March 26, 2009 - 9:48am EST by
2009 2010
Price: 12.75 EPS n/a n/a
Shares Out. (in M): 8 P/E n/a n/a
Market Cap (in $M): 102 P/FCF n/a n/a
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT n/a n/a

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  • Reinsurance


 "Many times I've gazed along the open road"

This originally was going to be another write-up on ENH but along the way I found a rather interesting pair trade. Rather than going long ENH, I am recommending that you go long ENH-PA and short ENH. This is basically a capital structure arbitrage between the preferred and the common.

The preferrred closed at $12.75, or just slightly over 50% of par. The common closed at $24.91 or about 87% of tangible book value (excluding preferreds and DAC). The preferred issue consists of 8 million shares, trades about 19K shares per day and here is the skinny:


"Endurance Specialty Holdings Ltd, 7.75% Non-Cumul Preferred Shares, Series A

Ticker Symbol: ENH-A     CUSIP: 29267H208     Exchange: NYSE

Security Type:   Traditional Preferred Stock

SECURITY DESCRIPTION:  Endurance Specialty Holdings Ltd, 7.75% Non-Cumulative Preferred Shares, Series A, liquidation preference $25 per share, redeemable at the issuer's option on or after 12/15/2015 at $25 per share plus declared and unpaid dividends, with no stated maturity, and with noncumulative distributions of 7.75% ($1.9375) per annum paid quarterly on 3/15, 6/15, 9/15 & 12/15 to holders of record on the 15th calendar day prior to the payment date or on the date fixed by the board, not more than 60 days or less than 10 days prior to the payment date. In regards to payment of dividends and upon liquidation, the preferred shares rank equally with other preferreds and senior to the common shares of the company. "


There are 62.8 million share of common outstanding, giving ENH a $1.56 billion market cap. Its shares are quite liquid and pay a quarterly dividend of $0.25.


"But what is and what never should be."

At 50% of par, the preferreds are trading like there is significant impairment and yet the common trades at a higher level. This is a major disconnect. When preferreds trade at such discounts, usually the common trades at much lower levels. Yet, ENH trades at a 37% discount to its 52-week high while the preferred trades at 50%.

Since insurers are essentially levered bond funds, the major concern is their bond portfolio. 54% of it is in MBS. Yikes. Take a step back and over half the MBS is agency, so 23% of their bond portfolio is non-agency MBS. Their 2008 10-K revealed that they had written down the non-agency MBS by almost 20% as of 12/31/08. This is despite having no subprime and only 2% Alt-A. Factor in that 86% of their bonds are either government or AAA-rated, and there is a lot of bad news already baked into the portfolio and which should benefit from recent government announcements. The fear is that the insurers like Endurance might be downgraded due to weaker financials and premium shrinkage. By doing the pair trade, you can be agnostic about the underlying business.


"The magic runes are writ in gold to bring the balance back"

The mechanics of the trade are buy two preferreds and short one common. You will net $2.875 in dividends per year ($3.875 from the two preferreds and pay out $1.00 on the common). That is what you will collect if Endurance tanks. While the preferreds are non-cumulative, the common cannot receive a dividend unless the preferreds are paid. Further, the preferreds represent only $15.5 million in annual dividends vs. the $62.8 million paid to the common. Given the difficulty in raising capital, Endurance would suspend the common dividend long before they touch the preferred dividend.

 The other downside is that the common recovers more than the preferred. In the past, ENH has traded over $42 at about 6-7X earnings. ENH currently trades around 5X earnings. Returning to normal would imply a price of $30 to $35 or appreciation of $5 to $10 from here. However, such a move would likely cause the preferred to trade closer to par. Further, given the 2-1 ratio of the trade, the preferred only has to move half as much as the common in order to offset the short.


"One day soon, it's got to stop, it's got to stop"

What I find interesting is that this situation is NOT confined to Endurance. The preferreds on ACGL, PRE and RNR also trade at significant discounts to par, albeit not as steep as ENH-PA. This makes me wonder if this disconnect stems from other factors, such a mass exodus by retail holders, either directly or indirectly via fixed income fund redemptions or margin calls.


Convergence of value between the preferred and the common

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