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Manulife subs offer good relative value in tight market

| November 8, 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.

The top performing sector in the investment grade index during the most recent tightening trend has been the insurance industry, with an excess return of +1.20% through the first week of October. Industry financials for insurers appear solid coming out of the 3Q19 reporting season; assuming equity markets maintain momentum, insurers could continue to outperform the broader IG market. Value opportunities in outperforming sectors are hard to find, but given investors’ persistently strong appetite for additional credit risk and spread, subordinated issues in names such as Manulife (MFCCN: senior rating A/A-) are poised to perform well in the near-term.

Insurance outperforms as investment grade spreads rip tighter

Despite a slight pause and a brief whiff of trepidation in the IG primary market, secondary corporate spreads tightened rapidly throughout the first week of November. IG spreads tightened about 14 bp from the wides in first week of October, on mostly positive sentiment coming out of 3Q19 earnings throughout the month.

Outperformance among insurance credits is not an uncommon byproduct during bull equity markets that are reaching record levels. The recent pop has edged the sector among the top five performers in the IG Index year-to-date on both an excess return (+4.52%), and total return (+15.17%) basis. It is also not uncommon for longer-duration segments to outperform on a spread basis when long US Treasuries are selling off. October performance in insurance was led by long-dated issues of mostly bellwether names (MET, PRU, LNC, AON, etc); while year-to-date leaders have skewed more into higher-beta territory, and include the long-dated issues of AIG, AXASA, XL and BHF.

The MFCCN 4.061% 02/24/32 (callable 2027) subordinated notes appear poised for further compression relative to the broader sector at a g-spread of +170 bp, which equates to roughly a 3.5% yield-to-call. Insurance issuers do not typically have much subordinated debt outstanding at the holding company level; therefore, the bonds seem to comp closer to the surplus note segment, despite being structurally senior and not part of that hybrid class. Relative to the senior life segment, the MFCCN bonds continue to trade materially wide of some of the comparably split-rated A/BBB senior notes of other issuers – such as: UNM 29s (Baa2/BBB), PL ‘28s (Baa1/A-), PFG 28s and 29s (Baa1/A-), RGA ‘29s (Baa1/A/BBB), TMK ‘28s (Baa1/A/BBB+), LNC 28s (Baa1/A-) (Exhibit 1).

Exhibit 1: IG life insurance long-dated senior and surplus notes

Source: Bloomberg Barclays US Corp Index, Amherst Pierpont Securities

Earnings update

Manulife reported 3Q19 results on Thursday (11/06) with EPS of C$0.76 beating the consensus estimate by three cents. Shares were up the following day by the most in nearly a year on the initial announcement, but flattened out as market enthusiasm tapered off in the second half of the session. Although flatter rate assumptions requires non-cash adjustments, core results were lifted by strong performance in Asia; and most importantly the comprehensive long-term care (LTC) review had no impact on reserves or net income.

MFCCN bonds saw a fast recovery in the first half of the year, in large part due to the favorable court ruling in March that alleviated concerns about potential legal liabilities. The legal uncertainty that dogged MFCCN credit and equity performance from late 2018 through 1Q19 was fully resolved 3/18/19, when a judge dismissed the claims by a hedge fund that Manulife, and other Canadian life insurers, should not be able to cap investments in life insurance policies with guaranteed rates of return.

The hedge fund saga began back in October of last year when short seller Muddy Waters revealed a position in MFCCN, stoking fears that the legal battle with hedge fund Mosten could result in billions in legal liabilities. When the case was settled, it fueled a sharp recovery in the name. Spreads subsequently gapped out with the broader market from April through May, but are now trading closer in-line with pre-lawsuit  levels. The drama that drove negative valuation throughout much of last year is off the table.

MFCCN is well diversified with a fairly even split between operations in the US, Canada, and Asia in most years. Last fiscal year was an anomaly, due to a special one-time charge against revenues in the US, which is typically the largest area of operation by sales. The US operations include the John Hancock Life and Health insurance operating subsidiaries, along with the Manufacturers Life Insurance operations in its home domicile of Canada, and Manulife International subsidiaries in Singapore and Japan.

In 2018, the company booked a $9.97 billion charge against revenue in its US operations to enter into a coinsurance agreement with RGA, which will help neutralize its variable annuity risk exposure going forward. This is a very favorable development for credit going forward, as variable annuity exposure and long-term care (LTC) represent two of the most visible operating risks for the life insurance industry.

MFCCN’s LTC exposure appears manageable. The company stopped underwriting this business back in 2016 and currently has more than C$10 billion in reserves over statutory requirements as of year-end 2018. The company maintains solid near-term liquidity with nearly $13 billion in cash on the balance sheet, plus an additional $500 million in revolvers available through 2021, versus less than $3 billion in total debt maturities over the next 5 years.

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