Financial contagion concerns weigh on the share price. Challenger share price has fallen ~$1.50 since early March on fears of financial contagion stemming from the US banking crisis. For CGF, the direct impact is minimal. The indirect impact is via potentially lower asset prices, particularly in the riskier parts of its investment portfolio, or higher corporate defaults in the CGF investment book. We note <25% of Challenger’s Fixed Income Book is non-investment grade.
High Yield (HY) credit spreads have retreated from CYTD highs. HY credit spreads have historically been a good proxy for movements in the CGF share price. HY spreads widened from 4.0% to 5.25% through March. They have now narrowed to 4.5%, with US Regulators doing enough at this point to act before contagion risks widen. The rescue of First Republic (FRC.US) by JP Morgan (JPM.US) has had minimal impact on HY spreads over the last week. The CGF share price has not yet responded to retracement HY spreads.
Challenger Life AUM asset allocation. Compared to 2018, CGF’s strategic asset allocation has downweighed both Property and Fixed Income exposures. Property has fallen from 21% to 14%, whilst Fixed Income increased from 59% to 68%. The introduction of the Alternatives asset class and up-weighting of Infrastructure has filled the gap. In our view, this has re-risked the Life portfolio, particularly in a world with still relatively low-interest rates.
“Golden age of annuities”. CGF’s largest shareholder at 19%, Apollo Global Management (APO.US), described the current environment as being the ‘golden age of annuities’, given the current uncertain investment environment and the ability to lock ~5% returns over the medium/long term to provide for retirement income certainty. Link
Investment View
The last few years of low-interest rates have been tough for CGF, but these conditions have started to reverse, and we can now see CGF gaining the benefits of higher interest rates. Retail sales of the annuities continue to improve as clients look to manage retirement incomes. New management continues to simplify the business, which we are supportive of.
The share price can trade on higher earnings multiples if the business can consistently earn its ROE target (RBA cash rate + 12%), something the market does not currently factor in.
We are buyers of CGF given the pathway to improved earnings (and ROE). 4Q is typically the strongest quarter for CGF annuity sales given seasonality. This should be assisted by the launch of CGF’s direct annuity product in the coming weeks. We rate CGF a Buy.
Risks to Investment View
CGF's earnings (and share price) are highly sensitive to changes in interest rates and interest rate expectations. Government policy can present a risk if changes adversely affect CGF’s business.
The key risk for Challenger is default risk on investments within the Life Company. The Life Company is required to mark to market its investments, which can result in CGF needing provision for any capital shortfall – creating earnings volatility.
CGF currently has two large offshore strategic investors on the share register, which provide CGF with a regular and steady flow of new business. Changes to the nature of the relationship; and or moves to acquire additional ownership of CGF would be a risk to our investment view.
CGF’s earnings would be at risk if the customer base/or funds under management fell.
Recommendation
We have retained our Buy recommendation.
Figure 1: CGF share price vs US High Yield spreads
Figure 2: CGF PER has derated significantly in 2023
Figure 3: CGR EPS momentum remains positive
