American International Group, Inc. (NYSE:AIG) has a lot of exposure to residential mortgage backed securities. These residential mortgage backed securities are basically a group of mortgages packed into a single document and grouped together based on investment grade. Residential mortgage backed securities are stamped with a risk rating, which is determined by a credit rating agency. The highest rating is AAA and the lowest rating is below investment grade.
AIG’s lending portfolio
Source: AIG
The company currently has $16.28 billion in below investment grade mortgage backed securities. This has made investors extremely queasy as high risk mortgage notes could potentially default. However, some savvy investors have earned high rates of returns on these securities as the risk premiums have continued to decline.
Source: YCharts
As you can see, the risk premium (amount of interest above the risk free rate) has gone down for bonds with a BBB rating. Over the past couple of months, the risk premium has really dropped as ten-year Treasury bond yields have gone up.
Why the risk premium is going down
Ben Bernanke told the joint economic committee he would be willing to raise the federal funds rate once unemployment hits 6.5%. Currently the unemployment rate is 7.5%, meaning we’re not too far from our first round of deflationary monetary policy. It only took a year and a half for unemployment to fall from 8.5% to 7.5%. Unemployment could hit 6.5% in less than two years, which is why investors are dumping bonds onto the open market in favor of stocks. In a deflationary environment, bond interest rates generally go higher.
If interest rates were to go up, the value of bonds that were bought at a lower interest rates go down in value. Rising interest rates have a negative effect on par value (think underlying security value). Investors chase higher risk securities which is reflected in the shrinking risk premium on higher risk debt.
Why AIG invests in junk
American International Group, Inc. (NYSE:AIG) invests into higher risk debt because it attempts to exploit the difference in the perceived risk and actual risk of these investment securities. What this means is that AIG is betting the par value on these securities will rise once bond investors in risk free, low yield treasuries move their cash elsewhere. This sudden increase in demand for high risk bonds will cause yields to fall and par values to go up.
In 2009, the FASB (Financial Accounting Standards Board) changed GAAP accounting standards so that companies would have to record assets at mark-to-market value. This means companies need to record the unrealized gain or loss of a security as income (or loss) prior to ever selling the security. The implications of this accounting change are enormous. And that’s because it forces bond investors to liquidate in anticipation of falling coupon values, which in turn forces them to re-invest the capital into higher risk securities like BBB rated bonds and stocks. This enriches the portfolio of those that are willing to take on a bit more risk, like American International Group, Inc. (NYSE:AIG).
Alternatives
American International Group, Inc. (NYSE:AIG) is a compelling investment opportunity, but is it the best place for our money? Is there anything better? If you want to invest in a business like this, is there anything safer? Diversification is one of the most practical strategies to protecting capital.
The Travelers Companies, Inc. (NYSE:TRV) is an investment alternative you might consider. Recently, it has been able to increase its profit margins from 5.5% to 9.5%, partly because the company’s loss adjustment ratio fell by about 4% over the past could years. Analysts expect the company to grow earnings by 22% this year, and this optimism is backed by its 43% exposure to AAA rated bonds.
However, the problem with AAA rated bond securities is the sudden decrease in coupon values, which would translate into unrealized losses in mark-to-market accounting. This could damper the company’s earnings. On the flip side, bond interest rates generally don’t move very fast so the effects of this could be balanced by The Travelers Companies, Inc. (NYSE:TRV) collection of higher insurance premiums and cutting of costs.
On the other end of the spectrum, the Bank of America Corp (NYSE:BAC)’s exposure to mortgages with a rating below BBB is huge, as it composes 57% of the banks credit exposure. In an environment of rising interest rates and falling risk premiums, the value of this lending portfolio could appreciate in value. Despite this potential upside, Bank of America Corp (NYSE:BAC) is attempting to be more conservative.
Source: Bank of America
Like American International Group, Inc. (NYSE:AIG), the composition of Bank of America Corp (NYSE:BAC)’s lending portfolio is smooth considering today’s interest environment. The CEO, Brian Moynihan, is planning to sustain net income growth by cutting $8 billion in costs by 2015. In anticipation of these cost cuts, analysts anticipate it to grow earnings by a substantial sum over the next 5 years.
Conclusion
American International Group, Inc. (NYSE:AIG) and its exposure to below investment grade securities could be undervalued if higher risk assets continue to appreciate. Deflationary monetary policy is causing bond investors to unwind large bond portfolios in favor of higher risk assets. This plays into AIG’s strategy and its junk could make for a quality investment.
Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends American International Group, Inc. (NYSE:AIG). The Motley Fool owns shares of American International Group and Bank of America Corp (NYSE:BAC) and has the following options: Long Jan 2014 $25 Calls on American International Group.
The article Buy AIG’s Junk originally appeared on Fool.com.
Alexander is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
