The Conundrum of the NAIC-3s

February 3, 2010

With investment grade-spreads constricting and new issuance sparse, private placement investors are in need of avenues to deploy their cash. NAIC-3 companies, the sell side says, could provide buysiders with the deals, and the spreads, they need… if they were willing to take the risk.

The PP community agrees that the demand for issuance far exceeds the supply. Investors are eager to deploy cash but do not have sufficient opportunity to do so. But with the exception of some large insurance companies, such as Prudential, MetLife, John Hancock and Pacific Life, investors seem unwilling to take a chance on NAIC-3 companies.

This frustrates the sell side, which would like to see more willingness to deviate from the market’s “vanilla investments.” Innovation and an increased acceptance of risk would open the PP market to more issuers, the agents argue.

It should be noted that the sell side likes the idea of NAIC-3s because, since the sell is a little more difficult than the average NAIC-2 issuer, they earn higher fees. A sell-side source also said NAIC-3 companies are increasingly approaching his bank looking to tap the private bond market.

However, following the financial crisis, many investors are still risk shy and weary of putting money into a company that is NAIC-3 or BBB-. Some investors also have a difficult time convincing their credit committees of the benefits of these lower grade credits. A NAIC-3 with “upward momentum” could attract some interest, agents agree, but it is still a hard sell.

Yet, the perception of risk is often greater than the reality, the sell side maintains. Some of the smaller NAIC-3 companies have the profile of NAIC-2s but fall lower in the credit spectrum due to size. Others were previously rated higher yet had to take on more leverage during the financial crisis.

Venturing lower in the credit spectrum would bring in greater returns on investment, but for most investors at this point the higher ROI is not worth the risk. It is possible that this attitude towards risk might loosen in the coming quarters, and some NAIC-3 deals might come to market in Q3 or Q4. But for now the buy side remains unconvinced.

In fact, one sell-side source said, “We are dissuading NAIC-3 companies that approach us. This is not the time or the place.”

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