Assured Guaranty, Ltd. (AGO) has surged approximately 46% since the start of the year and I am wondering if the stock can continue to move higher.
Assured Guaranty, Ltd.
Assured Guaranty is a Bermuda based provider of financial guaranty insurance. It is divided in three subsidiaries which do insurance for municipal bonds, international infrastructure financing, structured finance obligations and reinsurance. Basically the business model is to take on risk of loss against a premium. In particular the financial guaranty insurer offers an insurance policy that provides a guarantee of payment of scheduled principal and interest over the life of the insured bonds should the issuer default. The reinsurance business model is to assume risk initially assumed by another insurer.
There are two reasons besides the actual protection of insurance for wanting to insure a bond, these are credit enhancement and increased marketability. Credit enhancement is possible if the insurer has a better credit rating than the underlying insurer, since the issuer of the bond would save financing having to pay a lower yield on the bond. This is of course a tradeoff, since the issuer will pay a premium to insure the bond. The second reason is increased marketability, an insured bond from a lesser known or smaller issuer will typically get easier access to the capital market.
The history of bond insurance goes back to the 1970s when bond insurers guaranteed debt issues that had an underlying rating lower than the insurer's credit rating by using structured insurance policies. Companies engaged in this kind of business were called Monoline insurers because of their concentration to only a single line of business (typically insuring municipalities). The reason behind just insuring one type of debt was that it was hard to keep the strict capital requirements for obtaining a good credit rating. Over the time many more Monoline insurers came in to the market, reflecting the growing demand for insurance. In time reinsurance came along as a way to diversify risk. Then some insurance companies started insuring lower quality, low-rated or non-rate debt. Finally, before the financial markets went sour, some insurance companies started guaranteeing asset-backed securities, residential mortgage-back securities and collateralized debt obligations (CDOs). Of course, you all know how that went. In 2008 companies that had insured these kinds of debts, especially CDOs thast started seeing their ratings getting downgraded as some of their insured debt was deteriorating. The result was huge losses for the bond insurers which led to bankruptcies and consolidations within the market. These consolidations are far from over and there are some litigation cases originating out of insured bonds where the original covenant had been violated.
Business and financials
Assured came out as a struggling survivor after the financial crisis. Not exposed to the CDOs that brought down most of the Monolines, they bought Financial Security Assurance and the bond insurance part of Financial Security Assurance Holdings in 2009. Last year they bought Municipal and Infrastructure Assurance Corporation (MiAC) in a deal which also included taking over a $12.9 billion reinsurance portfolio. However, business has been diminishing the last few years and the company recently got downgraded again. At the same time many municipalities have been upgraded, further diminishing the possible market for Assured. The low interest rate environment together with tight spreads is also reducing the total market for bond insurance, since it takes away most of the savings in yield, which would typically save the issuer some financing cost. On the positive side the company reached a settlement with Bank of America in 2011 and won a lawsuit against Flagstar in February which counters some of the losses of the insured RMBS going bad. Furthermore the company is in the process of going through the rest of its RMBS portfolio to see if there are more breaches that could force existing contracts into execution. And since the Flagstar lawsuit, breaching counterparties should be more eager to settle.
Assured Guaranty Inc. has stated that they are going to rename the acquired company MiAC to MAC and use it as a muni-only platform, they expect to start selling business within the new company later this year. As of last year they wrote approximately 30% of all the A-rated issuance. But if you look at the graph of the premiums received it's still a diminishing business.
However, it's still a company with positive net operating income.
And a low, but still positive EPS.
And also trading below book value per share.
Just by looking at the financials and the industry one can draw the conclusion that the total market for bond insurance is currently diminishing and the company is doing mediocre. But why then has the stock moved up 50% since the start of the year?
Well there has been three major triggers since the start of the year. First, the announcement to buy back shares for $200 million. Second, the positive verdict from the Flagstar lawsuit. Third, the announcement to raise the dividend with 11.1%. Besides from these three factors the company has found some intelligent ways to create economic value for stockholders besides from signing new business. The company has done three interesting things as explained by CEO Dominic J.Frederico in a presentation as JPMorgan's 2013 Insurance Conference (transcript).
First and foremost they have bought back some of their own insured securities where they have found it trading lower than their own expectation of the value. In the extent that there is a loss embedded in the trade they take away the loss and thus lower their reserves. It also puts an asset on the books that has a future value that will amass up to the company's expectations. The second thing they have done is to target deals with no economic loss to the counterparty but which had a capital charge to Assured and therefore negotiated a settlement on that deal, which essentially lowered the capital requirements of the company. According to the transcript they have done so by keeping some of the economics which also meant that they could realize some accelerated earnings. The third thing is that they will keep on going through the RMBS portfolio which could see some more settlements in the future. So what can we expect going forward?
- The company stated that the $200 million buyback was an initial share repurchase. When cash flow will allow it, the company might buy back more.
- Recently downgraded by Moody's, the company is trying hard to get back into their good graces, doing smart moves - lowering their overall capital requirements will most certainly help. The downgrade was unjustified by many, so look for upgrades in the future.
- Rebranding MiAC to MAC and making it Assured's only muni-platform might bring in some new business in the later parts of the year.
- Higher dividend, the company has raised its dividend by 122% the last 15 months and expects to raise it even more in the future.
- The company is working on settlements with two major counterparties and 3 smaller counterparties.
Is it a buy at current levels?
Even though future earnings from the bond insurance business are uncertain the company has proven that it can create economic value for its investors by buying back bonds and negotiating settlements. Given that the company currently trades under its book value, has a 1.91% dividend and has plenty of triggers that could possibly send this stock flying even higher, it is definitely a buy in my opinion.