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Extend or barbell in insurance

admin | August 21, 2020

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 fair value spread curve for ‘A’ insurers remains notably steeper than the overall investment grade corporate curve. It also remains steep relative to the start of the year and to the start of July, just seven weeks ago. Investors can get compensated well to extend duration or to barbell longer maturities with shorter. Berkshire Hathaway and Aflac, Unum, Brighthouse and CNO Financial all look like strong candidates.

Insurance paper has performed well lately as investors have looked to longer durations for higher yields. Since the beginning of June, insurance has delivered a Top 5 performance by sector with an excess return of 4.67% and total return of +5.15%. This compares to excess return versus 3.63% and 4.01%, respectively, for the broad IG Index. With investors targeting longer insurance paper, it seems reasonable the 10s/30s curves would compress relative to the broader market. But that is not the case (Exhibit 1).

Exhibit 1. Spread Curves: Broad Investment Grade (Blue) vs A-Rated Insurance (Red)

Source: Bloomberg – IG Corporate and Insurance (A) Fair Value Curves

In order to take advantage of these market dynamics, investors should pursue extension trades and barbell strategies in the Insurance segment, focusing on situations that provide the most spread incentive to add or rebalance duration.

A “roll” study can help identify candidates among investment grade insurance issuers with outstanding benchmark issues in the 5-year, 10-year and 30-year maturity buckets (Exhibit 2). The analysis shows the available spread pick to move from each issuer’s 5-year bond to the comparable 10-year bond, as well as the spread pick to the 30-year bond from the 10-year bond. These available spread picks are provided on both an absolute basis as well as on a spread per turn of duration basis for extending. This corrects for any minor discrepancies in maturity that could have an impact on overall duration change in the perspective trade.

It is worth noting that the pricing demonstrates current YAS indications and may not fully reflect current bid-ask spreads for executing any given trading strategy. Nevertheless, the study provides a playbook for which issuers may provide the biggest incentive to either extend or pursue a barbell strategy and in which issuers might investors be best served to stay in the 10-year bucket.

Some key takeaways and trading recommendations:

Surprisingly, some of the best opportunities to extend from the 10-year to the 30-year issues include some of the higher quality issuers in the segment. Included among them are Berkshire Hathaway (BRK: Aa2/AA) and Aflac (AFL: A3/A-), with +61 and +72 bp picks respectively. In recent sessions, BRK and TRV (not in the study) have been trading weaker to the overall segment, and we believe there is an opportunity to add or extend exposure in those names. Compare BRK and AFL versus fellow low-risk issuer Progressive (PGR: A2/A) curve, with one of the flattest curves in the entire study.
Not surprisingly, many of the most attractive extension trades exist in the higher beta issuers. Notable among them are Unum (UNM: Baa3/BBB) and Brighthouse (BHF: Baa3/BBB+), offering +107 and +68 bp to extend from their respective 10-year tranches to the 30-year. Investors can balance the added credit risk by pairing these trades with an increase in higher-rated issuers and/or barbell strategies to mitigate the overall duration exposure to these specific names. Previously crossover issuer CNO Financial (Baa3/BBB-) also has an attractive 5s/10s extension (no 30-year bond available) offering roughly 25 bp per additional turn of duration.
With only 20 bp available and just 2 bp/per turn of duration, the incentive to extend from 10-year to 30-year maturity in Markel Corp (MKL: Baa2/BBB) appears very limited. Therefore, we believe investors are better served to hold the MKL 3.35% ‘29s for this particular issuer. We have been highlighting this bond as offering attractive value in the 10-year part of the P&C Insurance curve (APS Strategy – Markel 29s).
Also demonstrating a very flat 10s/30s curve is Prudential (PRU: A3/A) with only an aggregate +16 bp indicated pick to move out into the 30-year tranche. This name presents an opportunity to remain in the 10-year and/or potentially shorten duration to offset 30-year trades in names with more attractive extension pick.
AIA Group (AIA: A2/A) and Reinsurance Group of America (RGA: Baa1/A) have two of the flattest 5s/10s curves (+22 bp, +19 bp, respectively). These issuers present an opportunity shorten exposure and/or barbell added duration elsewhere in the portfolio.

Not every trade will be readily available for execution, as demand for longer-dated paper remains fervent in both the primary and secondary markets, and sourcing appropriate bonds remains a challenge to all investors. Nevertheless, for investors pursuing these strategies the results should provide a playbook for the individual situations that offer greater incentive to take on added duration risk should they become available.

Exhibit 2. Insurance Roll Study

Source: Amherst Pierpont, Bloomberg/TRACE – Spread Indications

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jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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