The Long and Short
One new P-CAP arrives, one old P-CAP departs
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.
Liberty Mutual Group (LIBMUT: Baa2/BBB) launched its first 30-year pre-capitalized securities (P-CAPs) this week under the issuer name Beacon Funding Trust. It was the first deal of its kind since Equitable Holdings (EQH: Baa1/A-) brought a similar structure back in June. P-CAPs are a unique trust structure mostly used by insurers to raise funds but keep leverage off the balance sheet until the funds are eventually needed. The new launch brought price discovery to a less liquid segment of the insurance sector. As Liberty Mutual brought a new deal, UNUM announced it would dissolve its P-CAP. Investors continue to be well compensated for the moderate give-up in liquidity and structural implications associated with these securities and should view P-CAPs as an attractive carry opportunity.
The Beacon Funding Trust notes priced on Wednesday at a spread of 175 bp over the 30-year bond versus initial price talk of 200 bp over, then initially backed up by a basis point or two once bonds hit the secondary market. They eventually settled closer to launch level later in the week. Although the LIBMUT bonds did not perform well after initial pricing, likely due to the surprisingly large $1.25 billion debt tranche, the deal priced in line with the typical PCAP discount to secondary market senior unsecured debt from the parent company.
The current valuation is about 36 bp of G-spread wider versus the maturity senior unsecured LIBMUT 5.5% ’52. This discount is highly comparable to most liquid 30-year P-CAP relationship between EQH’s Pine Street III 2054 maturity notes. Available spread pick in this segment ranges from 20 bp to 60 bp depending on maturity and differentiation in coupon. This continues to represent generous compensation given that the P-CAPs are rated in-line with their respective senior unsecured notes. The rating agencies consider the trust structures pari passu with comparable senior debt, since the issuers are required to issue senior debt into the trust if they ever take ownership of the Treasury securities that are held on issuance.
Some examples of P-CAPs in the insurance industry include: Equitable Holdings’ Pine Street Trust, Prudential Financial’s (PRU: A3/A/A-) Five Corners Funding Trust, Voya Financial’s (VOYA: Baa2/BBB+/BBB+) Peachtree Funding Trust, the Belrose Funding Trust issued by Lincoln National (LNC: Baa2/BBB+/BBB+) and Principal Financial Group’s (PFG: Baa1/A-) High Street Funding Trust (Exhibit 1).
Exhibit 1: Selected insurance P-CAPs and their senior unsecured credit curves
Source: Santander US Capital Markets LLC, Bloomberg/TRACE G-spread indications
Exhibit 2. Spread in insurance P-CAPs and comparable senior unsecured debt
Source: Santander US Capital Markets LLC, Bloomberg/TRACE Spread and G-spread indications
In other P-CAP news this week, Unum Group (UNM: Baa2/BBB/BBB) announced in conjunction with earnings that they would be dissolving their outstanding Hill City Funding Trust (UNM 4.046% ‘41%). Since the P-CAP structure was conceived, no other issuer has actually executed an exercise event before, which demonstrates the fallback nature of these liquidity reserves. As the first dissolution, the UNM bonds will serve as a case study for execution, and proof of concept, particularly for investors that might still be reluctant about the structure itself. UNM will take ownership of the Treasury securities previously held in the trust by issuing senior unsecured debt with identical coupon, principal and maturity into the trust. Therefore, the holders of the notes will continue receive the same coupon payments unabated, while the ratings and seniority of the bonds will remain the same.
Alternatively, back in June, EQH opted to tender for one of its shorter maturity P-CAPs, which it funded with the new 30-year P-CAP note issuance. This was a means for the company to effectively term out their liquidity reserve. The tender/re-issue demonstrated that an issuer has the means to redeem the notes early, without ever taking ownership of treasury securities or having the debt count toward their balance sheet leverage. With some of the earlier outstanding P-CAPs getting long in the tooth, it is possible we could see some other issuers follow suit.
Primer: Pre-capitalized securities (P-CAPs)
Pre-capitalized securities or P-CAPs are a unique trust structure that have been mostly utilized by insurance companies seeking to issue debt, but also wanting to keep leverage off the balance sheet until or if the funds are eventually needed. The bonds trade in the secondary market at a discount to comparable senior unsecured debt issued by the same insurance companies.
The motivational concept behind a P-CAP is fairly simple. The issuer creates a trust that accesses the public debt market, but that debt is held off balance sheet of the insurance company and does not contribute to financial leverage. The proceeds of the securities issued by the trust are used to purchase Treasuries (principal or interest strips), from which the trust will pay a coupon plus a locked in spread rate that is paid/provided by the underlying insurance company. In effect, it is a means for an insurance issuer to essentially lock in or create an option on interest rates at a time when they view rates as attractive but might not necessarily need to issue debt. The company effectively has a put option to issue senior unsecured debt into the trust at any time and take ownership of the treasury securities that are held (typically at increments of $50 or $100 million depending on the terms of the deal). Only at that point does the debt count toward financial leverage and the issuer have access to the funds.
All outstanding P-CAPs are rated in-line with the senior unsecured debt of the issuer, as the rating agencies view the credit quality as being closely linked to that of underlying insurance company. The notes issued into the trust upon exercise would be pari passu with all senior unsecured debt obligations of the underlying insurance company. An issuer would choose to execute voluntarily in the event that it could no longer access the public debt markets or simply views current rates as less attractive to issue new debt. Debt issuance to the trust can also occur as a result of a mandatory exercise event, which is described below. So far, no insurance company that has issued P-CAPs has ever exercised either voluntarily or through automatic/mandatory action.
An automatic exercise event occurs if either a bankruptcy event occurs at the underlying insurance company, or if the company fails to make scheduled payments to the trust. A mandatory exercise event would occur if consolidated net worth of the company falls below a certain threshold, or if the company defaults on other payments or violates debt covenants. In either case, the senior debt then issued to the trust puts holders of the P-CAPs in a pari passu position with other senior debtholders of the insurance company.
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