ASX Code: QBE
Security price: $10.02
Industry: Insurance
FY17 forecast distribution: 43.0 cents per share
Behind all the rhetoric and lofty promises of the inbound Trump administration in the US, one thing seems certain: inflation is returning to America. As ever, inflation is bad for bonds, which in large part explains the veritable rout in the bond market since Trump’s victory. This effect has rippled across financial markets, affecting many of Australia’s best-known and largest stocks. In essence, it is a reversal of one of the defining themes of the last few years, whereby defensive yield stocks benefitted from falling interest rates and bond yields. The relationship is simple: such stocks are considered bond proxies and as such, when bond yields are lower, the yields investors demand from these stocks are also lower. To put it another way, when bond prices are higher, such stock prices are typically higher.
QBE is an exception to this rule as it actually benefits from rising rates. Like most insurers, QBE invests its balance sheet into fixed interest securities like bonds. When the bond market falls, those securities decline in value but increase in yield. This increases QBE’s investment earnings and decreases its total asset value. At the same time, the present value of QBE’s claims fall, reducing the value of the group’s total liabilities. Because QBE’s assets have a shorter duration than its liabilities, the decline in the value of its liabilities is more pronounced than with its assets. The overall result is an increase in equity and an increase in earnings. This may sound complex but the lesson to draw here is that if bond yields continue to rise over the next few months, QBE’s value will too.
To quantify this benefit, movements in yields during the second half of FY17 thus far would suggest that QBE’s net profits could rise as much as 8% in the second half of FY17. This is not an exact science as bond prices are volatile under the current environment, but it should indicate the benefit from such movements is material.
To some, investing in QBE under these circumstances is tantamount to bond market speculation. But looking at it from another point of view, income focused investors can receive a ~5% yield (50% franked) whilst hedging against the risk of a further decline in bond prices. Given most other so-called defensive stocks would carry significant capital risk under the same circumstances, this safety shouldn’t be overlooked. Of course, QBE isn’t without its own risks – it is a large, mature business facing intense competitive pressures that continue to force prices down, while volumes creep higher in line with population growth. Yet, QBE’s yield and unique relationship with bond yields offer welcome protection in a world bracing itself for the return of US inflation.
Originally published in The Australian on Tuesday 22nd November 2016