Junk Bond Rally May Save Insurer

The failure of Executive Life Insurance Co. in April was largely blamed on its huge junk bond investments, but in an ironic twist, the controversial portfolio now is emerging as the key to the rescue of the $10-billion company and its policyholders.

The reason is that the junk bond market, crippled by corporate defaults and the insider trading scandals involving Drexel Burnham Lambert, has recovered--up about 30% this year--as interest rates dropped, the economy began to show signs of recovery and corporate debt problems eased.

This unexpected turn of events has made Executive Life more attractive to potential buyers. As the bidding heats up, so do the chances that Executive Life’s 372,000 policyholders will regain all of their coverage and most of their investment.

Already, a French consortium has made a $3-billion bid for Executive Life, but others are saying it is inadequate. An industry group said it will make an offer and at least three other groups are considering bids by the court-imposed Oct. 11 deadline.

“The market, in general, has gone up for junk bonds,” said Charles Perkins, a spokesman for Hellman & Friedman, a San Francisco-based investment banking group that may join in the Executive Life bidding war. “The current (French) bid clearly undervalues them.”

Junk bonds are corporate debt securities that carry lower ratings for risk than top-grade investment bonds. They generally pay higher rates than others to make up for the greater degree of investment risk. The securities came into prominence in the 1980s as a tool for hostile takeovers and leveraged buyouts. But the junk bond market collapsed as the merger frenzy faded, insider trading scandals erupted and Drexel faced prosecution and bankruptcy.

But this year, the junk bond market has changed dramatically. Issues that once looked tenuous now seem viable, said David J. Breazzano, portfolio manager for Fidelity Investments Capital and Income Fund.

“Since the beginning of this year, the junk bond market has experienced the biggest rally in history,” he said.

Although there is not one accepted measure of the strength of the overall market, Breazzano and other industry experts estimate that high-yield bonds are worth about 30% more today on average than they were in January. The average junk bond mutual fund was up 27.78% at the end of August, according to Lipper Analytical Securities.

There are several reasons for the surge. The stock market has been strong, which allowed several junk bond issuers to sell stock and retire debt. Corporate borrowing rates are also at near-term lows, which spurred other companies to trade junk bond debt for cheaper bank debt.

Both moves have restricted supply of junk bonds and made the bonds remaining in the market just a bit safer, said James R. Caywood, chief executive of Caywood/Christian Asset Management in San Diego.

And because returns on other fixed-income investments have slumped lately, junk bonds, which often pay more than 12% interest, have become comparatively more attractive. In addition, default rates, which soared in the final quarter of 1990 and in the first quarter of 1991, are expected to ebb in the future, said Richard Lehman, president of the Bond Investors Assn. in Miami Lakes, Fla.

Nearly everyone agrees that the increased viability of the junk bond market could benefit Executive Life, the second-largest failure of a life insurer in history, and eventually its policyholders.

A group of French investors headed by Altus Finance and Mutuelle Assurance Artisanale de France (MAAF) made a formal bid for Executive Life on Aug. 7. Under the proposal, Altus, a unit of Credit Lyonnaise, would buy the junk bond portfolio for $2.7 billion and MAAF would infuse another $300 million and operate the newly capitalized insurer.

But other potential bidders and analysts argue that the French bid is a low-ball offer that vastly undervalues that junk bond portfolio, which was carried on Executive Life’s books at $5.4 billion.

“The Altus plan gives a very low price for those bonds,” said one potential bidder who asked not to be named. “We think the bonds are worth significantly more and policyholders should have a chance to benefit from that.”

That echoes the feelings of the National Organization of Life and Health Insurance Guaranty Assns. (NOLHGA), which represents state guaranty funds nationwide, and an investment group that includes entertainment mogul David Geffen, Texas investor Richard Rainwater and San Francisco-based Bechtel Investments.

NOLHGA announced on Sept. 19 that it would submit a bid for Executive Life that would provide policyholders more than the French offer. This industry bid would keep intact Executive Life’s junk bond portfolio, which it values at about $3 billion.

Eden Safarty, president of NOLHGA, said that under his group’s plan, a return of just 9% on the junk bond portfolio would provide more funds to pay off Executive Life’s policyholders. The French group would have to reap 20% to provide the same benefit, he claimed.

However, the French group harshly criticized the industry’s proposed treatment of the junk bonds. “Leaving the junk bond portfolio in the insurance company would perpetuate the speculative investment strategy that created this fiasco and leave policyholders at the mercy of the volatile and uncertain junk bond market,” said Jean-Claude Seys, chairman of MAAF.

The Rainwater-Geffen-Bechtel group also believes that the French bid is offering too little for the junk bonds. The Wall Street Journal quoted sources saying the investment group is considering a bid that would keep the junk bonds with Executive Life. This would be done in the hope that the junk bond portfolio could be bought at a reasonably low price and that it would recover in value in the next few years.

Others considering bids are the group headed by Hellman & Friedman and including Chicago investor Samuel Zell, and representatives of holders of municipal guaranteed investment contracts sold by Executive Life, or Muni-GICs.

Altus, which started negotiating the terms of its takeover more than three months ago, maintains its deal is fair and has been unaffected by the swings in the junk bond market.

“Our deal was significantly enhanced in the course of negotiations, which didn’t conclude until Aug. 7,” said Jody Powell, a spokesman for Altus and a former press secretary to President Jimmy Carter. “The market hasn’t moved that much since then.”

Additionally, regulators say that Executive Life’s portfolio is filled with unusually bad junk bonds.

“I don’t think you can compare a carefully invested junk bond mutual fund portfolio to Executive Life’s portfolio,” said Bill Schulz, a spokesman for the California Department of Insurance.

Indeed, a study conducted by Salomon Bros. for the regulators said that more than half of Executive Life’s high-yield portfolio was “expected to default.” Only $3.81 billion of the company’s $8 billion in high-yield bonds were considered “minimal risk securities,” according to a summary of the Salomon report, which was completed in April.

Notably, regulators say the author of the Salomon study was Joseph Bencivenga, the former director of research at Drexel, the bankrupt investment house that sold Executive Life the bulk of its bonds. California regulators paid $1 million to have this study prepared.

Indeed, many of the potential bids have hired junk bond experts. A few of the consultants learned the tricks of the junk bond trade at Drexel.

One of the key players in Altus is Leon Black, the former co-head of Drexel’s mergers and acquisitions department. Some junk bond experts maintain that if the deal goes through, Altus and Black will make a fortune. The estimates of their potential profits range from several million to more than $1 billion.

Meanwhile, one of the players in a possible deal set forth by holders of Executive Life-backed Muni-GICs is Stanford Phelps. Phelps worked for Drexel in the late 1960s and early 1970s, and claims credit for teaching Michael Milken about junk bonds. Milken, who is now in federal prison, developed Drexel’s junk bond empire.

Today Phelps runs an investment company that buys debts of troubled firms. He has already offered to buy a $62-million chunk of First Executive’s holding in Crossland Savings for $10,000. As part of the deal, he also promised to give the insurance regulators the interest earned on the bonds.

The interest by bidders has been reassuring to some Executive Life policyholders--particularly those who have large policies that would not be fully covered under the French bid or by the state insurance guaranty funds.

“It looks like our situation is improving,” said Donn Sigerson, a 77-year-old Los Angeles policyholder. “The new bid looks quite a bit better.”

Added Maureen Marr, a spokeswoman for the Action Network for Victims of Executive Life: “The fact that there are additional bids coming out is really encouraging. People who thought they had lost everything on April 11 now have a sense that they haven’t. What they had on April 10 still exists.”

However, it is far from certain that all Executive Life customers will be able to save their whole investments.

The Altus bid, which proposes to buy Executive Life’s worst junk bonds, would provide most policyholders about 81% of their investments if they stick with the company for at least five years.

Those who had less than $100,000 in cash value, would have their losses recouped by life insurance guaranty funds, according to an agreement between Garamendi and NOLHGA.

However, holders of GICs that backed municipal bond issues and those who had policies over the $100,000 mark would stand to lose substantial sums.

Meanwhile, the industry bid says its proposal would pay at least 4% more to rank-and-file policyholders, but it would also shut out those holding so-called Muni-GICs.

The other potential bidders will not yet reveal details of their offers. However, all have said they believe their bids would pay policyholders more than the Altus plan. They said they have not yet been able to assess the industry proposal.

Nevertheless, regulators remain cautious and stress that policyholders should not count on optimistic projections from “buyers in the bush.”

“Our best-case scenario is a bidding war for the company,” said Tom Epstein, a deputy commissioner at the California Department of Insurance. “But not everybody has been running up with cash in hand to buy the portfolio. Right now Altus is the only one that’s submitted a firm offer.”