Implications Of Larry Summers’ Exit For Insurance Sector Stocks

Bond yields fell as treasury prices climbed after former U.S. Treasury Secretary Larry Summers withdrew his name from the race for Ben Bernanke’s successor as Federal Reserve chairman. Summers was touted as the frontrunner to take the job after Bernanke’s tenure ends in January and was largely believed to be hawkish, favoring higher interest rates. According to Bloomberg data, benchmark 10-year yields fell nearly 10 basis points to around 2.80%, after the news broke out on Sunday. ^[1]

Following the financial crises, the Fed has kept interest rates artificially low 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 Fed has linked the program to the country’s economic recovery and indicated a threshold of 6.5% unemployment rate as a target for the end of the program. With the unemployment rate reaching a four-year low of 7.3% in August, markets are keenly looking to the September 17-18 Federal Open Market Committee (FOMC) meet for a timeline on the tapering of the program.

Speculation regarding the tapering has influenced bond yields, the 10 year Treasury bond yield climbed from 1.66% in May to 2.78% at the end of August. ^[2] However, with Summers out of the race, Bernanke is likely to be succeeded by Federal Reserve Vice Chair Janet Yellen or former vice chairman Donald Kohn, both of whom are perceived to be more dovish, favoring lower interest rates to promote development, than Summers. ^[3]

Lower bond yields will likely affect financial stocks, particularly insurance companies like Prudential Financial (NYSE:PRU) and Manulife (NYSE:MFC), which invest a significant portion of their assets in fixed maturity securities. More than 75% of Prudential’s assets are invested in government and corporate bonds. Manulife portfolio is more diversified, with half of the investments in bonds, however, the company earns nearly 70% of its investment income from the same.

As bond prices rise, these companies book capital gains on these fixed income investments. Also financial stocks are viewed as pro-cyclical and have performed well in the low interest rate environment. However longer term, a lower average yield on these fixed income investments will limit insurance companies earnings unless rates rise.

We have a price estimate of $80 on Prudential’s stock, in-line with the current market price.

See our full analysis of Prudential here

Life insurance companies invest the premiums collected from the insurance operations to generate returns. Investment income is significant for the companies’ profitability. Excluding investment income, Prudential’s expenses to premiums ratio was around 130% from 2008 to 2011 but fell to 108% in 2012. This implies that if the company was not able to generate significant returns on its investments, it would be incurring losses. The same applies for Manulife, which has a ratio of 130%.

Bond yields have been low since 2008. The 10 year Treasury bond yield was close to 5% in 2007 but fell steadily to around 1.7% at the end of 2012. ^[4] This decline affected Prudential’s yield from investments. Prudential’s yield from fixed maturity investments was more than 5% in 2008 but fell to  3% in 2012. The insurer’s operating margin was close to 15% before the onset of the financial crisis but dropped to less than 2% in 2012. While increasing bond yields will allow the company’s margins to return to pre-recession levels in the long-term, the near term margins and yields will be influenced by the Fed’s policies in the coming years. We have based our current forecast on recent trends, expecting Prudential’s yield from fixed maturities to reach 2007 levels by 2015. However, there is a 10% downside to our price estimate, should the yield fail to reach the expected levels by 2016.

Excluding capital gains, Manulife’s yield from bonds was around 5.3% in 2007, but fell to around 3.8% in 2012. We currently expect the company’s net yield to reach the 5% 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 2014 as bond yields fail to pick up as expected.

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1. Summers Quit Fed Quest After Democrats Spurned Obama Favorite, Bloomberg, September 16, 2013 [↩]
2. Daily Treasury Yield Curve Rates, U.S. Department Of The Treasury [↩]
3. Treasuries Rise as Pimco Says Summers Withdrawal Is Supportive, Bloomberg, September 16 [↩]
4. Ref: 2 [↩]