CNO Financial Group

1Business Description

CNO Financial Group Inc., develops, markets, and administers health insurance and individual life insurance for senior and middle-income markets in the United States. It operates through different segments: Bankers Life, Washington National, Colonial Penn, and Long-Term Care in Run Off segments. The Bankers Life segment markets and distributes Medicare supplement insurance, interest-sensitive and traditional life insurance, fixed annuities, and long-term care insurance products; and Medicare advantage and prescription drug plan products through various distribution and marketing agreements. The Washington National segment markets and distributes supplemental health insurance, including specified disease, accident, and hospital indemnity insurance products; and life insurance at home and the worksite through independent marketing organizations and insurance agencies. The Colonial Penn segment primarily markets graded benefit and simplified issue life insurance directly to customers through television advertising, direct mail, the Internet, and telemarketing. The Long-Term Care in Run Off segment engages in the long-term care business. The company sells its products through career agents, independent producers, and direct marketing. CNO Financial Group, Inc. was founded in 1979 and is headquartered in Carmel, Indiana.


Buy Candidate Analysis

Insurance industry is one of those sectors that stand to gain from high interest rates. The insurers’ top line consist primarily of two components – premiums earned from customers and net investment income generated from the float (premiums collected that would be used to pay out claims in the future) invested by insurance companies. Insurance companies invest the funds from premiums earned to generate investment income. Insurers primarily utilize their surplus fund for safe investments, such as bonds. Investors should note that increases in rates by the Fed lead to rise in yields and coupons on these bonds. An increasing interest rates allows insurers to invest their funds at high yields and earn higher investment income

In the last decade, insurers witnessed a dent in their top line due to low investment income as investment yield declined due to low interest rates. However, the sector is looking to profit as companies in this space benefit from the hike in interest rates since it will lead to improvement in bond yields. Insurers can then invest their premiums and receive higher returns, which in turn, results in higher investment income. Apart from investment component, the hike also helps these companies’ base long-term average rates to fix premiums, as lower rates hurt the bottom line, especially in annuities.

2

Interest Rate Level Forecast

Interest rates and the debate of their movement are the most debated topics over the last couple years. The persistent low interest rate environment has had a notable impact on many segments of the economy, including the life insurance industry. Interest rates have declined significantly over the past several years in response to the 2007-2008 global financial crisis. Low interest rates are identified as a major threat for life insurance companies, given their rate-sensitive products and investments.

Overall, interest rates jumped after the presidential election because of the prospects for higher deficits and higher inflation, spurred by Trump’s tax and spending proposals. However, uncertainty exists over how much of his program will be adopted, when it will be adopted and how it will be paid for. This has caused the 10-year Treasury rate to meander up and down so far this year. However, it is highly likely that sometime in 2017, it will become clear to bond markets that both the deficit and inflation are headed higher.

The Federal Reserve raised interest rates by 25 bps in its December meeting and another 25 bps in its most recent March meeting. The Fed has only raised interest rates three times since 2006. The hikes, which have been highly anticipated by financial markets, takes the overnight funds rate to a target range of 0.75 percent to 1 percent and sets the Fed on a likely path of regular hikes. All but one member of the Federal Open Market Committee agreed in March with the decision to increase the federal funds rate. The disagreement came from Neel Kashkari, president and CEO at the Federal Reserve Bank of Minneapolis, as he saw the move as premature until further evidence of labor market tightening and inflation rates. Members of the FOMC predicted two more hikes in 2017 and three in 2018, and considered that only gradual rate hikes in the future would be appropriate.

CME Group’s “Fed-Watch” tool shows a 10.5% expectation that the fed will keep interest rates in the 75-100 bps range, a 35.4% probability of raising to 100-125 bps, a 37.1% probability of raising to 125-150, a 14.8% probability of raising to 150-175 bps and 2% probability of reaching the 175-200 bps levels through December. The market currently gives a 54% percent chance that the Fed will meet their prediction of two more moves this year, which would take the funds rate to the 125 to 150 bps range from the current 75 to 100 bps level. While there is considerable uncertainty about how much inflation will pick up due to higher energy prices and the ultimate economic impact of Trump spending policies, the trend in rates will be upward in the near term. Thus I, like the market, predict two more rate hikes of 25 bps each by the end of the year, which would take us to the 125-150 bps level.

2nd lat

Swap Rationale

The fixed income fund’s position in Clear Channel is risky, as it is low rated and in the publishing and broadcasting sector. The companies yield does not fluctuate higher or lower than 7% to 4%. The company is currently on the lower end of the spread with a yield of 4.61%, which means the company has ended its profitable return for the portfolio. My bond has a modified duration 6.30, compared to clear channel’s duration of 3.21. If we want to maximize our total return we must bare additional interest rate risk. Looking at historical yields, CCO’s yield has decreased since 2015, and even though CNO’s yield has remained stable since it was first offered, it will start to drop as financials gain momentum from rising rates. CNO, in the Life Insurance sector, has more potential to decrease its yield for a positive swap profit. My expectations of interest rates rising by 50 bps within the workout period signals that my bonds yield will shift in negative directions. The US treasury will continue to increase as the economy continues to pick up under Trump. I believe that this is reflected in the markets performance of 5.21% year to date. The overall portfolio duration is positioned at around 3.21 and if the switch is passed it will increase it to 3.60. Based off my regression, CNO’s current yield of 4.86 will drop 25 bps, and CCO’s yield of 4.42 will increase by 58 bps. CNO’s downward trend will provide an excellent return for the portfolio.

3

Regression Analysis

I conducted a regression analysis comparing the movements of the US-10 Year Treasury, and the S&P 500 historical to my buy candidate’s, CNO Financial Group, historical yield. I also compared the same variables to my sell candidate’s, Clear Channel, historical yield. The results are listed as below:

Regression Statistics
R-squared 0.139115
Std. Dev. estimate 0.241907
Observations 359

 

Input variables Coefficient Std. Error t- Stat P-value
Intercept 4.864097 0.077901 62.43911 1.3E-165
10 Year Treasury -0.08808 0.039061 -2.25485 0.024921
S&P 500 1.275546 2.195198 0.581062 0.561669

 

Yield Level CNO = 4.86 + (-0.08808 * 3% 10Y Treasury) – (4.850 CNO YTM)

Yield Level CNO = –25 bps

Regression Statistics
R Square 0.078539
Std. Dev. estimate 0.692715
Observations 359

 

Input Variables Coefficient Standard Error t-Stat P-value
Intercept 6.573441 0.215195 30.54639 2.9E-101
10 Year Treasury -0.14347 0.106354 -1.34901 0.178197
S&P 500 -2.8501 4.602672 -0.61923 0.536164

 

Yield Change CCO = 6.57 + (-0.14347 * 3% 10Y Treasury) – (5.558 CCO YTM)

Yield Change CCO = +58 bps

 

Based on my analysis, I expect the 10 Year Treasury to increase to 3% through our workout period, and the S&P 500 to return 8%. According to my regression, CNO’s yield will drop by 25 bps and CCO’s yield will increase by 58 bps. The company will be able to filter down its bonds yields due to rising interest rates which allow insurers to invest funds at higher yields and earn higher investment income. The company delivered positive surprises in three of its last four quarters, with an earnings surprise of 25% for the last quarter of 2016, which goes to show the positive outlook for the company. As evidence below, if the estimated scenario occurred, the portfolio would see a pickup of 204 bps. The applied regression results in the Horizon Return function on bloomberg gave me the following results:

Sector Spread

The proposed swap would take us out of Clear Channel’s communications sector and place us in the Life Insurance/Financials sector. As you can see the graph curve tenor between the financials rated BB+ and the communications rated B is widespread, as Communications have an average yield of 5.25 and Financials have an average yield of 4.51. They have moved quite similar to each other over the past year. More recently they have begun to close the spread are currently 0.74 basis points apart. I believe that the spread between the BB+ Financial sector and the B communications sector will continue to drop. This will definitely benefit the future portfolio.

Yield Curve for CNO

I also utilized Bloomberg’s Fair Value function to find CNO’s fair value when compared with the USD Financials BB+ Financial Index. This resulted in a spread of 107 basis points. You can see below the spread between the bond and its industry rating.

Mispricing = 107 bps spread

6

Yield Curve for CCO

7

I again utilized Bloomberg’s Fair Value function to find CCO’s fair value when compared with the USD United States B Communications Index. This resulted in a spread of negative -99.4 basis points. This indicates that CCO’s bond is overvalued compared to the industry’s credit rating. Below, you can see the spread between the bond and its peers in the communication industry.

Mispricing = -99.4 bps spread

Mispricing Change

After looking at the mispricing from the yield curves I applied this to both my buy and sell bond. This gave me a total of a 617 bps pick up after entering my regression results into the Horizon Return calculator on Bloomberg.

 

Mispricing BPS Pickup
No Change -13
IGT & AYR Change 617
Average 302

 

Spread Summary 

Below you can see the spread summary between CCO and CNO. Over the past year, the spread has continued to enlarge, however just recently the spread is beginning to tighten as yield for life insurance companies move downward. The narrowing of the spread is occurring due to rising interest rates due to deregulation and spending on behalf of the government. The swap to the financial sector will provide an astounding swap profit.

 Interest Rate Stress Test

Interest rates will play an important part in the pricing of bonds. To examine this, I conducted multiple interest rate stress tests to determine the sensitivity of each bond on different interest rate levels and more specifically how much bps pickup or loss we would incur according to the shift. I went about this process by utilizing the Fixed Income Horizon Analysis found on Bloomberg. I tested 50 different combinations of interest rate movement and determined the new yield of each bond, the dollar profit or loss and finally the basis point pick up or loss from the swap. I stressed in increments of 25 bps in each direction up to 75 basis points for each bond as well as workout date to fit into that of our investment policy statement. The results of this interest rate stress test can be found in the table below:

 

CNO CCO Spread CNO YTM CCO YTM Net P/L BPS Pickup
No Move No Move 43.97 4.8604 4.4207 $            (1,071.00) -13
No Move Down 25 68.97 4.8604 4.1707 $            (1,252.00) -16
No Move Down 50 93.97 4.8604 3.9207 $            (1,432.00) -18
No Move Down 75 118.97 4.8604 3.6707 $              1,613.00 -20
No Move Up 25 18.97 4.8604 4.6707 $                (891.00) -11
No Move Up 50 -6.03 4.8604 4.9207 $                (711.00) -9
No Move Up 75 -31.03 4.8604 5.1707 $                (900.00) -11
Up 25 No Move 68.97 5.1104 4.4207 $          (14,137.00) -182
Up 25 Down 25 93.97 5.1104 4.1707 $          (16,469.00) -212
Up 25 Down 50 118.97 5.1104 3.9207 $          (16,469.00) -212
Up 25 Down 75 143.97 5.1104 3.6707 $          (16,649.00) -215
Up 25 Up 25 43.97 5.1104 4.6707 $          (15,928.00) -205
Up 25 Up 50 18.97 5.1104 4.9207 $          (15,747.00) -203
Up 25 Up 75 -6.03 5.1104 5.1707 $          (14,137.00) -182
Up 50 No Move 93.97 5.3604 4.4207 $          (31,131.00) -403
Up 50 Down 25 118.97 5.3604 4.1707 $          (31,309.00) -405
Up 50 Down 50 143.97 5.3604 3.9207 $          (31,490.00) -407
Up 50 Down 75 168.97 5.3604 3.6707 $          (31,670.00) -410
Up 50 Up 25 68.97 5.3604 4.6707 $          (30,949.00) -400
Up 50 Up 50 43.97 5.3604 4.9207 $          (30,768.00) -398
Up 50 Up 75 18.97 5.3604 5.1707 $          (29,131.00) -377
Up 75 No Move 118.97 5.6104 4.4207 $          (46,066.00) -597
Up 75 Down 25 143.97 5.6104 4.1707 $          (46,246.00) -600
Up 75 Down 50 168.97 5.6104 3.9207 $          (46,426.00) -602
Up 75 Down 75 193.97 5.6104 3.6707 $          (46,607.00) -605
Up 75 Up 25 93.97 5.6104 4.6707 $          (45,896.00) -597
Up 75 Up 50 68.97 5.6104 4.9207 $          (45,716.00) -595
Up 75 Up 75 43.97 5.6104 5.1707 $          (44,092.00) -574
Down 25 No Move 18.97 4.6104 4.4207 $            14,225.00 183
Down 25 Down 25 43.97 4.6104 4.1707 $            14,044.00 181
Down 25 Down 50 68.97 4.6104 3.9207 $            13,864.00 179
Down 25 Down 75 93.97 4.6104 3.6707 $            13,683.00 176
Down 25 Up 25 -6.03 4.6104 4.6707 $            14,405.00 186
Down 25 Up 50 -31.03 4.6104 4.9207 $            14,585.00 188
Down 25 Up 58 -115.70 4.6069 5.7595 $            21,324.00 204
Down 25 Up 75 -56.03 4.6104 5.1707 $            16,209.00 209
Down 50 No Move -6.03 4.3604 4.4207 $            29,801.00 384
Down 50 Down 25 18.97 4.3604 4.1707 $            29,621.00 381
Down 50 Down 50 43.97 4.3604 3.9207 $            29,441.00 379
Down 50 Down 75 68.97 4.3604 3.6707 $            29,260.00 377
Down 50 Up 25 -31.03 4.3604 4.6707 $            29,982.00 386
Down 50 Up 50 -56.03 4.3604 4.9207 $            30,162.00 388
Down 50 Up 75 -81.03 4.3604 5.1707 $            31,786.00 409
Down 75 No Move -31.03 4.1104 4.4207 $            45,656.00 587
Down 75 Down 25 -6.03 4.1104 4.1707 $            45,476.00 584
Down 75 Down 50 18.97 4.1104 3.9207 $            45,295.00 582
Down 75 Down 75 43.97 4.1104 3.6707 $            45,115.00 580
Down 75 Up 25 -56.03 4.1104 4.6707 $            45,837.00 589
Down 75 Up 50 -81.03 4.1104 4.9207 $            46,017.00 591
Down 75 Up 75 -106 4.1104 5.1707 $            47,641.00 612

 

After reviewing the test I found that the proposed swap produces positive basis point pick up 44% of the time when stressed under different interest rate scenarios. Under my most anticipated scenario, CNO’s YTM would decrease 25 basis points and CCO’s YTM would increase by 58 bps. This scenario resulted in a 204 basis point pickup or $21,324 profit. Although, the average dollar profit and bps pickup through the stress test is negative, the results produce a positive return every time that CNO’s yield decreases, which is the most likely scenario under rising rates. The greatest basis point pick up would be 612 bps pick up (CNO -75, CCO +75), while the largest lost would be -605 bps (CNO +75, CCO -75). CNO’s bond is a strong contender to increase our overall portfolio’s total return during the workout period given the forecasted interest rate environment.

Source of Swap Profit

My regression analysis suggested a 204 bps pickup, it is important to investigate where that pickup will come from and what amount comes from each source. I analyzed four sources of return for my swap including interest rate risk, sector risk, credit risk and mispricing. The sum of these criteria gives me the overall basis point pickup of 204 that I will illustrate in the tables below.

BPS Pickup = Interest Rate + Sector + Credit + Mispricing

Credit Rating Stress Test -221

I conducted a credit rating stress test to determine the capital loss the portfolio would incur if CNO downgraded after our purchase. The scenario would be if after IGT was purchased it was downgraded four ratings from BB+ to B, which is the current rating on CCO. The comparable bond in the industry is Genworth Financial. CNO credit rating remains stable, and was reaffirmed by the S&P in October of 2016, as they believe CNO is able to reflect capital adequacy and earnings capabilities of its plan to recapture its closed block long-term care insurance business. Since it was recently reviewed, there is a small probability that the bond will default or get downgraded during our workout period. Also CNO’s debt is stable as their operational cash flow is expected to grow due to rising interest rates, which provide higher premiums on investment.

CNO Financial Group Company Genworth Financial
5.25 Coupon 4.8
05/30/2025 Maturity 2/15/2024
4.86 YTM 8.26
6.30 Modified Duration 5.52
0.48 Convexity 0.37
$103.46 Price $82.16
BB+ Rating (S&P) B
Callable Optionality Callable
Life Insurance Sector Life Insurance
BPS Pickup -221

 Below is the credit spread between United States BB+ Financial Index and United States BB Financial Index. As proven in the graph, the spread between the two ratings remains relatively stable. The financial sector will continue to drop yield as interest rates rise.  Higher rates create a better environment for Life Insurance companies, as higher rates increase top line revenues. I believe that in order to generate returns for the portfolio, we must reduce our credit risk as lower rated bonds will increase their yield dramatically as rates rise. I expect for the spread between a BB+ and BB bonds to continue to tighten and decrease for the near future.

Interest Rate Pickup: +237

To find the interest rate pickup I found several bonds with close to identical characteristics in terms of rating, optionality and sector to that of Clear Channel, but changed the duration from 3.21 to bonds with similar duration to that of CNO at 6.30. Longer duration in a rising interest rate environment will be beneficial to the portfolio as life insurance companies’ benefit from higher rates. This simulation resulted in an average bps pick up of 237, as shown below

Sell Candidate Buy Candidate Buy Candidate
Clear Channel Company Colombia Comm. McClatchy Co/The
6.50% Coupon 8.5% 9%
11/15/2022 Maturity Perpetual 12/15/2022
5.52% YTM 8.82% 7.45%
3.22 Modified Duration 2.58 4.61
0.13 Convexity 0.08 0.57
$103.25 Price $101.20 $103.60
B Rating (S&P) B B
Callable Optionality Callable Callable
Communications Sector Communications Communications
Basis Point Pickup 253 221
Average BPS 237

 

Sector Risk: +294

I also analyzed the sector risk pickup swapping from the Publishing & Broadcasting Sector to the Life Insurance Sector. The portfolio would benefit from the Life Insurance sector due to the fall in yields caused by rising interest rates. I compared CCO’s bond to Genworth Holdings bond, which has a similar duration, same rating, and same optionality, but in the Life Insurance Sector. By performing this analysis, I found that the portfolio would gain 294 bps from switching into the Life Insurance Sector.

Sell Candidate Buy Candidate
Clear Channel Company Genworth Holdings
6.5 Coupon 7.62
1/15/2022 Maturity 9/24/21
4.42 YTM 5.97
3.21 Modified Duration 3.66
0.13 Convexity  0.16
$103.94  Price $95.11
B Rating (S&P) B
Callable Optionality Callable
Publishing & Broadcasting Sector Life Insurance
Basis Point Pickup 294

 

Mispricing Pickup: -106

CNO’s bond is undervalued, while Clear Channel’s bond is essentially at its selling point. The mispricing bps pickup is found from subtracting the other pickups. If CNO’s bond yield was to decrease as it is expected to, then the portfolio would be in an excellent position to experience positive returns.

 

BPS Pickup Interest Rate Sector Credit Mispricing
204 = +237 +294 -221 -106

 

Callability Schedule 

CNO’s bond first becomes callable on February of 2025 at the price of $100, which is approximately $4 below its current price. That is the only call option, after that the bond matures on May 30, 2015.

 

Credit Analysis

It is essential to look into financial stability of CNO when considering swapping into a position for our portfolio. The company experienced an increase in top line revenue of 4% over the last year.  Net Income increased by 32% in 2016, from $270M in 2015. CNO shares have also recently gained momentum. Year to date, the stock has gained 5.2%, outpacing the Insurance industry’s increase of 0.46%. This outperformance reflects shareholders’ confidence on this company. The positive outlook is attributed to the company’s prudent capital deployment like share repurchases and dividend payment.

The company has been delivering strong top-line performance over the last few quarters. CNO Financial also plans to restructure its field leadership and introduce technologically updated products to boost agent productivity in this particular segment. CNO’s strong cash position reassures that the company will make their payments while enhancing operating efficiencies and customer retention. The stock appears to be undervalued. Its Price to Cash flow (PCF) ratio of 4.26 is lower than the industry level of 6.57. Another important valuation ratio is Price to Sales (PS) of 0.88 is lower than the industry average of 0.95.

S&P Global Ratings recently re-affirmed the ‘BB+’ long-term credit rating on CNO Financial Group Inc. bonds as of October of 2016. The ratings agency stated their main concerns were the company’s over dependence on debt as it raises borrowing costs, which limits profitability. CNO owns small market share, which creates tremendous challenges in some product lines, such as life insurance and fixed annuities. Despite holding the ninth position in the list of the top writers in the individual long-term care insurance business, the company has been unable to grow it market share above 3%. This may limit business opportunities for CNO Financial. Another problem is CNO’s commitment to inject $200 million of capital into its operating subsidiaries with a goal of maintaining a 450% consolidated RBC (Risk based Capital) ratio, and its commitment to suspend share repurchases through the remainder of the year. However, the S&P ratings agency said that if anything the next credit rating would be in 18-24 months, which is past our workout period.

Company CNO Life Insurance CCO Communications
Total Debt $4.22 Billion N/A $8.75 Billion 883.99 Million
Debt/Equity 94.12% 31.12% 70.53%
Current Ratio 8.36 10.31 2.09 1.54
ROA 1.15% 0.83% 2.35% 2.60%
Profit Margin 23.5% 12.61% 13.90 13.97

Conclusion

CNO Financial Group. (NYSE: CNO) is middle-income America’s valued financial security partner. They provide health and life insurance, as well as retirement solutions, to middle-income Americans through their insurance brands: Bankers Life, Colonial Penn and Washington National. The company and the industry tends to struggle in low interest rate environments, however, I believe they will prosper under rising interest rates, which will make CNO’s bond yield continue to fall as most of the fixed income securities yield rise with rates.  Switching to the financial sector will also generate profit for the portfolio, as they are expected to be the biggest winners. CNO’s better rating and longer duration will also benefit the portfolio as we leave the junk bond environment. The swap will earn 204 bps pick up if CNO’s yield decreases by 25 bps, and CCO’s yield increases by 58 bps. Therefore, I recommend the Roland George Investments Program to swap its position in the Clear

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