Broad rally creates RV opportunities in lower-BBB insurers

admin | July 26, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Bank and financial credits have been leading the charge tighter in IG spreads in recent sessions, as investors seek out higher yield bogeys and push further out the credit spectrum. The price action has caused higher beta names within the more traditional bank space to outpace the broader market. For example, Discover Financial Services (DFS: Baa3/BBB-)—among the lowest-rated large regional banking credits with a sizable debt footprint—has seen its more liquid senior debt instruments (DFS 4.1 ‘27s) race in by roughly ~50 bps since early June to a g-spread of ~130 to curve. That valuation puts DFS just a few bps off higher-BBB regional bank peers, such as COF (Baa1/BBB).

With such limited risk premium available to compensate investors for low-BBB credit in the more trafficked corners of the financial segment, investors are better rewarded to target BBB credits in the insurance space, particularly in more off-the-run issues/issuers. Although lower interest rates and the prospect of a flatter yield curve threaten the broader sector, the thriving stock market provides a relative backstop to the insurance space, as well as improved operating metrics in some key sectors.

There are two corporate bond offerings in BBB insurance that offer good value in a market that is rapidly pushing investors to reach a little too aggressively in their relative comfort zones. The first of those opportunities is P&C operator Assurant’s (AIZ: Baa3/BBB) off-the-run 10-year notes – AIZ 4.90% 03/27/28. Bonds are currently priced in the low +170s (indicative levels only). At a g-spread of nearly +180, AIZ bonds provide attractive compensation relative to the broader A/BBB P&C curve (Exhibit 1). Bonds are offering a total yield of nearly ~3.80%, which exceeds what we would consider adequate compensation for the higher dollar price / higher coupon of this specific issue. AIZ has largely outperformed the peer group over the past six months, but still appears to have some room to run.

Exhibit 1: AIZ 34s vs P&C comps

Source: Bloomberg/TRACE indications, Amherst Pierpont Securities

AIZ Credit Summary:

• AIZ experienced a period of relatively rapid expansion throughout much of 2017, culminating at the end of 2018 with the close of its $2.5 billion acquisition of The Warranty Group (TWG); and now presents an improving credit story. The TWG deal added to the Company’s operating diversity by bolstering its market share in vehicle protection services, but left AIZ with a stretched financial profile from the debt incurred in the deal ($596 million in repayment of TWG debt). Total leverage closed 2018 at a heightened level of 39%, up from a more traditional run rate of 25% in the prior year. Both Moody’s and S&P instituted downgrades in the prior year reflecting the additional leverage.
• Management’s growth appetite appears to have cooled, and they now appear more committed to a balanced approach to capital going forward. In late 2018, AIZ approved an additional $600 million in share repurchase authorization, which brings the current amount to just over $710 million following $50 million in repurchases in 1Q19. This appears a manageable plan for equity compensation over the near term, within the context of AIZ’s plans to gradually reduce the additional leverage from the TWG purchase, and maintain solidly investment grade financial metrics.
• The 2028 notes (along with the 21s and 23s) contain step-up language (+25 bp per notch below IG by Moody’s or S&P), providing incentive to management to maintain investment grade ratings (as much as +200 bp in coupon in the event both agencies go to single B ratings). The Surplus notes issued in 2018 (AIZ 7% ’48) are deferrable in the unlikely event that AIZ faces a capital shortfall, providing structural cushion to all outstanding senior notes.
• AIZ has sufficient sources of liquidity from the standpoint of long-term debt holders. In addition to $1.27 billion in cash on the balance sheet, the Company has $441 million (of $450 million) in available revolving credit facilities through 2022, which can be increased to $575 million at their discretion. That compares with just $300 million in near-term maturities in 2021, plus an additional $650 million in 2023. AIZ has generated $880 million in free-cash-flow over the last twelve months.
• AIZ maintains solid capital adequacy and a conservative investment portfolio for their current ratings. The vast bulk of investment holdings remain in investment grade fixed income, primarily in corporate and government securities. Only a small portion is retained in equity and non-investment grade fixed income holdings.
• Notwithstanding recent expansion efforts, the bulk of AIZ’s business remains concentrated in their mobile device protection services within the global lifestyle segment, which made up roughly 2/3rds of revenue in the prior year. Lifestyle also houses vehicle protection services, which increased markedly with the TWG deal and will make up a greater portion of earnings going forward. The remainder of business is within global preneed (funeral insurance) and global housing (homeowners, renters, etc); the latter of which represents a smaller portion of earnings, but a sizable component of cat risk to AIZ.

The second opportunity to highlight this week is life insurance issuer Unum Group’s (UNM: Baa2/BBB) long 5-years – UNM 3.875% 11/05/25s. These non-index bonds ($275 million outstanding) are priced in the mid-130s to the 5-year (issued as a 10-year note), yielding roughly 3.15% (indicative levels only). At the current level, they are trading well over a full standard deviation above the historic mean versus the comparable on-the-run, index-eligible UNM 4.0% ’24s (~101 to curve).

Exhibit 2: Historic G-spread pick: UNM 3.875 ’25s vs UNM 4.0 ’24s

Source: Bloomberg/TRACE indications, Amherst Pierpont Securities

UNM Credit Summary:

• Unum Group (UNM: Baa2/BBB/BBB) offers a very stable suite of mostly plain vanilla life and disability products. More recently the company began to expand into newer product areas, including vision and dental. Much of UNM’s credit risk is concentrated in its run-off, closed block long-term care (LTC) segment, which not surprisingly generates a lot of focus from investors. While material, the risks inherent to the LTC segment are well-reported, well-reserved, and manageable given UNM’s capital, liquidity and consistent cash flow generation from its core businesses. Bondholders appear well-compensated for these risks at current spread valuation.
• LTC exposure has raised a lot of alarms in the life insurance industry, as outsized exposures have led to huge losses at several highly visible operators, most notably Genworth. While LTC remains a serious consideration, given the higher underwriting risk and higher reserve requirements, the environment is causing many instances of LTC exposure to be unfairly penalized in credit valuation.
• UNM has over $12 billion in reserves ascribed to LTC in its closed block segment, which represents over a quarter of all reserves. Although the vast majority of the LTC policies are group (much lower risk) as opposed to individual, that small individual portion makes up over half of those reserves. UNM drew attention late last year, when they booked a $751 million pre-tax charge to boost reserves, resulting in a $593 million hit to earnings and a loss for the 3Q18. Management stated that the charge was “one-time in nature” and was the result of a comprehensive LTC reserve analysis. Looking back, it seems that UNM will typically make these types of assessments every 3-4 years and make the necessary reserve adjustments. While unfavorable LTC reserve development can be difficult to predict, it would appear that following this most recent analysis, UNM would be less likely to take any outsized, surprise charges over the near-term.
• Fitch recently affirmed the senior ratings at BBB, though left the outlook negative, which had been effective since UNM pre-announced the reserve charge back in August of last year. Moody’s affirmed the rating and left the outlook stable shortly after UNM had reported in late October 2018.
• UNM has solid liquidity in place ahead of the 2025 bond maturity. The company has over $500 million in cash and marketable securities on balance sheet as of 1Q19, plus an additional $498 million in undrawn revolving credit facilities that are in place through 2024. Those totals alone are roughly enough to cover the $1.1 billion in senior debt maturities through 2024, ahead of the $275 million in 2025. Management recently announced a $750 million repurchase program to be completed by late 2020. This is commensurate with the program completed in 2016-2017, and those announced in 2015, 2013 and 2012 (all $750 million); i.e. they are manageable and standard capital allocation to shareholders.
• UNM typically generates about $1.2 billion in annual free cash flows, pretty consistently; lagging-twelve-month FCF is closer to $1.7 billion. Current leverage is elevated following the 3Q18 reserve charge (which wiped out one quarter’s profitability), with Total Debt/EBIT at around 3.7x at year-end. UNM’s typical run rate is in the 1.8-2.0x range, which we expect them to return to shortly. Strategic M&A does seem a realistic expectation going forward given management’s desire to continue to diversify revenue streams (again the move into dental, vision and other business lines). However, the company will probably do so in a measured, strategic manner and is unlikely to put their balance sheet at material risk, given their typically conservative approach to capital and reserve maintenance.