Challenger Financial junks guidance

One of Australia’s biggest investors in junk corporate bonds has thrown out its month-old profit guidance.

Challenger Financial Services Group CEO Richard Howes.

One of Australia’s biggest investors in junk corporate bonds, life insurance group Challenger, has thrown out its month-old profit guidance and warned of a deteriorating fixed income market amid the coronavirus sell-off.

Challenger, which sells longevity insurance products known as annuities to thousands of retirees, said the company was “well capitalised” and was “actively” managing its investment portfolio to maintain is “strong capital position”, telling shareholders in a letter on Monday it had $150 million in undrawn debt and $250m held in cash.

Shares in Challenger have collapsed more than 40 per cent since late February amid the coronavirus as the company faces significant pressure from low interest rates and fears of a wave of corporate debt defaults.

At the end of December, Challenger held $3.2 billion worth of sub-investment grade bonds, known as junk bonds — accounting for about a quarter of the group’s fixed income portfolio. The company also had $2.85bn worth of BBB-rated bonds, just one notch above junk status.

Challenger said spreads on investment grade fixed income spreads had more than tripled to beyond 140 bps, although it made no mention on the junk bond market, which has seen a sharp sell-off following a 30 per cent collapse in the oil price as about one-tenth of the high-yield debt market is issued by energy companies.

In February, Challenger said it would post a full year profit of close to $550m but on Monday said it would more likely fall “between $500m and $550m” to allow the company to “actively manage its portfolio through this market volatility”.

“Challenger is well placed to manage through the current market volatility,” chief executive Richard Howes said.

“Our active investment portfolio management together with the financial flexibility we have, allows us to remain well capitalised in changing and volatile investment market conditions,” Mr Howes said.

“Importantly, the investment market volatility has not impacted our customers who continue to enjoy guaranteed returns from their annuities regardless of these market movements.”

Two year ago, Challenger, Australia’s largest retirement annuities company, made a dramatic change in its appetite for risk, swapping out higher risk bonds for safer AAA and AA-rated credit investments, as it initiated a sharp selldown in Challenger’s property investments.

Annuities are a form of longevity insurance that helps to provide savers with income in retirement beyond average life expectancy and Challenger has been one of Australia’s fastest-growing and most successful companies in recent years.

Challenger still holds 50 per cent more prescribed capital than the prudential regulator’s rules require.

Challenger sells long-dated products that provide a guaranteed source of annual income for retirees and must find investments with yields that are high enough to pay these, while tempering risk so as not to jeopardise its financial position. With global interest rates at record lows, high yields have become riskier investments.

Exchange-traded funds tracking US high-yield corporate bonds notched up their biggest fall since the global financial crisis last week following the slide in energy prices triggered by the Saudi Arabia-Russia oil price war.

Banks and financial companies in Australia with exposure to risky corporate bonds were sold off heavily over the past two weeks, amid fears of a rise in bad debts.

Shaw and Partners analyst Brett Le Mesurier said Challenger is most adversely affected by lower interest rates because the low fixed returns on annuities are increasingly unattractive.

“Deteriorating credit markets add to the drama,” Me Le Mesurier said.

Mr Le Mesurier said Challenger’s fixed income portfolio was generating returns of 4.45 per cent, well above the average fixed interest yield of 3.75 per cent.

“This means that Challenger is achieving yields on new business which are 70 bps higher than observable market rates across its entire fixed interest portfolio,” he said.

“This raises questions about the credit quality of the assets they acquire. The credit markets are reasonably efficient at understanding risk and pricing accordingly. Equity markets do not have that skill.”