KMPR - Kemper And Its Interesting And Very Undervalued 8.65% Baby Bond

2023-08-04 12:00:00 ET

Summary

• Kemper Corporation is a well-known name in the insurance industry.
• The Kemper BB+ rated baby bond, symbol KMPB, offers an 8.65% yield to maturity when 7% is the norm for BB+ bonds. So it is quite undervalued.
• Furthermore, KMPB has a very valuable reset-rate feature that will raise the dividend 42% to a yield to maturity of 12.27% if current interest rates remain as they are.
• At a price of$17.56, it has large capital gains potential. Just 1 year ago it traded at $25.00.
• I estimate at least a 13% yearly return over the next 3.5 years, with a call possible giving us over an 18% annual return to its call date.

Kemper Corporation

Kemper Corporation ( KMPR ) is a well-known property casualty insurance company which also has offers life and health insurance. It is actually a family of companies. They provide insurance to both businesses and individuals. They have over $13 billion in assets, have issued 5.3 million policies, and are represented by 26,000 brokers and agents. A.M. Best rates KMPR as A- (excellent). Many people may have heard of Kemper from the Kemper Open golf tournament that they sponsored.

KMPR is currently struggling due to losses on the auto insurance segment. But this is not strictly a KMPR problem. Other auto insurers, like Allstate, are also taking a beating on their auto policies. But KMPR is doing what all insurance companies do when they discover that they have underpriced their policies. They are in the process of raising prices on these policies.

In fact, according to Yahoo Finance, analysts expect KMPR to return to profitability in the third quarter, with earnings soaring to $4.74 per share in 2024. Additionally, KMPR common stock has been strong of late and is priced at 22% above its book value. So Wall Street seems to regard KMPR’s future positively.

Kemper Baby Bond ( KMPB )

KMPR has issued one baby bond, Kemper Corporation NT CALL 62 (KMPB), with the symbol KMPB. Here are the basics on it:

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Price $17.56

Yield to Maturity 8.65%

Yield to Call 18.18%

Current Yield 8.50%

Call/Reset Date 3/15/2027

Maturity Date 3/15/2062

Reset Rate 5 year treasury note plus 4.14% = 12.27% at current 5 year T-note rate

S&P Rating BB+

Moody's Rating Ba1

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KMPB is actually a junior bond, which means it is lower in the capital stack than their other unsecured bonds but is higher than any preferred stock that they might issue. Additionally, as a junior bond, KMPR can suspend dividends on KMPB for up to 60 months. But this fact is taken into account by the ratings agencies when making their ratings. The straight unsecured bonds of KMPR have an investment grade BBB- rating from S&P. Baby bond symbol NSS is another example of a junior bond that we have recommended in the past. Many may be more familiar with NSS than KMPB.

KMPB’s Undervaluation

KMPB currently carries a credit rating of BB+ from S&P and Ba1 from Moody's. These are essentially the same ratings. Until 3/15/2027, KMPB will be paying a fixed rate, and the chart below shows you just how good their current fixed yield is relative to all other BB+ baby bonds with similarly long maturities.

The above chart is a complete chart of all BB+ baby bonds, and they all have very similar long maturity dates to KMPB. As you can see from the right column that KMPBs yield to maturity ((YTM)) is very much higher than the average of the other BB+ baby bonds; about 1.9% higher.

The following scatter plot shows the YTM’s of all BB+ traditional bonds with at least 25 years until maturity.

As you can see, traditional bonds with the same rating and a similar maturity as KMPB tend to offer yields averaging around 7%. So again, this validates the very oversized yield that KMPB is providing relative to bonds with the same credit profile.

Outstanding Reset Rate

On 3/17/2027, KMPB will either be called, giving us a big return of 18.18% per year, or it will float at the yield on the 5 year treasury note plus 4.14%. That’s a good spread over treasuries at par, but at the current price of $17.56 it is a great reset-rate. Who knows where the 5 year note yield will be in March of 2027, but if it is at the current 5 year rate of 4.24%, the dividend on KMPB will jump 42% from its current $1.47 to $2.095. This would boost the YTM in March of 2027 to 12.27% . That spread of 8% over the 5-year treasury yield (US5Y) will insure that wherever rates end up, that we will have a yield that will be hugely better than treasuries. So KMPB will be an excellent bond regardless of where the interest rates go in the future.

Yes, the maturity is long in this bond, 2062, but that doesn’t trouble me given the kinds of return this bond can give us between now and 2027. Over time, as we get nearer to the reset-rate date in 2027, the price of KMPB should move up strongly in price given the huge spread over treasuries that will exist when KMPB’s rate resets. This will give us a strong capital gain in addition to a current yield of 8.50% for a very high total return. And given its current huge discount to fair value versus other BB+ bonds, it could move higher in price quite soon if the market takes notice. I am expecting the return on KMPB will be at least 13% per year over the next 3.5 years, and there is the possibility of a call, which would provide an annual yield of 18.18%.

KMPB Has Been Lagging The Market

I particular like when already undervalued securities lag the market. They generally outperform going forward, and sometimes in a big way. And KMPB has been an extraordinary laggard. Here is a 1 year price chart.

As you can see above, KMPR common stock is up 9.25% over the last year while the KMPB baby bond is down a whopping 27.15%. That is a massive disconnect. And the pink line represents the high yield bond index. As you can see it is only down 3.67% over the past year versus 27.15% for KMPR. So how can KMPB underperform the high yield bond index so massively during a time when the common stock is up? This is why KMPB’s current price is a bargain. KMPB has over 40% upside to get back to its price of 1 year ago.

And I want to add that KMPR’s unsecured bonds maturing in 2030 and 2032 are trading at a YTM of around 6.4%, so the bond market, as well as the stock market, are telling us that KMPR is not a distressed company.

Summary/Conclusion

1. BB+ rated baby bond KMPB is a bargain relative to other BB+ rated bonds with similar maturity dates. It has a YTM of 8.65% versus the typical 7% for similar bonds.
2. In 2027, KMPB will either be called giving us an annual return of over 18% from now until March 2027, or the dividend will reset based on the yield of the 5 year treasury note. Given today’s 5 year note rate, the dividend would reset 42% higher from its current $1.47 to $2.095. This would boost the YTM in March of 2027 to 12.27% . With the 5 year note currently at 4.24%, that means that KMPB will yield 8% more than 5 year treasuries. That is a huge spread over treasury yields for a BB+ bond and this means that no matter where the 5 year note yield is in 2027, KMPB will offer a massively higher yield. So KMPB is great in any interest rate environment.
3. KMPB has been a massive laggard over the last year. While KMPR common stock is up 9.2% the KMPB bond is down over 27% from a high of $25 to $17.56. And to put this decline into perspective, the high yield bond ETF, HYG, is down only 3.7% during the past year. So I believe we have very large capital gains potential for KMPB in the coming months as the market moves KMPB more towards fair value.
4. Given its huge reset-rate, I believe KMPB offers at least a 13% annual total return between now and near the reset date, as the likelihood is very high that investors will bid up the price of KMPB as the huge boost in its spread over treasuries gets nearer. A call is even possible, which would provide us with an 18.18% yearly return .

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