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Insurance Call Risk Being Rewarded

23 March 2017 by Eoin Walsh

The callability of financial institution bonds is a risk that always demands a lot of our focus, with the value in these bonds often being intrinsically tied to whether they would be called at the first call date or have the maturity extended. For banks this will partly depend on whether the bonds will continue to count as a form of capital and if not, how expensive the bonds would be as “senior funding” at the new reset coupon rate. For insurance companies the determination is different; most large insurers are not in need of funding and therefore rely on investors just for capital. In addition, the perception of an insurer’s “willingness to pay” is very important, and this extends not only to insurance policies, but also to the bonds outstanding.

These risks were highlighted in December last year when two banks decided not to call their bonds. Standard Chartered was first up, when they announced they didn’t intend to call their $ 6.409% legacy Tier 1 bond, which had a Jan ’17 call option. After the call date, the bond is only callable every 10 years so it automatically extended for this term. For us, this call was always a risk, the bond reset to a rate of 3M Libor + 151bps, which isn’t particularly expensive funding, but as the issue is a non-step up structure the bond will continue to count as Tier 1 capital for a period of time and then as Tier 2 beyond 2021, which makes it very cheap capital. Commerzbank followed shortly afterwards, when it failed to call its € 6.352% legacy Tier 1 bond – again, this was not a surprise as the bond (another non-step) will count as Tier 1 for a period of time and as Tier 2 after 2021, while the reset rate is also attractive at 12M Euribor + 200bps.

While we didn’t think that either of the non-calls were a surprise, it did focus investors’ minds on other bonds with short calls and some bonds did reprice wider. However, this was not limited to the banking sector, and various insurers also suffered a widening in spreads, which for us made less sense. While investors cannot simply expect all insurance bonds to be called (La Mondiale, a French insurer, failed to call a bond in Nov ’16), in many cases, we felt the spread widening represented a very attractive opportunity.

One of such cases was the RSA 6.701% bonds, with a call in July ’17, where spreads widened by over 200bps between November and December and yields of 4.5% were available for just 7 months risk. If not called, this bond would reset at 3M Libor + 251bps, which would appear to be relatively cheap capital; however, RSA has a Solvency II capital ratio of 158% (at the top of its 130-160% target), and we felt the likelihood of a non-call was very low. Any investor who did add the bonds during this period has been well rewarded with spreads having retraced all of the widening, and they got an additional bonus earlier this week when RSA announced a tender offer for their bonds, at a yield-to-call of just 35bps. Rather than having the cash sitting in the bank yielding very little, or waiting for the July call at par, they decided they would rather pay a premium to redeem these high coupon bonds early.

Another one of our favourite short-call bonds, the Lloyds of London 7.421%, also looks more likely to be called in June, given the new 4.875% bond that was issued in February, which could be seen as pre-funding.

While there are always risks to the outcome when the likelihood of a call is being evaluated, we have long felt that the call risks investors are being exposed to with insurance bonds are very different to those they are taking with bank bonds. As always, investors need to be selective, but so far, the spreads that were available in December still look like the good opportunities we saw at the time.

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