Natural disasters are a fact of life, but 2011 was a particularly catastrophic year, with Asia at the epicentre. Japan’s earthquake, a worse-than-usual hurricane season in the Philippines and the worst Thai floods in 50 years, helped contribute to a near-record $110 billion in catastrophe-related payouts by insurance companies globally.
Yet despite this negative backdrop, funds that invest in catastrophe ('cat') bonds – which transfer the insurance risk of mega-catastrophes from insurers and reinsurers to the capital markets – yielded positive returns last year. They also did so in 2008.
Most cat bonds have a maturity of three to five years, and if the natural disaster covered by the bond does not occur in that time, investors receive their interest payments and principal at the end of the term. But they may lose most or all of their principal and remaining interest payments if the event takes place.
Cat bond funds emerged from 2008 with low-single-digit returns and from 2011 with mid- to high-single-digit performance. These products now have a substantial track record that has been tested under severe market conditions, says John Seo, co-founder and managing principal at Fermat Capital Management in Westport, Connecticut.
Five-year cat bond performance to 30 September 2011
His firm manages around $2.5 billion in cat bond funds, making it one of the biggest players in this small market, and has managed a cat bond fund for asset manager GAM since 2004. Outstanding issuance of cat bonds stood at $14 billion globally as of December 31, says Seo, of which some 50-60% is held in cat bond funds and the rest by a diverse range of investors.
Asian investors are highly under-represented in this market, which is dominated by US and particularly European entities, he told AsianInvestor while he was in Hong Kong last week. That said, Asian inflows into cat bond investments – largely funds – have significantly risen over the past two to three years, he notes.
In the past, Asian investors may have been put off by one-year lock-up periods or quarterly, sometimes annual, liquidity terms imposed by some funds because they use illiquid forms of insurance-linked securities, says Seo. But some firms are now offering terms with higher liquidity than in the past, particularly for cat bond-only fund products which can offer monthly, twice- or thrice-monthly liquidity.
Typical investors in this sector might include firms like bond manager Pimco and the Ontario Teachers Pension Fund, says Seo. At any one time there’s likely to be 100 to 150 institutions globally investing directly or through funds in cat bonds.
At one point hedge funds represented around a quarter of that figure, but dealers say they currently account for just 5%. This may seem illogical, says Seo, as the risk-reward ratio is now better than before, but it may be because hedge funds are not able to borrow as freely now to generate leverage.
Institutions tend to buy cat bonds as part of high-yield credit strategies. The instruments are most frequently rated BB or B, but their yield spreads tend to be double the typical equivalent, duration-matched credit market spreads. The average spread at issuance in the cat bond market in 2011 was 850 basis points.
“If yield spreads were to come down to normal credit market levels, the supply response would be overwhelming,” says Seo, suggesting that annual issuance could potentially treble. But there would not be enough investment capacity to cope with that supply in time to avert a halt in issuance, he notes.
So since supply is strong at these wider spreads, the current spreads are likely to remain, adds Seo, but he sees the yield spread halving from its current level in the long term, say 25 to 30 years.