Aflac: The Perfect Japanese Short?

| About: Aflac Incorporated (AFL)

In the June 2013 letter to his investors Kyle Bass wrote that the Japanese government is edging closer to the precipice and that either a default or, at best, a de-facto default through a bond price cap (triggering massive volatility and inflation), was setting up to occur within the next 18 months.

Although even he has admitted that it is impossible to predict the exact timeframe for when a default may happen, there are many reasons to agree with Bass, and others, about Japan. The reasons basically boil down to a fundamental belief that markets are rational and even though they are exhibiting irrational behavior at the moment, that eventually reason will prevail. In arguing that Japanese debt is an irrational investment, Bass and others point to the fact that Japan has the highest debt to income ratio, by far, of any country in the world (over 240% of GDP) and climbing rapidly; it is facing dramatic demographic shifts that are causing more people to rely more heavily on the government for services, which will raise government expenses - exacerbating the debt. On the revenue side, the birth rate is nil and immigration is nearly non-existent - meaning that fewer people are, and will be paying taxes. In short, the situation for the government is bad and likely to get much worse.

Despite all of this evidence, there is a school of thought that Japan will be able to deflect any debt crisis because they own the printing presses and can become the buyer of last resort for every Japanese Government Bond (JGB) issued. I think that theory is ludicrous as history is pretty full of countries who have tried to print their way to prosperity, including the Weimar Republic in post-WWI Germany, Argentina, Zimbabwe, Brazil, China and Nicaragua among many others. There are always going to be "experts" who say that this time and for a particular special reason things are different than they have always been - unfortunately for Japan I think history will show that this time will not be any different.

Assuming you are convinced about the possibility of a short term default in Japan, the question that begs to be answered is how best to position ones assets to avoid the most severe repercussions of such an event. If you happen to be a well-heeled investor, there are additional tools available that offer straight-forward protection against default, such as credit default swaps (CDS) that pay in the event of default. However, due to the high entry point required and the limited number of investors who can participate in that market (not to mention the large counter-party risk), I want to focus on how a retail investor can effectively hedge his or her exposure to the negative impacts a Japanese default would bring.

Interestingly, a few relatively new ETFs have popped up that offer retail investors the ability to go short either the Yen or JGBs. Some of these funds include: Powershares inverse JGB fund (NYSEARCA:JGBS), Powershares triple inverse JGB fund (NYSEARCA:JGBD), and Proshares ultra short (2x) yen fund (NYSEARCA:YCS). These funds seem to be decently run and volume has ticked up since their inception, but the fund managers themselves caution that these ETFs are only reliable during short term movements and could even reverse performance during periods of volatility. As it is highly likely that the default or inflationary event occurs nearly instantaneously via an announcement from Tokyo, I have a hard time putting complete trust in an investment that may reverse direction right when I need it to perform! So, with that in mind, I believe I have found another way to short the Japanese debt and/or currency markets, with what I expect will be much better results than the other funds mentioned. The investment is to short Aflac (NYSE:AFL).

Aflac is a Columbus, Georgia based insurance products company best known for its supplemental health, life and disability products - as well as its duck mascot. It becomes an interesting play once one realizes that its primary business is not in the US, but rather in Japan.

As of 2012, Japan brought in approximately 75% of all company revenue and a corresponding share of profit. The 75% share of sales doesn't tell the whole story though as the growth of the Japanese market has really exploded over the past few years for Aflac. In the chart below, which is taken from the 2012 annual report, total company assets are compared over the last ten years, with assets broken out between the Japanese division and the American division. As is readily apparent in the below chart, total asset growth has doubled since 2007, with the vast majority of the growth in the Japanese division.

Although sales in the Japanese division have decreased during the first part of 2013 from 2012 levels, the Japanese market is still expected to constitute the vast majority of revenue for the company. Additionally, since each division (US and Japan) manage their assets and liabilities in either dollars or yen (respectively) the bulk of the company's assets are, and will continue to be denominated primarily in yen.

This is a problem if one considers the constitution of the assets that the company owns. Due largely to regulatory requirements that mandate that insurance companies keep a significant portion of their investments in "safe" investments, much of Aflac's investment portfolio is invested in government securities, with the largest investment (nearly 40% of the total investment portfolio, or $48 Billion at year end 2012) in Japanese Government Bonds. Further billions are invested in companies that also heavily invest in JGBs, or are denominated in Yen, so the true exposure to the Japanese government is around $100 Billion (at year end 2012).

Obviously, with nearly $100 Billion in JGBs and other yen-denominated assets on the balance sheet a default by Japan on any of its debt would be disastrous for Aflac and would likely result in immediate bankruptcy and stock values moving overnight to zero. It is true that Aflac owns some hedges against default, but their positions would not begin to cover the losses sustained in a default environment (if they could even collect from their counter-parties). However, almost as bad for the overall portfolio would be a rise in interest rates.

In reviewing the management discussion and analysis section of the most recent Aflac 10Q there is a very interesting section on interest rate risk (page 80 of the referenced 10Q). According to the company, a hundred basis point increase in market interest rates (1% increase) would translate into a market loss of $13.5 Billion based off of held assets at year end 2012 and $12.1 Billion at the end of the second quarter 2013. Being that the total market capitalization of Aflac is $28.9 Billion, an interest rate increase of 1% would obviously have a substantial negative impact to the share price.

In my opinion, given the large possible move, but uncertainty regarding the timeframe for when that move may happen, my recommendation would be to buy far out of the money put options with long lead expiration dates. In looking at the quotes for the options expiring on January 17, 2015, there are put options with strikes of $25, $30, $33 and $35 that all could be potentially lucrative investments (stock price as of this writing is $62). Volume for these trades are light, but the current ask for the $25 strike price is $0.25. If there were to be a default or if there were to be a major rise in interest rates before January 17, 2015, there is a good chance that the stock price of AFL would drop to near $0. In the event that happened, the value of the $25 put option would be $25, meaning the return on investment would be 100 times the initial investment. With potential returns of that magnitude, this would be a good investment to roll over every six to twelve months and keep as a hedge against long positions held in retirement accounts or other investments.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in AFL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Problem with this article? Please tell us. Disagree with this article? .