Investor viewpoint: RT1 a welcome pick-up

Julien de Saussure, fund manager at Edmond de Rothschild Asset Management (France), explains the key metrics by which he judges new Restricted Tier 1 issuance, and the pros and cons of the instrument versus bank Additional Tier 1.

Julien de Saussure

How do you approach the relative valuation of insurance RT1? What are the relevant comparables? Banks’ AT1, insurance subordinated debt?

The relative valuation of RT1s is based on four pillars for us:

  • Relative value between all outstanding RT1s, including a comparison of legal terms and conditions
  • Relative value of the capital stack of an issuer, vs. its senior, T2 and other RT1 outstanding
  • Relative value vs. other hybrid instruments, e.g. AT1 or corporate hybrids
  • Finally, relative value vs. equity and equity dividend yield.

As far as the comparison with AT1 is concerned:

  • Though coupon suspension must always be discretionary for both RT1s and AT1s, the exact attachment point of coupon suspension for European AT1s is assumed to be way higher than for RT1s given the CBR/MDA dynamics. Funnily, non-European AT1s can still include capital stoppers, which are not allowed for RT1s. But apart from that, we feel that a mandatory coupon suspension is more remote for a RT1 than for an AT1.
  • On the flipside, we agree that we feel more comfortable forecasting the CET1 level of a bank than the SCR level of an issuer. So in terms of loss-absorption mechanisms, we feel the distance to trigger for European issuers should be higher in the long run given that the volatility of the ratio could come from the numerator as well as the denominator. To balance this, the 5.125% or 7% trigger on AT1s is probably beyond PONV, while it is still very unclear how a supervisor would assess an insurance company with a SCR level below 100%. And potentially, it could be considered viable. A negative for RT1s, however, is that curing a SCR breach with the current loss-absorption mechanism is quite limited, given that a conversion or write-down would likely not increase the SCR level, but would only increase the quality of the capital stack.

So we tend to find RT1s a better credit structure than AT1. But given where insurance Tier 2s are trading (also considering the mandatory coupon for bank T2s), the spread difference between RT1 and insurance T2 vs. AT1 and bank T2 gives a feeling that the junior subordination premium is more attractive on the banking side.

Would you see any fundamental difference between the equity conversion and the principal write-down loss absorption mechanisms?

At this stage of the credit cycle, where the loss-absorption mechanism is deemed to be deeply out of the money, we assign a limited valuation difference between the two mechanisms.

We have a modest preference for the equity conversion feature as we deem it to be more straightforward and easier to understand. The exact sequence of write-downs and write-ups is less palatable as some implementation details will only be tested when the mechanism is actually triggered. We have adapted our mandates so as to avoid being forced-sellers in case of equity conversion, even though our primary mandate is to invest in bonds.

What are the key credit parameters and metrics that you look at in your RT1 investment process?

As the introduction of Solvency 2 is still recent, we try not to rely purely on SCR.

So I guess the basic metrics are solvency levels, financial leverage and interest coverage, and we look at their recent history to sanity-check the sensitivity levels generally provided by companies in their SFCR reports.

The quality of the capital stack (unrestricted Tier 1 as a percentage of SCR, grandfathering vs. fully-compliant structure) and the resulting issuance headroom is also an important aspect to look at. Then, understanding the sustainability of the business models, cashflow generation and profitability is at least as important as purely static metrics.

Finally, a qualitative assessment of the governance of the issuer, its track record and its commitment to its stated financial guidelines is paramount to wrap-up the analysis

What are the key elements that you expect issuers to communicate in the context of an RT1 transaction?

On top of the parameters mentioned above, a clear ladder of intervention to prevent a SCR breach (e.g. what ASR provided during its inaugural RT1 roadshow) is interesting, even though reinsurance retrocession and other capital relief mechanisms are difficult to dynamically model.

How do you view RT1 and more generally insurance subordinated debt supply dynamics?

We like the product as a source of additional spread for a given issuer.

We feel it is still limited to (i) big issuers willing to show their financial strength or (ii) specific situations where the absence of T1 is jeopardizing the financial flexibility of an issuer.

We continue to believe that the vast majority of the insurance subordinated debt supply is going to come with a T2 format, given how well established this structure is, in different currencies and with different investor base.

The spreads of some recent transactions (ASR, SCOR) could lure issuers to the segment on an opportunistic basis.

A swing factor is the refinancing of grandfathered T1 instruments. As a credit investor, if the choice is between legacy T1 not being called and limited supply or sticking to the market practice to call at first call date and more supply, I would definitely support the latter scenario.

Read an exclusive interview with SCOR about its RT1 here.

And key considerations for RT1 issuance, rating agency views and comparisons with AT1 from CACIB here.