[비즈한국] Recently, Lotte Insurance000400 decided to delay the exercise of a call option (early redemption) on 90 billion won worth of subordinated bonds, causing growing anxiety in the market. There is a prevailing sense of concern among investors regarding the potential impact on other insurance companies that must also decide whether to exercise call options on their own subordinated bonds.
The bond at the center of the recent issue is the 'Lotte Insurance 8 (Sub)', a subordinated bond issued by Lotte Insurance on May 7, 2020. Subordinated bonds are debt instruments that have a lower priority of repayment compared to other debts in the event of the issuer's default. While general corporate bonds are unsecured and unsubordinated 'senior debt', subordinated bonds only allow for the repayment of principal and interest after all senior debt has been settled if a default occurs. For this reason, issuers offer higher interest rates on subordinated bonds.
From the perspective of a company raising funds, there is no need to unnecessarily increase interest expenses by issuing subordinated bonds when senior bonds could be issued instead. Therefore, subordinated bonds are generally issued by financial companies such as banks, insurance firms, and securities companies. Under certain conditions, subordinated bonds are recognized as supplementary capital. By issuing these bonds, financial companies are able to maintain the soundness of their capital ratios.
Investors choose subordinated bonds due to their high interest rates and call options. If they believe the risk of the financial institution failing is low, they can reap the benefits of high interest—a premium for the risk taken. Although the maturity is typically 10 years, they are effectively perceived by the market as 5-year corporate bonds because they usually include a call option that allows for early redemption after 5 years.
A call option is not a legal obligation but a choice for the issuer. However, if the option is not exercised, it can signal that the issuer is in poor financial health, so investors typically invest under the expectation that the issuer will exercise the call.
For example, when Woori Bank did not exercise a call option on its overseas subordinated bonds in 2009, investors interpreted it as a sign of a liquidity crisis at the bank, triggering a sell-off in the bond market. As interest rates on financial bonds surged as a result, Woori Bank immediately issued counter-measures. As such, in normal circumstances, investors expect issuers to exercise their call options.
Of course, since there are cases where issuers do not exercise call options, investors must be aware that the investment period could be extended, and early withdrawal is not possible. Experts advise that because subordinated bonds have long maturities, liquidity risk must be considered and that they should not account for a large portion of one's investment portfolio.
From an issuer's perspective, it may be advantageous to exercise the call option and redeem the debt because failing to do so would require paying additional interest if the bonds are kept until maturity. However, for an insurance company like Lotte Insurance to exercise a call option, the Insurance Business Supervisory Regulations require that the K-ICS (Korea Insurance Capital Standard) ratio be maintained at 150% or higher after the redemption. Exercising the call option reduces capital, which lowers the K-ICS ratio, so the company must re-issue bonds to maintain the required capital ratio.
For this reason, the Financial Supervisory Service (FSS) rejected the call option exercise, stating, "As of March this year, Lotte Insurance's K-ICS ratio was below 150%; repaying debt first would be a violation of regulations." The FSS added, "In a situation where financial soundness has deteriorated, repaying subordinated bonds first using assets funded by policyholder premiums could lead to problems regarding policyholder protection."
Lee Se-hoon, Senior Deputy Governor of the FSS, stated on the 8th, "While I cannot confirm it, I presume that unlike other insurance companies, its governance is structured around financial investors, which may be leading it to prioritize maximizing short-term shareholder profits over capital increases." In response, Lotte Insurance argued, "The decision to delay redemption was made primarily for investor protection and the stabilization of the bond market."
As a result, analysts suggest that when investing in insurance capital securities, a selective approach that considers both the fundamentals and the solvency ratio is necessary. Choi Sung-jong, a researcher at NH Investment & Securities005940, said, "As uncertainty regarding early redemption has increased, the price volatility of capital securities issued by Lotte Insurance will likely expand for the time being. While the introduction of mandatory compliance standards for the K-ICS ratio is a burden for Lotte Insurance, the possibility of a credit event remains limited."
However, he also offered advice on the need for a differentiated approach to capital securities based on the solvency ratio. Researcher Choi stated, "Despite Lotte Insurance's decision to delay the early redemption of subordinated bonds, investment demand for insurance capital securities that can secure high interest rates during periods of falling market rates will continue." He added, "As the extension risk has become a reality, monitoring the capital expansion plans of insurance companies with low K-ICS ratios is necessary."