Petrobras – Century Bond

“Mark, what would you think of our firm buying a 100-year bond? Brazil’s Petrobras had issued a 100-
year bond in 2015 with a coupon rate of 6.85% and some of the bond is coming up for sale on the market.
The firm may want a piece of that bond.” That was the question posed by my desk manager as we began
our weekly portfolio meeting. Being the lead bond analyst, the job of bond selection fell on my desk.
Now I have to make a case for my firm either including or excluding this bond into our portfolio. Being
an insurance company we are very careful in considering bonds because we try to match the expected
payments to the revenue streams of the fixed instruments that come with coupon payments. But the
current interest rate environment is challenging to say the least. Now there is talk of negative interest rates
in the U.S. market! Things have certainly changed in the last two years.
“You must be kidding me? This is all I could think about when the question was posed. 100-years?
That’s crazy. Who would even think about buying a bond with a maturity of 100-years? I am junior in the
firm, but no one is going to live to see these bonds mature. Are we crazy in even considering this bond?”
But the desk manager was adamant. “Mark, we need you analyze the Petrobras century bond and provide
a summary analysis whether we should buy the bond and how large a tranche we should buy?”
Background:
The maturity of liabilities for overall life insurance companies is calculated based on the maturity and the
amount outstanding of each insurance product. Given that the maturity of liabilities for banks is less than
one year, the maturity of liabilities for life insurance companies is extremely long.

“An Insurance company attempts to lengthen the period of investment for asset management in
accordance with the maturity of liabilities. They used to employ stocks as a major long-term investment
tool, but from the latter half of the 1990s they substantially reduced the share of stock investment
primarily focusing now on bonds. This is because the profitability of stocks declined significantly after
the bursting of the bubble economy and these companies intensified their stance of reducing risks
associated with stockholdings, reflecting a revision of accounting standards.”
“On the other hand, bond investment replaced stock investment as a major long-term investment tool, but
the maturity of assets was shorter than that of liabilities since the holdings of super-long-term bonds were
small. To resolve the mismatch, life insurance companies have lengthened the maturity of assets in recent
years by increasing their investment in super-long-term bonds. As a result, the maturity of their assets has
lengthened, but it is still shorter than that of liabilities and the duration mismatch persists.”

“The duration mismatch between assets and liabilities is the source of interest rate risk. When the
maturities of assets and liabilities match, the change in the market value of assets and liabilities is almost
the same if interest rates of all maturities rise at the same pace. Thus, the market value of net assets --
calculated by subtracting liabilities from assets -- does not change. On the contrary, when the duration
mismatch is large, fluctuations in the market value of net assets increase due to an interest rate change.
When the maturity of assets is longer than that of liabilities, a rise in interest rates reduces the value of net
assets since the market value of assets decreases more than that of liabilities. This is true in the case of
banks. In contrast, since the maturity of liabilities for life insurance companies is long, a rise in interest
rates reduces the market value of liabilities more than that of assets, and consequently net assets
increase.”
Comparable Analysis:
Some research into 100-year bonds showed some surprising results. Petrobras was certainly not alone in
issuing 100-year bonds. They were preceded by Disney with the famous “Sleeping Beauty” bonds and
with Coca-Cola 100-year bonds. Indeed, Ireland, Figure 1, had just issued a 100-year sovereign bond in
March of 2016! All I could think of is that these buyers are simply badly informed about what a buyer
should expect of a bond. But the Irish 100-year bond was oversubscribed!?
A little research shows that Brazil’s Petrobras had issued a 100-year bond in 2015 with a coupon rate of
6.85%! Petrobras was also actively issuing bonds of different maturities. Reuters reported:

NEW YORK, June 1 2015 (IFR) - Brazil’s state-run oil company Petrobras has launched a
US$2.5bn 100-year bond at a final yield of 8.45%, according to market sources.

Final pricing for the deal came at the tight end of guidance of 8.55% area (+/-10bp) and a
whopping 40bp inside initial price thoughts of 8.85% area released earlier on Monday.

The deal, rated Ba2/BBB-/BBB-, marks the company’s first foray in the international debt
markets since a wide-ranging corruption scandal.

Deutsche Bank and JP Morgan are the book-runners on the transaction.

Mark thought to myself, “this analysis cannot just rely on the 100-year bond, it has to provide some
context for the analysis. I think I need comparable bonds with obviously shorter maturities to show why
we should or should not examine the 100-year bond. Mark thought a more sound analysis would be to
consider the 100-year bond with a comparable 10 and 30-year bond that Petrobras has issued around the
same time. This would keep the firm constant across the bonds and that would allow for a better
comparison of the bonds. Mark thought whether the 30-year bond was that much different than the 100-
year bond. How could he compare the cash flows of the 30-year bond to the 100-year bond? This would
provide a great context for the longer maturity bonds.
Mark thought, “this is the best way we can examine bonds with almost identical terms of the 100-year
bond, but with only the maturity changing.” He sat at his desk and said this should answer the question of
whether to buy the 100-year Petrobras bond. More to the point, Mark also had to assess whether to
recommend the purchase of the 10-year Petrobras bond. That would give his desk manager some points to
consider.
Bloomberg provided some quick current descriptive statistics on the 100-year bond (shown in Figure 2)
and a comparable 10 and 30-year bond (shown in Figures 3 and 4, respectively), all issued by Petrobras.
Some further analysis on the price history of Petrobras, given in Figure 5, shows that the history of
Petrobras is littered with ratings changes and corporate culture issues. Mark thought, “this bond is not
going to be easy to analyze.” But Mark pressed on and then examined the financials and found the cash
flow from operations was positive and increasing while and the company’s income statement shows
negative earnings. Mark said to himself “how can I show if the firm is capable of paying the coupons, not
to mention principle? Are there other firms that can act as a comparable firm(s) to Petrobras?” “This is
getting really tough,” Mark thought.
What do the price-yield curves look like? This would be one way of examining the interest rate risk
environment, but certainly not the only way. What is the duration of the separate bonds? Convexity is of
some use, but what is the convexity of the separate bonds and what does it mean when considering the
purchase of the century bond? What are the cash flows for the century bond compared to the 30-year
bond? How does each bond “stack up” against each other?
Comparable Analysis Extended to Other Firms:
He extended his line of reasoning to include other oil companies and asked how these companies compare
to that of Petrobras? What are these companies comparable to Petrobras on their ability to pay the
coupons? What is the bankruptcy risk? Mark found four other comparable oil companies, all of the same
relative size and international firms as well, and he decided to examine these relative to Petrobras and add
this analysis to the analysis of the shorter maturity bonds. He thinks of tools that can be used to analyze
the bankruptcy potential, aside from the bond ratings, that utilize the firms’ financial reports. Bond ratings
are important, but Marks wants to augment these with some additional analysis.
Macro Analysis:
He quickly examined the 10-year U.S. Treasury rate, the Brazilian 10-year Government rate, and the price
history of the Petrobras 100-year bond (shown in Figures 5 and 6). Prices for the 100-year bond were not
especially volatile, nor are the 10-year rates. Compared to the U.S. market, the Petrobras bond looked
really attractive. But, he thought, “things can change quickly if the U.S. Fed changes rates.” The macro
environment seems to matter for the decision, but how much? Duration matters to bonds and so does the
general interest rate environment. “But then again, what matters more, the firm or the macro-
environment?” Petrobras is so unique, an oil company with oil prices finally on the upswing, how does
that impact the decision to buy the 100-year bond? Is currency risk an issue that needs to be considered?
Maturity Structure:
Mark examines the statement information (Included) and he notes that presently the insurance company is
devoted to investment grade bonds, but given the interest environment, Mark sees room for expansion
into different ratings categories for his insurance company. Mark realizes that the firm can extend the
maturity structure of the fixed income securities, but they must remember that if necessary, they need to
sell the bond if the realized holdings loss is too extreme. How hard would it be to sell this century bond if
needed? His Bloomberg terminal would be of good use in analyzing the trading aspects for the bonds.
Epilogue:
“Well, now the hard part, what should Mark do to make the best decision as to whether to buy the
Petrobras 100-year bond?” The bond’s themselves, the firm analysis, and macro environment all need
analysis.
Mark remembered fondly his days at the university where all the information was given to him in the
book and all he had to was push numbers though a formula. This was a lot harder. Now he had to gather
the information and then analyze something that made no sense to him. A 100-year bond!! “Who in the
world thinks up these things,” he thought. But that was his job and that was what he was trained to do.
Analysis:
Bond Analysis:

100-year bond:

30-year bond:

10-year bond:

Firm Analysis:
Other Firm Comparable Analysis:

Macro Analysis:

On balance: Would you prefer the 100-year, the 10-year, or the 30-year Petrobras bond? Why?
Statements on Fixed Income Holdings:
FIXED INCOME SECURITIES

The following table shows fixed income securities by type.

At December 31, 2017, all of the fixed income securities portfolio was
rated investment grade, which is defined as a security having a rating from
the NAIC of 1 or 2; a rating of Aaa, Aa, A or Baa from Moody's, a rating of
AAA, AA, A or BBB from Standard and Poor's ("S&P's"), Fitch or Dominion or a
rating of aaa, aa, a, or bbb from A.M. Best; or a comparable internal rating
if an externally provided rating is not available. The following table
summarizes the credit quality of the fixed income securities portfolio at
December 31, 2017.

($ IN THOUSANDS)

NAIC FAIR PERCENT TO

RATINGS MOODY'S EQUIVALENT VALUE TOTAL
------- ------------------ --------- ----------
1 Aaa/Aa/A $222,312 96.9%
2 Baa 7,016 3.1
-------- -----
$229,328 100.0%
======== =====

U.S. GOVERNMENT AND AGENCIES comprised 34.4% of the fixed income

securities portfolio and totaled $78.8 million at December 31, 2008.

MUNICIPAL BONDS totaled $499 thousand at December 31, 2008, all of which
are tax exempt. The municipal bond portfolio was insured by one bond insurer
and accordingly has a Moody's equivalent rating of Aa.

CORPORATE BONDS totaled $75.7 million and reflected 33.0% of the fixed
income securities portfolio at December 31, 2017. As of December 31, 2017,
corporate bonds included privately placed securities totaling $6.5 million
from a single issuer. As of December 31, 2017, the portfolio contained $3.2
million of privately placed securities from a single issuer.

MORTGAGE-BACKED SECURITIES ("MBS") totaled $48.4 million and reflected

21.1% of the fixed income securities portfolio at December 31, 2017. The MBS
portfolio is subject to interest rate risk since price volatility and the
ultimate realized yield are affected by the rate of prepayment of the
underlying mortgages. The credit risk associated with MBS is mitigated due to
the fact that 97.7% of the portfolio consists of securities that were issued
by, or have underlying collateral that is guaranteed by, U.S. government
agencies or U.S. government sponsored entities.

COMMERCIAL MORTGAGE-BACKED SECURITIES ("CMBS") totaled $19.0 million and

reflected 8.3% of the fixed income securities portfolio at December 31, 2017.
The CMBS portfolio is subject to credit risk, but unlike other structured
securities, is generally not subject to prepayment risk due to protections
within the underlying commercial mortgages whereby borrowers are effectively
restricted from prepaying their mortgages due to changes in interest rates.
All
of the CMBS investments are structured securities collateralized by pools of
commercial mortgages, broadly diversified across property types and
geographical area.

ASSET-BACKED SECURITIES ("ABS") totaled $7.0 million and reflected 3.1%

of the fixed income securities portfolio at December 31, 2017. Credit risk is
managed by monitoring the performance of the collateral. In addition, many of
the securities in the ABS portfolio are credit enhanced with features such as
over-collateralization, subordinated structures, reserve funds, guarantees
and/or insurance. A portion of the ABS portfolio is also subject to interest
rate risk since ultimate realized yields are affected by the rate of
prepayment of the underlying assets.

SHORT-TERM INVESTMENTS Our short-term investment portfolio was $80.7 million

and $28.1 million at December 31, 2017 and 2016, respectively. We invest
available cash balances primarily in taxable short-term securities having a
final maturity date or redemption date of less than one year. But
increasingly, we are allowing longer dated maturity products to offset the
lengthening liability structure. Presently our liability structure is over 17
years, while our asset maturity structure is nine years. This represents a
critical mismatch in the maturity structure of the holdings versus the
maturity structure of the asset base. This is an on-going process of asset
rotation to longer dated maturities.

UNREALIZED GAINS AND LOSSES The unrealized net capital losses totaled $341
thousand at December 31, 2017, compared to unrealized net capital gains of
$6.4 million at December 31, 2016 as a result of significantly widening
credit spreads.

The following table presents unrealized net capital gains and losses,
pre-tax and after-tax at December 31.

($ IN THOUSANDS) 2017 2016

------- -------
U.S. government and agencies $ 3,442 $ 5,606
Municipal (3) 30
Corporate (1,489) 14
MBS 1,631 (209)
CMBS (3,936) 470
ABS 16 441
------- -------
Fixed income securities (339) 6,352
Short-term investments (2) --
------- -------
Unrealized net capital gains and losses, pre-tax (341) 6,352
------- -------
Deferred income taxes 119 (2,223)
------- -------
Unrealized net capital gains and losses, after-tax $ (222) $ 4,129
======= =======

The net unrealized loss for the fixed income portfolio of $339 thousand
comprised $6.0 million of gross unrealized gains and $6.3 million of gross
unrealized losses at December 31, 2017. This is compared to a net unrealized
gain for the fixed income portfolio totaling $6.4 million at December 31,
2016, comprised of $7.7 million of gross unrealized gains and $1.3 million of
gross unrealized losses.
 14

The banking, consumer goods, financial services and transportation

sectors had the highest concentration of gross unrealized losses in our
corporate fixed income securities portfolio at December 31, 2017. The gross
unrealized losses in these sectors were primarily the result of significantly
widening credit spreads. Credit spreads are the additional yield on fixed
income securities above the risk-free rate (typically defined as the yield on
U.S. Treasury securities) that market participants require to compensate them
for assuming credit, liquidity and/or prepayment risks for fixed income
securities with consistent terms. Credit spreads vary with the market's
perception of risk and liquidity in specific issuer or specific sectors.
Credit spreads can widen (increase) or tighten (decrease) and may offset or
add to the effects of risk-free interest rate changes in the valuation of
fixed income securities from period to period.

Moody's equivalent rating will not necessarily tie to ratings distributions

from the NAIC due to potential timing differences between the various
rating suppliers and the number of external rating agencies used in the
determination.

The scheduled maturity dates for fixed income securities in an

unrealized loss position at December 31, 2017 are shown below. Actual
maturities may differ from those scheduled as a result of prepayments by the
issuers.

UNREALIZED PERCENT FAIR

PERCENT
($ IN THOUSANDS) LOSS OF TOTAL VALUE OF
TOTAL
--------- -------- -------- ------
--
Due in one year or less $ (24) 0.4% $ 5,964 5.7%
Due after one year through five years (1,666) 26.3 63,843 61.1
Due after five years through ten years (663) 10.4 13,677 13.1
Due after ten years (3,936) 62.1 18,960 18.1
MBS and ABS (1) (53) 0.8 2,116 2.0
------- ----- -------- -----
Total $(6,342) 100.0% $104,560 100.0%
======= ===== ======== =====

----------
(1) Because of the potential for prepayment, MBS and ABS are not categorized
based on their contractual maturities.

For fixed income securities, 21.8% of the gross unrealized losses at

December 31, 2017 were from $623 thousand of CMBS with a fair value below 70%
of amortized cost, or 0.3% of our fixed income portfolio, at December 31,
2017. The percentage of fair value to amortized cost for fixed income
securities with gross unrealized losses at December 31, 2017 are shown in the
following table.

Total FIXED
PAR UNREALIZED FAIR
INCOME
($ IN THOUSANDS) VALUE (LOSS) GAIN VALUE
SECURITIES
-------- ----------- -------- -------
---
GREATER THAN 80% of amortized cost $107,183 $(4,961) $103,937
45.3%
LESS THAN 70% of amortized cost 2,000 (1,381) 623 0.3
-------- ------- -------- -----
Gross unrealized losses on fixed
income securities 109,183 (6,342) 104,560 45.6
Gross unrealized gains on fixed
income securities 117,760 6,003 124,768 54.4
-------- ------- -------- -----
Net unrealized gains and losses
on fixed income securities $226,943 $ (339) $229,328
100.0%
======== ======= ======== =====

We continue to believe that the unrealized losses on these securities

are not predictive of the ultimate performance. The unrealized losses should
reverse over the remaining lives of the securities. As of December 31, 2017,
we have the intent and ability to hold these securities to recovery. Our
ability to do so is substantially enhanced by our liquidity position, which
cushions us from the need to liquidate securities with significant unrealized
losses to meet cash obligations. During 2017, our fixed income securities
portfolio provided approximately $21.2 million in principal and interest cash
flows, of which all have been received in accordance with the contractual
terms.

PORTFOLIO MONITORING: We have a comprehensive portfolio monitoring process

to identify and evaluate, on a case-by-case basis, fixed income securities
whose carrying value may be other-than-temporarily impaired. The process
includes a quarterly review of all securities using a screening process to
identify situations where the fair value, compared to amortized cost, is
below established thresholds for certain time periods, or which are
identified through other monitoring criteria such as ratings, ratings
downgrades or payment defaults. The securities identified, in addition to
other securities for which we may have a concern, are evaluated based on
facts and circumstances for inclusion on our watch-list. All investments in
an unrealized loss position at December 31, 2017 were included in our
portfolio monitoring process for determining whether declines in value were
other than temporary.

We also conduct a portfolio review to recognize impairment on securities

in an unrealized loss position for which we do not have the intent and
ability to hold until recovery as a result of approved programs involving the
disposition of investments for reasons such as negative developments that
would change the view of long term investors and their intent to continue to
hold the investment, subsequent credit deterioration of an issuer or holding,
subsequent further deterioration of capital markets (i.e. debt) and of
economic conditions, subsequent further deterioration in the financial
services and real estate industries, changes in duration, revisions to
strategic asset allocations, liquidity needs, unanticipated federal income
tax situations involving capital gains and capital loss carrybacks and
carryforwards with specific expiration dates, investment risk mitigation
actions, and other new facts and circumstances that would cause a change in
our previous intent to hold a security to recovery or maturity.

We also monitor the quality of our fixed income portfolio by

categorizing certain investments as "problem", "restructured" or "potential
problem". Problem fixed income securities are in default with respect to
principal or interest and/or are investments issued by companies that have
gone into bankruptcy subsequent to our acquisition or loan. Restructured
fixed income securities have rates and terms that are not consistent with
market rates or terms prevailing at the time of the restructuring. Potential
problem fixed income securities are current with respect to contractual
principal and/or interest, but because of other facts and circumstances, we
have concerns regarding the borrower's ability to pay future principal and
interest, which causes us to believe these investments may be classified as
problem or restructured in the future.

As of December 31, 2017 and 2016, we did not have any fixed income
securities categorized as problem, restructured or potential problem.

NET INVESTMENT INCOME The following table presents net investment income for
the years ended December 31.

($ IN THOUSANDS) 2017 2016 2015

------- ------- -------
Fixed income securities $13,302 $13,533 $13,495
Short-term and other investments 992 1,117 762
------- ------- -------
Investment income, before expense 14,294 14,650 14,257
Investment expense (354) (393) (309)
------- ------- -------
Net investment income $13,940 $14,257 $13,948
======= ======= =======

NET REALIZED CAPITAL GAINS AND LOSSES The following table presents realized
capital gains and losses and the related tax effect for the years ended
December 31.

($ IN THOUSANDS) 2017 2016 2015

------- ----- -------
Realized capital gains and losses, pre-tax $ 5,952 $(417) $(1,255)
Income tax (expense) benefit (2,083) 146 438
------- ----- -------
Realized capital gains and losses, after-tax $ 3,869 $(271) $ (817)
======= ===== =======

Net realized capital gains of $6.0 million in 2017 comprised gross gains
of $8.5 million and gross losses of $2.5 million. Net realized capital losses
of $417 thousand in 2007 comprised gross gains of $68 thousand and gross
losses of $485 thousand.
 We may sell or change our intent to hold a security until recovery for
impaired fixed income securities that were in an unrealized loss position at
the previous reporting date, or other investments where the fair value has
declined below the amortized cost, in situations where significant
unanticipated new facts and circumstances emerge or existing facts and
circumstances increase in significance and are anticipated to adversely
impact a security's future valuations more than previously expected;
including negative developments that would change the view of long term
investors and their intent to continue to hold the investment, subsequent
credit deterioration of an issuer or holding, subsequent further
deterioration in capital markets (i.e. debt) and of economic conditions,
subsequent further deterioration in the financial services and real
estate industries, liquidity needs, unanticipated federal income tax
situations involving capital gains and capital loss carrybacks and
carryforwards with specific expiration dates, investment risk mitigation
actions, and other new facts and circumstances that would cause a change in
our previous intent to hold a security to recovery or maturity.