Sampo benefits from rising interest rates

In recent years, investors have, depending on the point of view, enjoyed or suffered from record low interest rates, thanks to the central banks' stimulus measures.

For Sampo low interest rates are a headache since the majority of the group's investment portfolio worth over EUR 22 billion consists of fixed income. At the end of 2017, some 67 per cent of our investments were invested in fixed income. The share is large particularly in If, 84 per cent at the end of 2017. In Mandatum Life fixed income investments constituted 42 per cent of total investments.

If's large fixed income weight is explained by two factors: dividends and credit rating. When it comes to return on equity, our objective is to keep If's balance sheet light and efficient. However, at the same time, the high credit rating and ability to pay large dividends require strong solvency. Thus, the risk profile of If's investment portfolio must be low. In addition, the group level profit performance benefits from the fact that If's profit is based on successful risk assessment and pricing i.e. underwriting rather than profits from investments.

From an investor's point of view, one key figure to keep an eye on is the average yield to maturity of the fixed income portfolio without taking into account the FX hedging costs - or in financial jargon, running yield. The figure expresses the average return on the fixed income portfolio when all investments expire normally.

At the end of 2017, the running yield for If amounted to 1.5 per cent and for Mandatum Life to 2.4 per cent. Traditionally, Mandatum Life has taken more risk than If, which usually means higher running yield. However, the trend in running yield has been decreasing during the past years. For example, in 2011 the running yield for If amounted to 4.1 per cent and for Mandatum Life to 5.4 per cent.

Running Yield, If and Mandatum Life 2011-2017, %

The lower the bond yields go, the lower the running yield sinks. When billions are invested, every single basis point matters. Sampo's success in the challenging market environment of recent years can be considered excellent.

Lately, there has been some signs of rising interest rates. In the U.S. Fed has already raised the Federal Funds rate multiple times. Furthermore, in Europe the first raise for ECB since July 2011 is a step closer as the economy is picking up. While writing this, the yield of the European safe heaven, the German 10 year bund was 0.60 per cent. In February the yield temporarily exceeded 0.80 per cent. The near 5 per cent levels seen before the financial crisis are still far but on the other hand, the minus rates seen in 2016 seem to be in the past.

10y Government Bond Yield, %

 

We are prepared for rising interest rates by keeping the duration of our fixed income portfolio short. Duration expresses the average cash flow weighted maturity of the fixed income portfolio. At the end of 2017, the duration for If was 1.4 years and for Mandatum Life 2.0 years. When interest rates rise, the prices of bonds decrease. However, for shorter-term bonds the decrease is smaller than for longer-term bonds. Respectively, when interest rates go down, bond prices benefit from longer duration.

Sampo would benefit from rising interest rates more than many of its comps. We estimate that if the yield curve increased by one percentage point throughout, our financial benefit would be approximately EUR 600 million. The benefit would be generated from higher discount rates for technical provisions, higher running yield and improved interest margins for Nordea.

Even tough low interest rates have hampered our investment activities, they have had some positive effects as well. Because of the lower interest rates, Sampo has been able raise foreign capital at a very attractive price. In February we issued a EUR 500,000 million bond with a maturity of 10 years. The fixed coupon rate is 1.625 per cent, but we swapped it to variable rate, which is only 0.28 per cent at the moment.

Strong balance sheet and the ability to raise foreign capital at a competitive price support our strategy to create shareholder value with our investments. During the past year, we have made direct investments in three companies that operate in the financial and fintech sector: Nets, Saxo Bank and Nordax. We have reserved approximately one billion euro for these kind of investments and we have now used roughly EUR 750 million of that. Thus, it's quite possible that we make more direct investments of these kind in the future as well.