Fixed Income Viewpoint
Insurance – April 2014
Sector Rating: Market Perform Relative Value
5-Year: Market Perform 10-Year: Market Perform 30-Year: Market Perform
Spread View – Canadian insurance credit has performed rela- tively in line with the FTSE TMX Canada Corporate Uni- verse in Q1/14 with returns of 1.55%, 3.73% and 6.21% in the short, mid and long ends of the curve, respectively, com- pared to 1.39%, 3.85% and 6.06% for the FTSE TMX Cana- da Universe Corporate Bond Index. However, life insurance credit has underperformed relative to Canadian bank credit in Q1/14, with the spread differential between 5-year average senior life insurance credit and bank sub debt widening to -3 bps compared to -11 bps at the end of 2013. While the funda- mental backdrop has improved for the life insurers, we recom- mend a market weight position in life insurance credit given the significant outperformance over the past year. That being said, we do not expect the insurers to be active in the primary market in 2014, which should bode well for credit spreads.
Credit Curve – In Q1/14, the life insurer 2s-5s curve tightened 1 bp to 26 bps, the 5s-10s flattened 4 bps to 48 bps, and the 10s-30s curve flattened 9 bps to 30 bps. We recommend that investors position themselves in the mid part of the curve.
Sector Value – In terms of relative value, we believe the Sun Life senior fixed-floaters (4.80%/15-35) look attractive relative to the MFC 4.079%/15 at a pick up of ~40 bps. While these securities include a +20-year extension, we believe the risk of extension is very low given that the recent restructuring of their captive reinsurance arrangement eliminates the need for existing senior debentures and short-term letters of credit.
Recommendation
Top Pick – From a fundamental perspective, Great-West re- mains our top pick. The company has excellent market posi- tion, strong asset quality and solid capital. In addition, the company has the lowest sensitivity to equity markets, strong brand recognition and enhanced financial flexibility with ex- cess capital sitting at the holding company. That being said, we believe the pension announcement in the 2014 U.K. bud- get is negative from a credit perspective given it is expected to significantly reduce sales and margins in its U.K. annuity business. We estimate this business represents ~7% of GWO’s bottom line and approximately one-third of the company’s U.K. earnings.
Risks
External – The life insurers’ sensitivity to equity mar- kets and interest rates has declined given product repo- sitioning, hedging and out- right dispositions.
M&A – We believe M&A ac- tivity will be limited to small tuck-in acquisitions.
Regulatory – On November
12, 2013, OSFI released an
update to its Life Insurance
Regulatory Framework, orig-
inally published in September
2012. The update pushes back
the implementation of the life
insurance capital framework
to 2018 from 2016. In addition, draft guidelines are now ex- pected in 2015 and final guidelines in 2016.
New Issuance – The life insurers have not been active on the primary front in 2014, with only Manulife tapping the mar- ket with a $500 million 5+5 opco subordinated fixed-floater in February. Manulife also issued a $200 million rate reset preferred share in February. The proceeds from both these securities are expected to be used to refinance the $1 billion senior holdco maturity in June. Sun Life did not refinance its $500 million sub debt holdco maturity at the end of March; however, we are not surprised given the high amount of excess cash at the holding company level.
Credit Profile
Sector Financials – The Canadian lifecos reported solid core EPS growth in 2013 with GWO up 11% (8% excl. Irish Life), IAG up 10%, MFC up 17% and SLF up 13%. We expect earnings growth to continue in 2014 and 2015 given increased contributions from wealth management businesses, growth in insurance premiums and deposits, continued focus on reduc- ing costs, and positive operating leverage.
Sector Fundamentals – The fundamental backdrop for the life insurers improved in 2013 due to the increase in equity markets and long-term interest rates. In addition, the insur- ers have built fortress capital positions that can withstand sig- nificant volatility. Finally, the insurers have been moving away from more capital-intensive life insurance businesses to less capital-intensive wealth management.
Credit Ratings – All three rating agencies have Stable outlooks for the Canadian Insurance sector.
George Lazarevski, CFA
BMO Nesbitt Burns Inc. george.lazarevski@bmo.com (416) 359-7488