Investment idea rises from regulatory rubble

Solvency II in Europe has given Sarasin CIO Burkhard Varnholt an intriguing idea for cautious but yield-hungry investors.
Investment idea rises from regulatory rubble

An old truism is that new regulation and market dislocation create a plethora of challenges, but also opportunities in areas either overlooked or under-researched.

Burkhard Varnholt, global CIO and head of asset management product and sales for Bank Sarasin, believes he has unearthed one such gem of an investment idea.

“To me this is one of the most intriguing investment opportunities that neither the media nor analysts have picked up on yet,” he told a briefing in Hong Kong yesterday.

His strategy revolves around the Solvency II capital requirements due to be imposed on European insurance firms by 2016, and rolled out globally thereafter.

Historically insurers have issued subordinated perpetual bonds largely because they count as core capital and provide a relatively cheap net cost of capital. But from 2016 these bonds will be reclassified as debt, which Varnholt identifies as a game-changer.

“Your average cost of net capital with perpetual bonds is roughly 8%, which is cheap in comparison to equities [15-20%] but very expensive in comparison to debt since companies can raise debt in the markets for 10 years at 2%," he notes. "So [insurers] will be using their next possible call dates to call these bonds back and redeem them.”

And here is the twist. Investors can buy these subordinated perpetual bonds in the secondary market at 60-70 cents on the euro, states Varnholt.

“When you add it up, buying these bonds in the secondary market at 60-70 cents on the euro expecting that they will be redeemed when Solvency II is introduced in 2016 gives you two sources of return: one, they will be pulled to par, and secondly and simultaneously they will be paying an average of 8% every year. That adds up to a 20% annualised return.”

These bonds are trading so cheaply because Basel III capital requirements are forcing banks which originally syndicated these bonds to offload them from their balance sheets.

“The intriguing fact is you have forced sellers on one side of the market, and the only buyers are insurance companies which are using limited treasury liquidity to buy these up. This leaves ample opportunities for investors to take advantage of this regulatory development.”

On a global basis Sarasin is underweight risk assets and overweight cash, with Varnholt describing the latter as the best hedge in this economic climate.

He reflects that Sarasin was double overweight equities at the end of last year – with US companies in particular having earned more last year than ever before – and took profits in April with Greece and the eurozone increasing anxiety among corporate executives.

“They fear [the eurozone crisis] could morph into a global credit crunch, so they are keeping their cash dry and watching how it plays out,” he notes.

Such caution is behind the latest batch of negative economic indicators, he argues, with temporary weakness likely to stretch into the third quarter. But he expects a benign resolution to the eurozone crisis, resulting in a stack of investment plans being reactivated to create a new recovery towards the fourth quarter of this year.

“It will make the economic cycle of the last few quarters and the next few quarters look something like a W,” he says.

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