Sterling market observers have spent all year pondering the impact of PS04/16 on the credit portfolios of UK insurance companies. But the recent success of Wal-Mart’s £1 billion 31-year issue and the £300 million Standard Life 15-year non-call perpetual issue seem to suggest that the regulatory changes have not disturbed the market, at least for now.
To recap for those who have been on a yearlong holiday, PS04/16 is a policy statement from UK regulator, the Financial Services Authority, that supersedes consultation papers CP190 and CP195. It stipulates that from the end of the year – generally considered an unrealistic deadline – insurance companies will have to make sure they have adequate capital held against their assets. Although the changes concern both life and non-life insurers, credit market participants have focused on life insurers as they have greater assets in the market and are more affected by the changes.
PS04/16 is a wide-ranging document with significant repercussions for the way insurance companies operate and the policies they are likely to sell in the future. But with reference to bonds, the most important element is a new regime for assessing capital requirements. Put simply, the FSA policy now states that insurance companies should hold set levels of capital against assets on a sliding scale: the longer the maturity and the lower the rating of a bond, the higher the capital allocation. To work out a suitable level of capital allocation, the FSA has established stress tests that indicate to what extent bonds of each rating should be ‘shocked’ and the consequent capital that must be held against them.
The reason why it was generally assumed that no new issuance would be coming at the long end of the sterling curve was that many people believed PS04/16 would lead to a widespread sale of credit by insurance companies as they moved into gilts, in order to lower the capital charge they must take. Given that with-profits funds, the life insurance funds most affected by PS04/16, hold up to £132 billion in non-gilt fixed-income assets (out of a total market of £320 billion), according to JPMorgan, the effect could have been significant.
This made the appearance of US-based retailer Wal-Mart, largest retailer in the world, in the sterling market all the less expected. Its issue in mid-September was the first deal at the long end of the sterling market since triple-B rated France Télécom’s £500 million bond in February and came after months of soul searching about the sustainability of long-dated sterling issuance. According to Robert St John, head of origination at RBS, bookrunner for Wal-Mart with Barclays Capital and Deutsche Bank, since February investors have built up piles of cash and had nowhere to put it apart from gilts. “Investors are really looking for spread,” he says.
Granted, Wal-Mart had some qualities – it has been double-A rated since 1983 and offered useful diversification to investors – that might have made its success the exception that proved the rule that the long sterling market was closed. But a split-rated deal from Standard Life (Baa1/A-) at the end of October appeared to indicate there was demand for a greater breadth of long-dated issuance, in terms of ratings, than previously suspected. Triple-B rated bonds were thought to be most susceptible to insurance companies either selling existing holdings or refusing to buy new holdings as it is at this level that the capital charge they must apply to credit becomes significantly more onerous. Although insurance companies do not provide breakdowns of fixed-income allocation by rating category, JPMorgan argues that in theory with-profits funds could hold the entire liquid triple-B rated sterling corporate bond market, worth £35 billion. This is unlikely though.
So does the success of the Standard Life issue mean that fears over PS04/16 were unfounded? “From our perspective the whole thing has now blown over,” says Marco Baldini, director on the syndicate desk at Barclays Capital, a bookrunner on the deal with JPMorgan and Merrill Lynch. “Standard Life confirmed that most fears have been dispelled.”
Baldini also notes that many market observers have come to the conclusion that the holdings of insurance companies are “not material enough to cause a problem” in selling new issues or, indeed, driving a wider sell-off. “Equally, many people appear to have overlooked the fact that what is bad for one investor might be good for another,” he says. “If spreads widen slightly it might make triple-B rated bonds, for example, attractive to different investors. Certainly, Standard Life’s rating didn’t prevent people from getting involved.”
Less anecdotally, JPMorgan has recently released a weighty tome on PS04/16, which, if not the last to be published on the subject, is certainly definitive. It states that the introduction of PS04/16 should not cause insurance firms to move out of credit, particularly long-dated triple-Bs, and into gilts. Some capital-constrained insurers may have to sell triple-B rated credits but these will be a small minority. The report notes that many observers have made a number of incorrect assumptions, largely regarding the perceived flexibility of insurers in dealing with their liabilities or their ability to change their capital base, in deciding that a sell-off – and a reluctance to buy new paper – would occur.
The report also notes that certain books of insurance business have some onerous set targets with regards to yield that cannot be met through investment in gilts. More importantly, the belief that credit will be sold off in favour of gilts fails to take into account that the focus of PS04/16 is in calculating realistic liabilities and matching assets with them. “It would appear that the market has focused on the stress tests in isolation and on their impact on the asset side of the balance sheet – ignoring the offsetting treatment of the liabilities,” notes the report.
Indeed, according to JPMorgan’s calculations, there are scenarios where a corporate bond will attract a lower capital charge than a gilt with a longer maturity because of the emphasis the new regulations place on insurance companies matching their assets to their liabilities rather than just investing in the lowest-risk assets. Overall, it says sell-off concerns have been overdone and that the main burden of PS04/16 will fall on the equity market.
Of course that doesn’t necessarily translate into a vibrant long-end market. “The sell-off that took place earlier this year is overdone and we expect the long end to come in over the coming months. The success of Wal-Mart and Standard Life’s issue has indicated that the long end is far from dead,” says Ben Ashby, European financials analyst at JPMorgan in London.
But Barclays Capital’s Baldini does raise concerns: “There is a problem in that there are no clear buyers. The trading houses have been prepared for the sell off and are unlikely to want to change direction and the insurance companies will be waiting to see what their actuaries suggest. The test will be to see what happens to the traditional actuary-driven year-end rally.”
|A green light for derivatives |
Ben Ashby, European financials analyst at JPMorgan, notes that rather than the overwhelming attention paid to the long end of the sterling curve, one of the most interesting potential repercussions of PS04/16 in terms of the development of the credit market overall is that it appears to open the door to greater derivatives use.
“At the moment there are only a handful of insurers, perhaps two, that have the systems, process and techniques available to use derivatives,” he says. “But in the longer term we believe there could be a general migration toward derivatives to match liabilities at the longer end, where it may not be cost effective from a capital requirement point of view to hold corporate bonds and where yield would not be substantial enough on gilts.”
Insurers will look to buy products or combinations of products that allow them a high degree of flexibility, says Ashby. “Dependant on the final format of PS04/16, we could see a growth in products like self-managed CDOs,” he says. “The characteristics of such products - that there could be frequent trading underneath but the notes held by the insurer would remain stable - might make them attractive as they would fit in with new regulations allowing such holdings not to be marked-to-market.” He says that it is entirely possible that insurers will switch from cash to derivative-based fixed investments on a large scale.