Most fixed income investors are well aware of the greatly increased difficulty of finding and acquiring yields that are high enough to provide the cash flow they need or desire without being accompanied by very significant and unacceptable risks, either in loss of principal or in long term wealth losses related to inflation. Consequently, we look under the hood of hundreds of companies to find the hidden gems that satisfies our client demand for both high yields and acceptable risk. This week we reconsider a debt instrument denominated in Swiss francs, from one of Europe’s most reputable insurance companies, SRLEV N.V. This high yielding floating rate bond has a first call date in 2016, at which time it will either be called by the company, or it will reset its coupon rate to the 5 year CHF swap rate (the Swiss National Bank’s key lending rate) plus the initial spread of 5.625%. Originally intended as a benefit to SRLEV’s credit worthiness, the tethering to parent company SNS Reaal’s credit rating recently resulted in a downgrade of SRLEV’s bonds to BA1/BB+. Last week, it was announced that SNS Reaal would be nationalized and its subordinated bonds expropriated. While SRLEV’s escaped this fate, the uncertainty over where SRLEV would land is allowing us to acquire this bond at a greater than 13% discount to par value, which would return bondholders cash flow that is about 15% higher than its current 7% coupon rate, or in other words – an interest cash flow rate that is over 8%. In spite of the recent strength of the Swiss franc relative to the dollar, we see this as an outstanding yield in swiss franc as being from a sound issuer, and we think this is a great opportunity for additional exposure to this traditionally strong currency in our Foreign and World Fixed Income bonds.
Switzerland is a peaceful, prosperous, and modern market economy with low unemployment, a highly skilled labor force, and a per capita GDP among the highest in the world. Switzerland’s economy benefits from a highly developed service sector, led by financial services, and a manufacturing industry that specializes in high-technology, knowledge-based production. Its economic and political stability, transparent legal system, exceptional infrastructure, efficient capital markets, and low corporate tax rates also make Switzerland one of the world’s most competitive economies. The Swiss have brought their economic practices largely into conformity with the EU’s, to enhance their international competitiveness, but some trade protectionism remains, particularly for its small agricultural sector. The fate of the Swiss economy is tightly linked to that of its neighbors in the euro zone, which purchases half of all Swiss exports.
The demand in 2011 for the Swiss franc by investors seeking a safe haven currency resulted in the independent Swiss National Bank (SNB) conducting major market interventions to prevent further appreciation of the Swiss franc, as the franc’s strength made Swiss exports less competitive and weakened the country’s growth outlook. In the final quarter of 2011 exports fell 6.8% due to its strong currency. While unemployment has remained low for most of 2012 at about 3.1 to 3.3%, GDP growth expanded to 1.4% in the third quarter of 2012, and the debt to GDP remains lower than most nations at less than 50%. Interbank rates for Switzerland remain in negative territory, and according to the Swiss Federal Statistical Office the inflation rates was recorded at -.4 percent in December of 2012.
When deflation concerns begin to wane, there will be increasing pressure for an exit strategy from the EURCHF “floor”, along with other unconventional policy strategies. Furthermore, there is increasing evidence of international and internal pressure to limit continued intervention. The SNB took a huge risk, which has paid off so far, in their strategy but the SNB’s balance sheet is slowly expanding, increasing the risk that the 1.2000 floor might come with a heavy price. From a historical perspective, the last time the SNB pegged the franc to another currency (the Deutsche mark) it lasted for about years before it was unwound.
Swiss franc (CHF) per US dollar -
Standard & Poor’s credit rating for Switzerland stands at AAA. Moody’s rating for Switzerland sovereign debt is Aaa. Fitch’s credit rating for Switzerland is AAA.
Update on SRLEV N.V.
We first reviewed SRLEV N.V., which provides insurance services in the Netherlands, in April of last year and then again in September. Operating as a subsidiary of REAAL Verzekeringen N.V., the insurance division of SNS REAAL N.V. (SNREF.PK), SRLEV N.V. is one of the crown jewels for cash generation within the parent company’s large and troubled property financing portfolio. SNS Reaal is the fourth largest Dutch financial after Rabbobank Group, ING Groep N.V. (ING) and ABN Amro Group.
In the first half of 2011, SRLEV, the legal entity comprising most of the life Insurance activities of SNS REAAL, successfully placed € 400 million of 30-year Tier 2 notes and CHF 105 million of perpetual subordinated notes. These transactions were part of the capital management of SRLEV and were related to the replacement of internal funding by external funding, a significant portion of which were to the Dutch government. The Supervisory Boards of SNS Bank NV, REAAL NV and SRLEV NV are composed of the same individuals as the Supervisory Board of SNS REAAL.
While Moody’s initially rated these bonds at Baa3, most aspects of SRLEV’s Insurance Financial Strength rating scorecard (including market position and brand, product focus and diversification, asset quality, capital adequacy, liquidity and ALM, reserve adequacy, and financial flexibility) all received the higher A rating. However, Moody’s is quoted as saying:
”The rating agency notes that although the insurance operations are increasingly financed autonomously through direct issuances from SRLEV N.V., the financial flexibility of SNS REAAL’s insurance operations remains intrinsically linked to the Group and the banking operations’ financial flexibility. In stress scenarios, Moody’s also believes that any potential weakening of SNS REAAL’s banking operations would further constrain the financial flexibility of the Group and its insurance operations.”
As a result, and despite the relative stability of the stand-alone profile of SNS REAAL’s insurance operations, Moody’s considers the ratings of these entities cannot deviate significantly from the rating of the Group’s banking operations.
While SRLEV’s overall rating was weakened as a result of its lack of diversity of distribution and geographic diversification, Moody’s also tethered its financial flexibility to the SNS REAAL Group in its analysis. After acquiring ABN Amro’s property-finance unit in 2006, losses on real estate loans within the troubled mortgage division has left SNS Reaal struggling to repay a government bailout. As risk-weighted assets and loan losses in the property-finance unit increased, its banking unit’s core Tier 1 capital ratio, a measure of financial strength, fell to 8.8% at the end of the third quarter, below the European Banking Authority’s 9 percent minimum. Consequently, when ratings for the parent company SNS REAAL were recently lowered, ratings for the SRLEV bonds were obliged to follow.
In the ongoing effort to bolster its required Tier one capital ratio, it was reported in various sources that SNS Reaal brought in Goldman Sachs to look into various scenarios for restoring its financial health, which among other considerations could include selling the Reaal and Zwitseleven insurance arms (which include SRELV.) Being the epicenter of the problem, we believed that the SNS Reaal Group itself carried a much higher risk than we are comfortable with. However, we viewed the profitable and very valuable cash generating insurance arms of the business as being severable should the cancer within SNS Reaal’s foreign property investments fail to be driven into remission. It was our opinion that SRLEV’s insurance business, having achieved a high sustainablity rating of 238% in the third quater of 2012, appeared to have a notably higher proportion of creditworthy fundamentals than the parent banking group (SNS REAAL), and the benefit that would normally come from the “bank guarantee” associated with this bond was reckoned as more of an enfettering. The advantage in recognizing these kind of linked relationships and understanding the correlation between them has many times enabled us to acquire highly desirable assets with very high yields at substantial discounts for our clients, and we cherish finding these rare and elusive opportunities.
An example of this are the 3.75% Cyprus Government bonds, acquired for our clients at 14% and then 18% yield to maturity, which, appear to be tethered to the financial stability of two of the major banks operating within the country. More recently, we reviewed the 11.8% yielding bonds from Transportadora de Gas del Sur, which seem to have been snubbed by the market more because of regulatory ties to the Argentine Government and its creditworthiness, rather than much consideration of the improvements and fundamental soundness of the underlying utilities financials.
Being the fourth largest of the Dutch banks, SNS Reaal appeared to qualify as being “too big to fail,” and subsequent to our review on Tuesday (January 28), it was announced last Friday (February 1) that the bank would be nationalized. While certain details of the government takeover are still lacking, yesterday (February 6) Fitch is quoted as saying,
“SNS REAAL’s operating insurance subsidiaries, SRLEV and REAAL Schadeverzekeringen’s IFS ratings reflect the insurance subsidiaries’ strong business position in the Dutch insurance market, solid capital adequacy and stable profitability. These strengths are offset by moderate financial flexibility, following the recent change of ownership. Although no information regarding the possible disposal of the insurance operations has been made available yet, the agency still views the sale of the group’s insurance operations, either partly or in total, as a possibility. If the insurance operations are acquired by a financially stronger group, SRLEV and/or REAAL Schadeverzekeringen’s ratings could be upgraded. However, if the insurance operations are sold to a financially weaker group, the ratings could be downgraded.”
We concur with this view, and believe the window for acquiring these bonds at the such favorable discounts might soon prove to be short lived.
The default risk is SRLEV N.V.’s ability to perform. While the higher yield of this debt issue reflects a higher degree of risk typically associated with hybrid/perpetual issues, given its sound business fundamentals, its quality investment grade rating, and its hefty 5.65% spread above the CHF swap rate, it is our opinion that the default risks for these rate adjusting bonds is quite low relative to the remarkably high yields that they offer.
The currency risk of the Swiss franc could and will affect the returns of these bonds and possibly in a negative way as it exposes investors to Switzerland’s economy and the policies of the Swiss National Bank.
SRLEV is relatively small from a global perspective, and it may face increasing competition as substantially larger and better financed companies such as France based AXA Group (AXAHY), Germany based Allianz (AZSEY ), or U.S. based Metlife (MET), attempt to increase market share within the massive insurance industry.
SRLEV is directly affected by prices in market and interest rates both internationally and domestically, as well as by the exchange rate of the Dutch guilder and Swiss franc.
We believe that these SRLEV bonds have similar risks and maturities to other high yielding foreign currency Eurobonds, such as the previously reviewed 7.24% Jaguar Land Rover bonds (in £’s) and the 9.2% Hungarian Development Bank bonds (in €’s).
Accessibility and Liquidity
Aside from owning various emerging market funds and ETFs that blend together various winners and losers into a mixed yield cocktail, the question arises as to how a retail investor might own or acquire individual, maturity definite Swiss franc denominated bonds. Many times broker/dealers require an institutional sized single bond purchase. However, with a broker and advisor’s assistance, it is possible for a number of retail clients to be combined together in order to make a larger institutional sized purchase. Previously, we have been able to facilitate purchases as low as US $10,000.
We continue to search for individual corporate instruments denominated in the currencies of growing economies that yield higher than average returns to help protect our clients against the erosion of wealth that results from a constant devaluation of the US dollar. We acknowledge that a stronger US dollar would directly reduce the total returns of this Swiss bond. Conversely, if the US dollar continues on the longer term path of relative weakness to the Swiss franc that it has been on, this alone would add significantly to the already higher positively accruing returns of this bond.
The combination of offering a remarkably high yield, some protection against a further loss of wealth with a continuation of the US dollar’s weakness against the Swiss franc, and a diversification away from heavily overweight US dollar based assets into one of the world’s top tier fiscally conservative countries is why we are adding SRLEV N.V. bonds at this time to our Foreign and World Fixed Income bonds.
First Call: 12/19/2016
Current Yield: ~8.05%
Disclosure: Durig Capital and certain clients may have a position in SRLEV perpetual bonds.
To know more about this SRLEV bond call our fixed income specialist at 971-327-8847.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. If you intend to use our research efforts to make an investment decision, we kindly ask that you respect our fiduciary business model and allow us the opportunity to assist in your equity acquisition. We sincerely appreciate your courtesy and understanding.
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