Seiya Tabuchi
Assured Guaranty (NYSE:AGO) continues to increase shareholder value led by its strong management team and leading position in the financial guaranty business. Bond insurance is not a sexy industry. The only real time when it is in the news is when there is a debt default, such as with Puerto Rico, Detroit, or the Financial Crisis. As a long-term investor, I’ve admired the way the company has handled these adversities and kept its eyes on growing per-share intrinsic value. I believe that long-term investors should continue to do well buying the stock at current levels, but I’d recommend a dollar-cost-averaging strategy as volatility from a weakening economy seems likely.
The bear case on AGO is that the business generates a low return on equity and the Puerto Rico debacle has been the black cloud hovering over the company for many years. While most of the defaulted debt has been addressed and restructured, the process has been brutal at every level. I don’t think history will look too fondly at the job the Federal Oversight Board has done, but the reality is we are in the last innings finally. Moving forward, the company won’t need to post additional reserves for Puerto Rico, which should lead to improved returns and a lower risk financial profile. Higher interest rates increase the attractiveness of bond insurance, while also allowing for higher investment income from the fixed income portfolio. A weakening global economy can pressure credit, but the company currently has the lowest below investment grade exposure in its insured portfolio that I can recall in its history. AGO’s foray into asset management produced mixed results including relatively consistent operating losses, but now should turn into a positive contributor to earnings and returns on equity moving forward.
In July, AGO completed its transactions with Sound Point Capital Management and Assured Healthcare Partners, which resulted in a $241MM pre-tax gain, net of expenses. These important deals not only monetized a mostly unprofitable division, but also allowed the company to secure a 30% stake in Sound Point, which management indicated was solidly profitable, with reports coming on a one quarter lagged basis. We will see how profitable the $46B money manager Sound Point is in subsequent quarters, but removing the losses from this division in itself is a nice positive, along with the gain from the sale. These moves should help boost returns on equity moving forward. AGO plans to invest a total of $1B in Sound Point managed alternative investments within two years, and the company committed $150MM to two Sound Point funds in Q3, and another $100MM since the end of Q3. As of September 30, AGO had $630MM in alternative investments, that since their inception have generated annualized returns of 12%.
On November 7th, AGO reported solid 3rd quarter results with adjusted operating income of $206MM, or $3.42 per share. The big driver of earnings was the gain from the sale to Sound Point. The insurance segment had operating income of $590MM, due to increased reserves for PREPA. AGO continues to grow adjusted book value per share and adjust operating shareholders’ equity per share to $148.03, and $99.18, respectively, both reaching record highs. The company returned to its stock cannibalistic ways, buying $64MM shares in the quarter, and the board of directors increased the repurchase authorization by $300MM. Management announced that they have requested a special dividend, which if approved, should bolster buyback capacity.
For the fourth consecutive year, PVP through the first three quarters exceeded $240MM, coming in at $249MM YTD. In U.S. Public Finance, YTD municipal bond par issuance was down 9% YoY, but the company still managed to achieve a nearly 10% increase in the par amount of bonds sold with its insurance, guaranteeing $14.1B for a 62% insured market share. AGO is the go-to company on large transactions, including $7.2B of par from 27 large transactions that each involved at least $100MM of insured par. The industry is maintaining steadily high insured penetration rates, with a rate of 8.5% on new issue par sold YTD, which is the highest in a decade, up from 7.8% at the same time last year. In Q3, despite par volume issued only being up by 3% YoY, AGO insured almost 50% more primary market par sold than at the same time last year. Higher rates not only increase the debt service amounts insured but also create a bigger need for bond insurance, especially as spreads widen. Issuers are desperate to keep debt costs as manageable as possible and bond insurance can be an affordable option to do so, while also increasing trading liquidity on the issues. The company is seeing increased interest in insurance on bonds with underlying double-A ratings, insuring roughly $2.8B through the first three quarters, up from $2.3B at the same point last year.
Management indicated that they are off to a good start in Q4, insuring three U.S. public finance transactions between $350MM and $750MM in just the month of October. The international public finance business produced $38MM in PVP YTD, but in Q4 the company is in the process of closing five transactions in the airport, water utility, higher education, and student accommodation sectors, with par totaling almost $600MM. In global structured finance, the company produced $82MM of PVP YTD, making 2023 the best year for direct structured finance since 2009, and the company has more deals lined up in Q4 to add to that. The diversification is a big advantage for AGO in that when one market is a bit slower, they can pick up business elsewhere. AGO has been very judicious in structured finance over the last 15 years but can pick up lucrative deals to help other companies with capital requirements etc., that carry a low risk profile.
After nearly a decade, the Puerto Rico debt saga is nearing an end in a disgraceful manner, with highly questionable legal rulings that jeopardize the underpinnings of our credit markets, such as questioning what constitutes secured debt. Every step has been a nightmare with the government, the Oversight Board, and the court. AGO’s last remaining non-paying Puerto Rico exposure is PREPA where there will be a contested plan of confirmation, that ultimately seems likely to go to an Appeals Court, if no consensual deal is made prior to approval. AGO has been materially increasing its loss reserves for PREPA, so I think the risk is very much mitigated at this point, so any real surprise would likely be on the upside. I don’t think the Title III court should feel confident that some of their key rulings won’t be successfully appealed so finding a consensual solution has always seemed like the best course of action. AGO has made material progress in reducing its below investment grade exposure in the insured portfolio, which now stands at just 2.1% of the portfolio, down from 4.6% in 2017. In Q3, S&P affirmed the company’s AA financial strength rating with a stable outlook on the insurance companies, and in October, KBRA affirmed its AA+ rating with a stable outlook.
At a recent price of $64.79, AGO trades at 65% of its operating book value and 44% of its adjusted operating book value per share. The company has a clear path to continue growing these metrics via stock buybacks at large discounts and retained earnings that should benefit from less Puerto Rico losses, and profitability from its 30% stake in Sound Point. Many market participants are focused on growing new business production and the opportunity is big there, but to be a successful investment AGO just needs to continue its fantastic capital management strategy, while posting solid insurance underwriting. I’d like to see the ROE get consistently over double-digits, but I believe the stock should trade around $75-$80 per share, which would still be a discount to the key book value metrics. As returns increase, that discount should shrink materially offering substantial upside potential long-term.
