Initiating coverage with Credit Sell on FWDINS 6.25% Perps

Deutsche Bank Markets Research Asia Hong Kong Corporate Credit Financials Company FWD Ltd. Date 14 March 2017 Initiating coverage with Credit Sell on FWDINS 6.25% Perps ________________________________________________________________________________________________________________ Deutsche Bank AG/Hong Kong DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016. Franco Lam Research Analyst (+852 ) 2203 6226 franco.lam@db.com Viacheslav Shilin, MBA Research Analyst (+65 ) 6423 5726 viacheslav.shilin@db.com Holds and Sells Bond Ask/Bid YTC (%) G-Spread (bp) Hold Bid Bid FWDINS 5% 24 104.2 4.3 185.5 Sell Bid Bid FWDINS 6.25% Perp 105.0 4.9 308.3 Source: Deutsche Bank, Bloomberg Finance LP Initiating coverage on FWD bonds – recommending Credit Sell on the perps We are initiating coverage of FWD bonds, with a Credit Sell on the newly issued 6.25% Perpetual (callable in January 2022, Ba1/BB+) USD250m bond and a Credit Hold on the USD325m 5% senior unsecured FWDINS 2024s (Baa2/BBB). Within the HY insurance space, we instead prefer the Asahi Life 7.25% Perp-cal-2022 bond, on which we recently initiated coverage with a Credit Buy <link to report>, as it appears to be one of the most undervalued perpetual bonds of a financial company in Asia. Relative comparison: Not pricing in the risk of being downgraded? FWD perps appear to be one of the best-performing bonds in Asian financial space YTD. Despite the relatively more attractive absolute YTC levels vs. IG peers, we believe that the bond’s outperformance has been overdone amid the hunt for yield and better familiarity with its brand by HK-based investors, together with their strong association with its main shareholder (Richard Li). In our view, at current 104.5 bid price and 5.19% bid YTC, the bonds are priced beyond their fundamentals and RV contexts alike, and we call for a 20-25bp YTC correction. Our view is based on the company’s short track-record, well-penetrated and competitive operating environment, high leverage, likely debt-financed future international expansion and tangible risk of a ratings downgrade. Within the comparable bonds in the Asia-Pac region, Asahi Life Pc22 bonds are currently trading at 110-160bp YTC differential vs. Japan-based IG peers, and we see a further ~30bp upside. Assuming 4.1-4.2% YTC for China Taiping Perp c-22, FWD Pc22 bonds trade at a ~85bp differential, as we believe ~100bp differential would be fairer. Fundamentals: Strong premium growth, more than offset by expenses The profitability profile looks weak, as the company lost ~USD16m in 1H16 (2015: loss of USD0.7m). FWD’s 27% CAGR in gross written premium (GWP) (in 2013-15) has been largely offset by (1) higher commission expenses at 14% of GWP vs. 7-10% for key China/Taiwan life insurers; and (2) limited contribution from investment income (1H16: account only 10% of operating income). FWD’s claims ratios and charges in reserves liabilities are also much higher than peers, at 113% of GWP and investment income together (Peers: 80-90%). Further, the majority of FWD’s investment is currently classified as available-for-sale (AFS), which is subject to MTM movement to book value. With higher rates ahead, we expect this to cause more volatility to its reserves, negatively affecting book value growth. Sector outlook: Size does matter! Despite being one of the highly penetrated markets, the insurance industry in HK has been growing at a healthy pace, with 10% total premium growth in 2015. While FWD’s growth has been much stronger than the system, its market share and ranking have been largely stagnant over the past 10 years as the bigger players continue to dominate. Moreover, the noticeable bancassurance tie-ups between the large insurance players in the region will likely make the industry even harder to penetrate going forward. The silver lining is that the interest rate cycle in the US is about to pick up, which on a positive side should alleviate further pressure in the cost of liabilities and possibly facilitate better investment returns. Upside risks: (a) pick-up in interest rates; (b) substantial reduction in commission expenses/benefits paid vs. peers; and (c) removal of negative outlooks (perps) or credit rating upgrades (’24). Downside risks: (a) change of shareholder’s control; (b) continued low interest rate environment; and (c) significant erosion of life insurance market shares Distributed on: 14/03/2017 09:00:00 GMTDistributed on: 14/03/2017 06:51:00 GMT 14 March 2017 Corporate Credit,Financials FWD Limited Page 2 Deutsche Bank AG/Hong Kong Structure and relative valuations of the bonds We are initiating coverag