Description

The ARGO Resettable Fixed Rate Preference Shares trade at a 16% discount to par, and 8.4% current yield. The unique nature of the preferreds presents a situation that is largely agnostic to the direction of interest rates and could produce a 14% CAGR over the next three years, particularly if it is called. While not exactly a tremendous upside, it should be fairly stable.

For some good background on the Bermuda-based P&C insurer ARGO, read this VIC write-up by unlatchmergers from 2020. I recently kicked the tires on it again but could not get excited enough to buy. The common stock could do well but it is a turn-around story as it has divested most of its international business to focus on the U.S. I hate turn-around stories, particularly in insurance where it takes longer to play out and show actual proof. That being said, there is value in the business and I believe that a bankruptcy would be a remote possibility. By chance, I happened to look at the ARGO baby bonds (ARGD) and the series A preferreds, and the preferred pricing was interesting.

A number of insurers issued preferred shares in recent years that had fixed yields under 6.0%, some in the mid 4s. Seeing those shares prices trade lower was not surprising, as those are almost like perpetual bonds. Even with the recent interest rate hikes, most of those are trading with current yields in the 6s. Meanwhile, ARGD trades at a current yield of 7.14% and almost 10% discount. You could argue that the baby bonds should trade higher due to being higher up in the capital structure but the reality with insurers is if the stock and preferred shares are toast, so are the notes. Any insurer insolvency in the US is handled by the state insurance department where the insurance subsidiary is located. The first priority is to pay claims, not creditors, and it can take many years.

With regard to current yields, most other P&C preferreds and baby bonds are trading in the 6s. The Conifer common trades at $1.64 and yet its 6.75% Senior Note trades at $23.56 for a 7.14% yield which makes no sense. The ARGO common trades at $22.24/share.

The ARGO “A” preferred shares started trading on 7/21/2020 and have a fixed rate of 7.0% for five years. 6 million shares were issued at $25 par. The first dividend was paid on 9/15/2020 and resets every 5 years. The preferreds do not have a maturity date but they can be called starting 9/15/2025. Per the

prospectus, the reset is 6.712% plus the 5 year US Treasury rate:

“From and including the First Reset Date, dividends will be payable on a non-cumulative basis, with respect to each dividend period, only when, as and if declared by our Board of Directors or a duly authorized committee of the Board of Directors, during each reset period, at a rate per annum equal to the Five-year U.S. Treasury Rate (as defined below) as of the most recent reset dividend determination date plus 6.712% of the liquidation preference per annum.”

Since the initial dividend was 7.0%, the assumption is that the 5-year was at 0.288% back then which seems correct. Reviewing the historical data on the 5-year Treasury rate, that was basically the bottom:

The current 5-year US Treasury rate is 4.14%. If the preferreds were to reset today, the rate would be 10.852%. This presents an interesting situation. In three years, if rates are still this high, there is a good chance that the company calls the preferreds at par. If rates go down, there is a good chance that the preferreds trade up to par. In fact, the preferreds traded above par up until about 5 months ago. Either way, the price should return par.

In terms of taxes, the dividends are qualified for individuals. Since the company is foreign, the dividends are not eligible for the dividends received deduction for corporate holders. Given that and the small size, this is likely best suited for personal accounts.

There are risks. The company is in the process of reviewing strategic alternatives. There are two activist funds that have been agitating for a sale. Unfortunately, these funds may be underwater and not very happy. If either fund were to sell out, the market may react negatively.

ARGO has had issues in recent years with adverse reserve development that has impacted profitability.

The preferreds are non-cumulative, which presents the possibility that if things were to deteriorate that the dividend could be stopped. I will note that most insurance preferreds are non-cumulative for regulatory reasons. Non-cumulative preferreds are treated as equity while cumulative preferreds are considered as debt. When it comes to leverage, equity is better than debt.

Catalyst

Collect dividends and wait for price to rise or be called and redeemed by the company.