2018 was a great year for AmTrust Financial Services Inc. shareholders. The common stock rallied as the company was taken private. The AmTrust baby bond and preferred stock holders were not as fortunate. The privatization and subsequent delisting caused a selloff in these issues. This article is focused on the AmTrust baby bonds. I have provided 10 reasons why income investors should consider the baby bonds. The major risk factors are also highlighted.
The baby bonds
AmTrust Financial Services 7.25% Sub Notes AmTrust Financial Services 7. AmTrust Financial Services 7.25% Sub Notes AmTrust Financial Services 7.25% Sub Notes (NYSE:AFFS) is a par $25 7.25% subordinated note maturing on 6/15/2055. Interest is paid quarterly on 3/15, 6/15, 9/15 and 12/15 to holders of record on 3/1, 6/1, 9/1 and 12/1. Note that the x-dividend date is one business day prior to the record date. AFFS now yields 10.3% at a recent price of $17.55. AFFS may be called at par starting on 6/18/2020. There are 6 million shares or $150 million par value of AFFS outstanding. See prospectus for additional details.
AmTrust Financial Services, 7.50% Subordinated Notes due 9/15/2055 (OTCPK:AFFT) is a $25 7.50% subordinated note maturing on 9/15/2055. AFFT has the same payment dates, record dates and x-dividend dates as AFFS. AFFT now yields 10.3% at a recent price of $18.20. AFFT may be called at par starting on 9/16/2020. There are 5.4 million shares or $135 million par value of AFFT outstanding. See prospectus for additional details.
AFFS and AFFT are equal in seniority and both now trade on the pink sheets. Daily volume is typically 15,000 - 30,000 shares. Use patience and limit orders when trading. The bid/ask spread is now typically somewhat wider than when the issues were NYSE listed. While pink sheet trading is a little more difficult, this should not be a major deterrent for yield seeking bargain hunters. AFFS traded as high as $24.99 as recently as 9/6/2018. The higher coupon AFFT traded as high as $25.78 on 9/7/2018. Note that credit quality (as measured by the A- A.M. Best Rating) has not changed since September 2018. Many investors are unable or unwilling to own pink sheet issues. Pink sheet issues are not marginable in most brokerage accounts.
Possibility of an early call for the baby bonds
While there is certainly no guarantee that either AFFS or AFFT will be called early, both issues do have relatively high coupons. An early call is certainly possible if the new owners focus on further deleveraging the balance sheet. As a private company, AmTrust faces less pressure to immediately pay dividends to equity holders and could choose to retain more capital. AmTrust now has a very strong financial backer (see item #2) and may have access to cheaper capital. Since both AFFS and AFFT are trading at a large discount to par, an early call at $25 would result in quite a windfall for those buying at current prices.
AmTrust could also repurchase some of the AFFS/AFFT baby bonds on the open market. However, this would be difficult given the fairly low average trading volumes of these pink sheet issues. I believe that the prices would tend to appreciate quickly towards par if substantial quantities were repurchased in this manner.
The 2023 notes
The AmTrust senior unsecured 6.125% notes trade on the bond market (CUSIP 032359AE1). They have a 6.125% coupon and mature on 8/15/2023. The notes now offer a 7.8% yield to maturity at a recent price of $93.95. There is $250 million par value of the notes outstanding and they would rank ahead of AFFS and AFFT in the very unlikely event of an AmTrust bankruptcy. The 2023 notes traded above par 100 as recently as 9/27/2018. Note that credit quality (as measured by the A- A.M. Best Rating) has not changed since September 2018.
The 2023 notes traded as low as $83 on 1/2/2019 and have been rebounding back towards par since then. Many high yield issues sold off in December. I believe that the decision to go private also caused some forced selling in the bonds. Some institutional investors may be unable or unwilling to own private company bonds where disclosure requirements are lower.
The preferred stock issues
AmTrust has 6 non-cumulative par $25 perpetual preferred stock issues with a total par value of $915 million. These now trade on the pink sheets as AMTRUST FINCL SVCS PFD A (OTCPK:AFSIA), AMTRUST FINCL D/S PFD F (OTCPK:AFSIN), AMTRUST FINCL D/S PFD B (OTCPK:AFSIB), AMTRUST FINCL D/S PFD D (OTCPK:AFSIP), AMTRUST FINCL D/S PFD C (OTCPK:AFSIC) and AMTRUST FINCL D/S PFD E (OTCPK:AFSIM). See QuantumOnline.com for the details of each issue including the coupons and record dates.
So far AmTrust has continued to pay dividends on these deeply discounted preferred stock issues. However, there is speculation that the privatization could make it easier to suspend the non-cumulative preferred dividends. AmTrust could easily decide to retain more capital by suspending dividends to private equity holders as well as preferred stock holders for a few years. Preferred stock holders would be entitled to elect 2 Directors after 6 dividends were skipped.
On 1/18/2019 AmTrust announced its intent to voluntarily delist the baby bond and preferred stock issues. This was quite a surprise to investors. The company had previously reported that it was planning to maintain its NYSE listings and the related SEC reporting requirements. The baby bonds and preferred stock issues were delisted on 2/7/2019 and began trading on the pink sheets shortly thereafter.
The delisting lawsuit
Keefe, Bruyette & Woods, Inc. (NYSE:KBW) was one of the underwriters for the AmTrust baby bond and preferred stock issues. KBW believes that the unexpected delisting of the AmTrust issues has harmed investors as well as their reputation as an underwriter. They have filed a N.Y State lawsuit in an effort to challenge the delisting. Seeking Alpha author Jan Martinek recently wrote two excellent articles about activist efforts to fight the delisting. Her articles are available here and here.
Comparison to the delisted Phoenix baby bonds
The Phoenix Companies Inc. was a public insurance company that was taken private by Nassau Re in 2015. A lawsuit was filed by Phoenix baby bond investors in an effort to ensure continued access to the quarterly earnings reports. It was eventually agreed that Phoenix would continue to provide baby bond investors with access to the earnings reports subject to a non-disclosure agreement. I believe that we may see a similar outcome for AmTrust.
Note that the par $25 Phoenix 7.45% baby bonds maturing on 1/15/2032 are now trading on the bond market (CUSIP 71902E208) at a recent price of $16.37. Phoenix carries an A.M. Best rating of B (fair) and is more difficult to trade than AFFS/AFFT.
How can investors track credit risk?
As a private company, it is unclear whether or not AmTrust will continue to make quarterly earnings reports and financials available to the general public. This may depend on the outcome of the lawsuit (see above). However, this should not be a major concern for baby bond investors. A.M. Best will continue to have access to the financials and provide timely balance sheet financial strength ratings. Investors can easily monitor AmTrust credit risk just by watching for any changes to the A- rating (see item #1).
1. AmTrust has an A- rating from A.M. Best
A.M. Best is widely known and well respected for their focus on rating insurance companies. A.M. Best issued an A- (Excellent) rating to AmTrust on 7/3/2018 with a stable outlook. A.M. best categorizes AmTrust's balance sheet as "very strong". AmTrust has continued to maintain this A- rating. Note that the A- rating applies to insurance policies issued by AmTrust. Corporate debt obligations are junior to insurance obligations and the corporate debt rating is slightly lower.
2. Solid financial backing
AmTrust is now 55% owned by the Zyskind family and 45% owned by Stone Point Capital LLC. Stone Point Capital is a leading private equity group that manages about $5.5 billion in capital. This type of deep pocketed backing is important if additional capital is needed to grow AmTrust or maintain its financial strength.
3. Maintaining a strong balance sheet is critical for the new owners
Total revenues (see page #4 of the Q3 earnings report) were $5.2 billion for the nine months ended on 9/30/2018 as compared to $4.7 billion for the nine months ended on 9/30/2017. Much of AmTrust's value is derived from its strong growth prospects in key insurance niches. Maintaining or improving the A- rating from A.M. Best is a critical factor for continued growth. Consumers are highly motivated to buy insurance from a company with the financial strength to pay insurance claims.
As a private company, AmTrust can better focus on long term goal such as growth and increasing financial strength. Private equity investors typically have more patience and a longer term horizon as compared to public shareholders. Substantial pubic reporting and compliance costs have been eliminated. AmTrust may be able to focus on retaining capital rather than gratifying public shareholders with a high short term dividend payout.
4. The baby bonds are ahead of almost $4 billion in equity
The AFFS/AFFT baby bonds are senior to both the common and preferred stock equity. AmTrust was taken private on 11/29/2018 in a transaction that valued the common stock at $2.95 billion. This does not include 36.6 million shares of par $25 preferred stock with a combined par value of $915 million. It's very comforting for baby bond holders to be ahead of $3.87 billion of equity.
5. Asset sales and debt reductions strengthened the balance sheet
AmTrust sold some business units resulting in a gain of $716 million. This helped to strengthen the balance sheet and fund subsequent debt repurchases. The 11/29/2018 going private transaction was considered to be a fundamental change. As a result of this fundamental change, holders of the 5.50% Convertible Senior Notes due 2021 were able to tender their notes for repurchase. A similar tender offer was made to the holders of the 2.75% convertible senior notes due 2044.
6. New Reinsurance agreement reduces risk
Like many insurance companies, AmTrust is focused on selling insurance policies. Reinsurance agreements are used to reduce the risk of excessive policy claims. On 1/2/2019 AmTrust announced that it had signed a reinsurance agreement with Swiss Reinsurance America Corp for $2.9 billion in projected written premiums. This replaced a reinsurance agreement with struggling Maiden Hldgs Ltd (MHLD). As CEO Barry Zyskind commented:
"This reinsurance partnership for our U.S. small commercial business provides AmTrust with an AM Best A+ rated partner who we believe will deliver significant value beyond the strength of its balance sheet, and provide us enhanced capital flexibility. The opportunity to partner with Swiss Re on this quota share is a vote of confidence in the strength of the AmTrust franchise, and our core business supporting small businesses across the U.S."
7. Insurance is a recession resistant business
Many investors are concerned about the possibility of a U.S. recession over the next couple of years. Insurance is a non-cyclical and recession resistant business. This reduces the risk of the AFFS/AFFT baby bonds as compared to other high yield bonds in cyclical sectors such as shipping.
8. Insurance is highly regulated
Big U.S. insurance companies such as AmTrust rarely fail. Insurance is a very highly regulated business. Insurance regulators are focused on ensuring that insurance companies maintain sufficient assets to cover all potential policy claims. Regulators will limit distributions to equity holders as necessary in order to ensure that adequate capital is retained. Weaker insurance companies are often pressured by regulators into merging with stronger companies. This strong regulatory environment helps to reduce the credit risk of insurance company debt issues such as the AFFS and AFFT baby bonds.
9. The baby bonds are undervalued as compared to the 2023 notes
The 10.3% yields offered by the AFFS/AFFT baby bonds appear to be undervalued as compared to the 7.8% yield to maturity of the 2023 bonds. A yield differential of about 1% seems justified by the higher seniority of the 2023 notes. Some additional yield differential is justified by the longer 2055 maturities of the baby bonds. The 5 year Treasury rate is now 2.6% as compared to the 30 year Treasury rate of 3.1%. This suggests that a 0.5% yield differential is justified by the longer baby bond maturity. Therefore the AFFS/AFFT baby bonds should trade at about a 9.3% yield based on the current pricing of the 2023 bonds.
10. A three year total return of 65% is possible
In addition to offering a high yield with very moderate credit risk, there are several potential catalysts for the AFFS/AFFT baby bonds to trade higher. Both issues become callable in 2020. An early call or significant open market repurchases are possible for these high coupon issues. There is increased access to capital through Stone Point Capital (see item #2). The KBW litigation could help to resolve investor uncertainty about continued access to AmTrust financial reports. AFFS traded near par and AFFT traded above par as recently as September 2019. Both baby bond issues are already rebounding from the forced selling that was caused by the delisting process. Even if we assume that AFFT takes three years to rebound to par, this would result in a total 3 year return of 65% including interest and capital gains.
What are the major risks?
See page #20 - 37 of the 2017 10-K annual report for an extensive discussion of AmTrust risk factors. Risk factors specific to the AmTrust baby bonds are detailed on page #S-13 - S-15 of the AFFT prospectus. Here is a brief summary of the major risk factors as I see them. AFFS and AFFT mature in 2055. Long maturity debt issues have significant interest rate risk if interest rates rise over time. AmTrust has been subject to an SEC investigation over accounting errors and has had to restate some prior year financials. Going private should significantly reduce accounting and legal expenses related to this intensive SEC scrutiny and I believe that any further material restatements are unlikely. The AFFS/AFFT baby bonds are subordinated debt which makes them junior to senior debt as well as claims from insurance policy holders.
AmTrust was profitable in 2013, 2014, 2015 and 2016, but suffered a loss in 2017 (see page #41 of the 2017 annual report for details). AmTrust reported a $461 million profit for the 9 months ended on 9/30/2018. However, they would have been unprofitable if not for a gain from the sale of some business operations (see item #5).
The AmTrust privatization and subsequent delisting of the AFFS/AFFT baby bonds have created an excellent opportunity for high yield investors. The baby bonds offer yields in excess of 10% with only moderate credit risk. There are several potential catalysts for the baby bonds to trade higher as summarized in item #10.
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Disclosure: I am/we are long AFFS, AFFT. 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.
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