Insurance Hybrids Back in the Spotlight

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UK specialist insurer Rothesay Life came to the market yesterday, the latest company to issue in the fledgling RT1 sector introduced by the regulator as Solvency II compliant capital. There is nothing too startling about that news, but for us the interest has been the significant adjustment to the spread levels available in this sector compared to a year ago and in comparison to other sectors in the credit market.

The first significant public RT1 came from Dutch insurer ASR in late 2017, a well-publicised transaction that came at a time when market sentiment was particularly buoyant. The bond was well received and within four months was trading eight points above its re-offer level, with subsequent RT1 deals following suit. However, roll forward almost a year and it all looks very different. Market sentiment has changed and those same ASR bonds are trading over 10 points below their January peak, along with other pioneering RT1 issues.

Some market observers will point to general market weakness over the period in question, and similar woes for swathes of the AT1 banking sector, and to a certain extent we agree. But there are enough differences to suggest that the moves in RT1 have created a pocket of relative value that are now worthy of closer scrutiny. The insurance sector is of course a highly regulated industry with strict controls over minimum capital thresholds, and insurers typically operate with leverage levels below 1x compared to the 15x or 20x found at many banks. With the high levels of surplus capital (in some cases over 50%) now carried by the major insurers, it would take an event far greater than the global credit crisis to breach the minimum solvency ratio and the threshold to trigger the RT1 bonds, which would halt coupon payments and initiate a possible full write-down.

It has therefore been no surprise that subordinated insurance bonds have, in general, traded at tighter spreads than the banking equivalent in previous years. However, RT1s in 2018 have under-performed and are now trading at similar levels to deeply subordinated bank debt, as this latest Rothesay Life issue illustrates with a 6.875% coupon and a spread of around 545bp over Gilts for a BBB-rated issue.

Of course, insurance companies are closely correlated to sovereign bonds, as they typically have large holdings of sovereign debt on their balance sheets (as indeed do the banks). So with central bank tightening creating a duration headwind investors are rightly becoming more cautious on rate-sensitive product. Given RT1 is typically issued with the first call at 10 years, it is understandable that investors are demanding additional spread premium to compensate them for the duration risk these bonds exhibit.

It goes without saying that these hybrid bonds require considerable due diligence and are likely to be more volatile than typical plain vanilla credit bonds. However, looking at where the RT1 secondary levels have now reached, and where the new issue printed this week, it seems the level of compensation is now at a point where the sector is showing some real relative value again.

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