed income stream from US treasuries no longer matched their liabilities! The difference between their obligated life insurance payments and funded claims became a loss.
Imagine you had 100,000 yen of funded payouts, and 25% was originally fully funded from US treasuries. If the US dollar declined 5% against the yen, then the insurer incurred a 1.25% (5% x 25%) loss, or 1,250 yen.
While the example amounts seem small, insurers usually do not carry too much excess reserves. These types of fluctuations can bankrupt them, because the underlying insurance liabilities are very large. Goldman Sachs estimates that a 10% appreciation in New Taiwan dollars will deplete the insurers’ foreign reserves and create solvency concerns.
The currency appreciation cycle is also self-reinforcing. When a Taiwanese life insurer sell US dollar assets to cover NT dollar liabilities, they (1) sell US treasuries, and (2) buy NT dollars with US dollars. Their US treasuries selling action drives down prices further. When they buy NT dollars, they drive up NT dollar appreciation further. Partially, this is what caused the massive and quick spike in NT dollar appreciation as they covered losses.
Yields for long dated Japanese bonds skyrocket
Japanese life insurers faced a similar issue and are facing billions of dollars in losses, though their exposure to US assets is marginally lower than the Taiwanese insurers.
However, the Japanese have another problem, even when most of their reserves are funded against their home country currency, their own government bonds’ yields are having a roller coaster moment. Their 30-year bond yield rose ~1% in less than almost a month.
A ~3% yield for long dated Japanese bonds had not been seen since the 1990’s!
Remember, for bonds, prices move opposite of yields. When yields rise, bond prices fall.
Normally insurers that are buying bonds for held-to-maturity, yield volatility for long dated maturities would not impact them. The underlying fixed income stream does not change assuming the default risk does not change. The underlying insured liabilities are still funded.
But think, how realistic is it for the insurers to really hold these bonds to maturity when there is substantial currency volatility?
Insurers risk another First Republic Bank moment during times of currency volatility. Their demand for liquidity can lead to bond sales. Insurers are often held to a lower capital reserve standard than banks.
If the Japanese yen continues to experience unprecedented appreciation against the dollar, these movements and the resulting paper losses will force insurers to sell held-to-maturity bonds! They have to reduce leverage to remain sufficiently capitalized.
Unfortunately, if that cycle takes place, the same self-reinforcing phenomenon would create a contagion effect across the global capital markets. Japan is the largest foreign holder of US treasuries.
If they must unwind their foreign and local bond holdings to reduce leverage and maintain capital ratios, the selling activity will drive US treasury and Japanese government bond yields higher.
When yields rise, prices fall. The resulting contagion effect is hard to stop.
In the Japanese bond market, the Japanese central bank already holds ~50% of all Japanese long dated treasuries; this was the result of almost 2 decades of quantitative easing amid Japanese yen deflation and low growth. Bank of Japan is quite aware of their limited tools for market intervention.
In the US market, US treasuries are already seeing signs of tested demand levels. With rising US deficits and interest payments, the US must continue to issue treasuries to fund the government. The final backstop would be a Federal Reserve action to purchase treasuries in the open market to support prices.
When central banks purchase bonds on the open market, they do so with their asset side of the balance sheet. On the asset side of the central bank, they simply “create” money into the system.
In other words, the only backstop is for central banks to print money.
Large bathtub, big spillover: where will foreign reserves go?
There has been more and more talk of foreign investors looking for non-US assets to diversify away from the current US risks.
But foreign investors hoping for alternatives to US assets have limited options.
In 2023, MSCI estimated the global investable market to be ~$271 trillion dollars. Investable assets generally includes securities and investments that are easily accessible by institutional investors.
The US market is about ~44.5% of the global investable market:
Fixed income: ~$44.7 trillion
Public equities: ~$44.6 trillion
Private equities ~$2.3 trillion
Think about the global capital markets split up into different bathtubs of different sizes.
Each country’s economy gets a bathtub in the size of their investable market.
But with these bathtubs, you cannot change their sizes overnight. They change sizes very, very slowly.
It requires economic development and demographic changes to change the size of the investable economy. For some economies, the demographic trends are on an absolute downtrend (i.e. South Korea and Japanese demographic trends). For others, the majority of the economy is an export economy (i.e. Taiwan). These factors take decades to change.
Investors that try to bail water away from the US bathtub to other bathtubs (including their own) will find only one outcome.
Other bathtubs will overfill and spillover. It will destroy real value if not done in a gradual and careful manner: more risk taking without adequate opportunity for returns.
For now, foreign investors are stuck and the taps will keep flowing. But the big elephant in the room remains, the next crisis will likely be a crisis of currencies. It will be a return of currency volatility of the 1970’s to 2000’s. When a stampede starts, it will be difficult to stop it.
See ya next week.