* Top insurers set to report a strong fourth quarter
* Stocks rose 20-40 pct in 2012
* Analysts say bond yields don't justify stock levels
By Cameron French
TORONTO, Feb 3 (Reuters) - After ringing up share-price gains last year that led the market, Canada's life insurers look ripe for a setback even if they post blockbuster quarterly results over the next couple of weeks.
Insurers such as Sun Life Financial Inc and Manulife Financial Corp have reduced their exposure to equity markets over the past two years, but their shares are heavily influenced by bond yield movements.
While yields have been on the rise since hitting historical lows last July, Canadian insurance stocks have positively sky-rocketed. That suggests that investors are betting on a further substantial rise in yields, a gamble that not everyone is willing to make.
"The Canadian lifeco valuations suggest a steepening of the yield curve, a pretty considerable one," said Peter Routledge, an analyst at National Bank Financial, referring to a graph of rising long-term bond yields. "That's a big bet and it's not one that we'd make."
Higher yields make the insurers' investment products more appealing and also increase the expected returns from the bonds they hold to offset their long-dated insurance liabilities.
But shares of the insurers - after rising between about 20 and 40 percent last year and even further in January - already reflect a rich premium.
"A ton of positive news is being priced in at this stage of the game," said John Aiken, an analyst at Barclays Capital.
Shares of Sun Life, Canada's No. 3 insurer, rose 39.5 percent last year, while larger rival Manulife gained 24.5 percent. Great-West Lifeco and Industrial Alliance Insurance and Financial Services Inc, the sector's No. 2 and 4 players, both climbed 19.4 percent.
That compares with a 4 percent rise for Canada's benchmark stock index, the S&P/TSX composite.
U.S. 10-year bond yields, which analysts often use as a benchmark, rose to 1.76 percent at the end of 2012 from a low of 1.39 percent in July. They have since climbed above 2 percent.
"The rug may not get pulled out from underneath (the insurers), but the march in the evolution of the valuation multiples has got to come to an end," Aiken said.
The four insurers now trade at about 12 times one-year forward earnings, according to Thomson Reuters data, and have higher valuations than all of the country's major banks.
Even though bond movements may not justify the valuations, analysts are expecting fourth-quarter results that should compare well to the fourth quarter of 2011, when profits were stung by volatile markets and one-time charges.
Manulife will be the first insurer to report, on Thursday, and is expected to post a profit of 32 Canadian cents a share, versus a loss of 5 Canadian cents a year earlier.
Sun Life is expected to earn a net 38 Canadian cents a share, versus a loss of 90 Canadian cents, while Great-West's EPS is expected at 46 Canadian cents, down from 65 Canadian cents.
Industrial Alliance, the final insurer to report, on Feb. 15, is seen earning 71 Canadian cents a share, compared with a steep loss of 90 Canadian cents a year earlier.
With little drama expected, and with both equity and bond yields on the rise, investors may already be looking past the results.
"People are expecting a relatively benign environment from the last quarter, but they're more concerned with what's coming up front," said Michael Sprung, president of Sprung Investment Management.
This could include hints from management about how the recent rise in bond yields will affect future results.
While the insurers may be pricey based on current market factors, they seem better positioned than most to benefit from an economic recovery.
Once among the largest stocks on the Toronto Stock Exchange, the insurers were hit harder than most by the 2008 market crash, which turned many of their insurance and investment products into money-losers and forced them to take billions in charges.
They responded by hedging much of their market exposure, and shedding money-losing assets. Sun Life, for instance, announced in December the sale of its U.S. annuity business.
Manulife and Sun Life have also focused on expanding their operations in Asia, where they see favorable demographics and a low penetration of insurance products.
But even with the recent stock gains, Manulife is trading at barely a third of its record high, set in 2007, while Sun Life is trading at just over half of its record high, giving them plenty of room to rise if and when bond yields emerge further from the remarkably low levels of the past two years.
Despite their recent rise, bond yields are still low on an historical basis. As recently as 2011, the U.S. 10-year Treasury yielded 3.5 percent, and the yield was above 5 percent before the 2008 financial crisis.
For the time being, analysts say they are approaching the sector with caution, at least until market fundamentals offer more support for their current prices.
"The relative risk/return now isn't very good and I wouldn't be surprised if that's what came out of the quarter and you saw a little bit of consolidation," said National Bank's Routledge.