After months of speculation, the Federal Reserve has finally decided to scale back its $85 billion monthly bond purchase program.  Through its Quantitative Easing 3 program, the Fed has been purchasing assets such as long-term treasuries and mortgage-backed securities from commercial banks and other financial institutions, thereby increasing liquidity and reducing long term rates. Fed Chairman, Ben Bernanke, stated that the Fed will cut back purchases of Treasury securities and mortgage securities by $5 billion each from January onwards. 
However, the Federal Funds Rate, the rate at which banks borrow from each other to maintain capital reserves, will still be kept low as long as the unemployment rate remains above 6.5% and inflation is in check. The rate is currently less than 0.1%.  The decision was positively perceived by the U.S. markets which saw the Dow Jones industrial average and the S&P 500 hit record closing highs.  Insurance companies like Prudential Financial (NYSE:PRU), MetLife (NYSE:MET) and Manulife (NYSE:MFC) invest heavily in bonds and will be directly affected by any changes in yields. After the Fed’s announcement, the three stocks gained 3%, 2% and 1.7% respectively.
Our price estimate for MetLife is $49, in line with the current market price, while that for Prudential is $80, implying a discount of 10% to the current market price. We have a price estimate of $17 for Manulife’s stock, in line with the current market price.
Markets Expecting Tapering
The Fed first suggested the possibility of QE tapering in May, leading to speculation in the bond market.  As a result, the 10-year Treasury bond yield, which can be used as a benchmark for bond yields, increased from 1.6% in May to 2.85% on December 17.  The bond yield jumped to 2.94% after the Fed’s announcement, but then settled to 2.85%.  This indicates that the market might have priced in the possibility of tapering. The 10-year bond yield was around 5% before the financial crisis began. With the zero interest policy still in force, we do not expect the yields to reach the pre-recession levels in 2014.
Investment Income Is Important
Investment income is quite important for insurance companies, MetLife has maintained an average expenses to premiums ratio (loss ratio) of 144% in the last four years in the U.S., while Manulife has maintained a ratio of 130%. Prudential’s loss ratio was around 130% from 2008 to 2011, but fell to 108% in 2012. This implies that if the companies would be running in losses if they were not generating sufficient returns from their investments. Around 75% of MetLife’s and Prudential’s assets are invested in bonds, while half of Manulife’s assets are invested in the same. MetLife’s fixed-maturities yield fell from 5.4% in 2008 to 4% in 2012, while Prudential’s yield fell from 5% in 2008 to 3% in 2012.
Excluding capital gains, Manulife’s yield from bonds was around 5.3% in 2007. In the last few years, 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 by 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.
Around 35% of the company’s assets are invested in Canada and around 50% in the U.S. The Canadian Government 10-year bond yield is highly correlated with its U.S. counterpart and has increased from 1.68% in May to 2.66%.  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 by this time. There is a 15% downside to our price estimate for Manulife, should the margins and yields remain at the 2012 levels by 2015 as bond yields fail to pick up as expected.
Fore MetLife, we calculate the annualized spread earned on the average account balance by subtracting the interest credited to policyholder account balances from the net investment income. According to our analysis, MetLife’s annualized spread in the U.S. dropped from 4.15% in 2010 to 4% in 2012. We expect a moderate increase in the annualized spread in the coming years, with the yield from fixed maturities reaching the pre-recession level of 5% by 2015. There is an upside of 5% to our price estimate for the company’s stock, should the yield reach the 5% level in 2014. However, MetLife’s margins could be significantly affected if the yield remains at the current level through 2017. There is a downside of 10% to our price estimate in this scenario.
Like MetLife, we expect Prudential’s yield from fixed maturities to cross the 5% level by 2015. There is a downside of 20% to our estimate, should the insurer’s yield remain at the current level of 3% by the end of the decade.Notes:
- Fed’s ‘Very Dovish Tapering’ Spurs Rally, Wall Street Journal, December 18 2013 [↩]
- Taper seen as positive for economy, bad omen for bonds, CNBC, December 18, 2013 [↩]
- U.S. Federal Funds Rate, Bloomberg [↩]
- Dow Jones industrial average, S&P 500 end at record highs after US Fed trims stimulus [↩]
- U.S. 10-Year Yield Tops 2% as Bernanke Says Fed May Taper Buys [↩]
- Daily Treasury Yield Curve Rates, U.S. Department Of The Treasury [↩]
- Treasury Bond Prices Rebound After a Brief Drop on Fed Tapering News, Wall Street Journal, December 18, 2013 [↩]
- Canadian Govt Bonds 10 Year Note, Bloomberg [↩]