Manulife (NYSE:MFC) is one of the biggest insurance companies in North America with a market share of 3.25% in the U.S.  and around 6% in Canada. Like that of most of its peers, the company’s stock has been surging through 2013, gaining nearly 30% since the turn of the year. While Manulife reported strong results through the first half of the year with a 12% year-on-year increase in core earnings from the U.S. and a 40% increase in the same from Canada in the June quarter, the recent rise in bond yields has also contributed to the optimism surrounding the company.
Around half of Manulife’s assets are invested in government and corporate bonds and the company earns nearly 70% of its investment income from the same. Around 35% of the company’s assets are invested in Canada and around 50% in the U.S. The 10-year Treasury bond yield has climbed from 1.66% in May to 2.78% at the end of August.  )) The Canadian Government 10-year bond yield, which is highly correlated with its U.S. counterpart, increased from 1.68% to 2.62% in the same period. 
In this article, we take a closer look at Manulife’s investment portfolio and the effects recent trends could have on the company’s performance. We have a price estimate of $17 for Manulife’s stock, in line with the current market price.
Investment income accounts for 32% of Manulife’s revenue, however, it is far more important for the company’s margins. This is because Manulife, like other life insurance companies, invests the premiums collected from the insurance operations to generate returns whilst establishing reserves to provide for the estimated costs of paying claims under the policies written. The company’s expense to premium ratio is around 180% (including fees and other income, the ratio is around 130%) which shows that it would actually be going into losses if it was not able to generate sufficient returns on investments. It can be inferred that if the claims to premiums ratio remains the same, the investment income is the primary driver for Manulife’s margins.
Excluding capital gains, Manulife’s yield from bonds was around 5.3% in 2007, before the onset of the financial crisis. Since then, interest rates and subsequently bond yields in the U.S. have been kept artificially low by Federal Reserve through its Quantitative Easing programs. The QE 3 involves purchasing assets like long term treasuries and mortgage-backed securities from commercial banks and other financial institutions, thereby increasing liquidity and reducing long term interest rates. The 10-year Treasury bond yield, which can be used as a benchmark for bond yields was around 5% before the financial crisis but fell to around 1.5% in 2012.  Manulife’s interest income from investments has dropped steadily and its yield from bonds was just 3.8% in 2012.
However, the asset repurchase program also resulted in an increase in bond prices leading to capital gains for Manulife. The company reported gains of around $3 billion in 2012 and close to $9 billion in 2011. As a result, its operating margins have not dropped as significantly as one might expect looking at the bond yields. The operating margin was around 17% in 2007, fell to 0.7% in 2008, but recovered to 6% in 2011 and 13% in 2012.
With improvements in the U.S. economy, the Fed is expected to start tapering the QE program in the near future. The Fed has indicated a threshold of 6.5% unemployment rate as a target for the economic recovery before it might start increasing interest rates. The unemployment rate reached a four-year low of 7.3% in August and investors are looking ahead to the September 17 Fed meet for a possible timeline of the tapering. 
Bond yields and prices are negatively correlated, and in the coming years, Manulife will not be able to realize the capital gains it has in the past few years. However, in the long term, rising bond yields will help the company maintain margins. Manulife’s net yield, including capital gains and losses, was around 5.14% in 2007. We currently expect the net yield to reach this level by 2015 with operating margins reaching the historical 15% levels during the same time frame.
There is around 15% downside to our price estimate for Manulife should the margins and yields remain at the 2012 levels by 2014 as bond yields fail to pick up as expected. You can modify the interactive charts below to gauge the effect a change in forecasts would have on our price estimate.Notes:
- National Association Of Insurance Commissioners Life And Fraternal Insurance Industry [↩]
- Daily Treasury Yield Curve Rates, U.S. Department Of The Treasury [↩] [↩]
- Canadian Govt Bonds 10 Year Note, Bloomberg [↩]
- U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]