PIC’s RT1: The Brexit Premium in Practice

The UK’s political situation, and in particular the harder Brexit stance of the frontrunner for next prime minister, Boris Johnson, has provided the market with a steady stream of headlines over the past few weeks. As a direct consequence sterling is close to 6% off recent highs and domestic credit spreads have also underperformed their European and US peers.

As in most uncertain situations, these moves are not selective but appear contagious across the whole UK sector, which of course does create opportunities; this is why we continue to embrace sterling denominated credit, though with a high degree of selectivity. This also highlights the importance of having a global view of credit markets when investing in fixed income.

Yesterday Pension Insurance Corporation (PIC), the specialist UK based insurer of defined pension benefits, issued its inaugural Restricted Tier 1 (RT1) deal. PIC is a highly regulated institution whose business involves selling annuities to pension schemes in order to cover part of their liabilities (i.e. a pension insurance buy-in) or in some cases all of the liabilities (i.e. a pension insurance buyout). This is a very large but specialist sector where PIC has been successful in building a market share in a prudent manner. It may not be a household name, but its balance sheet is currently approaching £50 billion and it was awarded a single-A rating by Fitch last year.

The RT1 deal issued yesterday is a BBB- rated perpetual, with a first call in 10 years. The bonds were priced at a yield of 7.375%, equivalent to just over 9% in dollars after the currency hedge. We believe this compares favourably to the $ BBB US Corporate index, which has a similar duration but a yield of 3.55% for just a single notch higher in rating. The $ BBB US Financial Index is about two years shorter than the PIC deal, and is also BBB rated but offers a yield of just 3.57%.

To obtain a yield of 9% in dollars, investors would have to go way down into the sub-investment grade universe in either developed market corporate credit or hard currency emerging market credit. While we acknowledge these indices are shorter in terms of duration, and that the PIC RT1s come with a degree of call risk (i.e. the bonds are perpetual with a call schedule), we believe the relative value looks extremely attractive for such a highly regulated issuer, particularly in a world where yield is a scarce commodity.

PIC is a UK-centric business with operations carried out exclusively in the UK, so even in the event of a hard Brexit its day-to-day business is unlikely to be disrupted in a meaningful way. Of course, a potential macro deterioration and moves in credit spreads and sterling rates could all potentially have an impact on the issuer’s performance, but we believe that at these levels investors are being handsomely rewarded for the risk.

For us, the Brexit uncertainty will continue to interest investors with hidden opportunities.