IAG Hybrid reflects the inherent value in Tier 2 Market
IAG are in the market with a new AT1 (IAGPE) – pricing [3.50%-3.70%] above 3m BBSW. Note, distributions are franked at the same rate as IAG ordinary shares (currently 70%).
The deal offers value against the AT1 curve (insurance) and is pricing fair versus the major AT1 curve. There are no issues with the credit – IAG has an excess capital position, reinsurance cover and one of the top two general insurers in the market (IAG and SUN).
However, for investors who can access T2 securities within their wheelhouse, the opportunity cost is low when considering the value given up by buying T2 vs AT1. The APRA stimulated volatility with regards to extension risk on uneconomic capital call decisions has made this clearer. Remember, T2 margins were already cheap relative to AT1 margins prior to APRA’s announcement.
Let’s examine the insurance opportunity set.
|Name||Issue Margin||Trading Margin||Time to Call (years)||Structure||Ratings ( S&P/Moody’s/Fitch)|
|IAG 2044||+374||+266||1.6||Tier 2||BBB|
|Sun 2028||+215||+211||1.0||Tier 2||A-/A-|
|IAG 2045||+235||+310||2.6||Tier 2||BBB|
|QBE 2036||+275||+295||3.8||Tier 2||Baa1/BBB|
|IAG 2036||+245||+293||4.1||Tier 2||BBB|
|SUN 2035||+225||+295||3.0||Tier 2||BBB+/A-|
|SUN 2037||+230||+308||4.5||Tier 2||BBB+/A-|
|IAGPE||+350||6.5||Additional Tier 1||Unrated|
As at 18/11/2022. Time to call based on first call date.
Then, let’s examine the differences in security structure. The IAGPEs have discretionary, non-cumulative distributions. That is, coupons can hypothetically be missed which would lower the overall yield to maturity (YTM) an investor would achieve. The insurance T2 security has non-discretionary coupons – so income is more assured. Secondly, the IAGPEs sit lower in the capital structure (AT1 vs T2) and would be first to take write-offs (after common equity that is).
We won’t touch on the franking specific. But remember the level of franking may vary over time and distributions may be fully, partially, or not franked. Investors should not assume that the IAGPEs will always have the same franking. It is a common assumption for investors to foresee the level of franking as constant. This can change with company’s profitability and level of franking credits held on balance sheet.
In conclusion, any of the insurance T2 securities above look better risk/return especially in the current cycle. The outlook for weaker growth and inflation next year also makes T2 more attractive vs AT1 in a balanced portfolio context given: i) the current higher starting margin; ii) alongside lower correlation to equity markets. Therefore we have been rebuilding our fixed income duration, with a more modest overweight T2 to take account for these risks.