Catastrophe bonds: the perfect alternative investment?

MATTHEW LAMB OF GAM EXPLAINS THE ATTRACTIONS CATASTROPHE BONDS HOLD FOR PENSION FUNDS AND WHY THE CURRENT OUTLOOK IS SO PROMISING

With a history of delivering uncorrelated and attractive riskadjusted returns, catastrophe (or “cat”) bonds can provide unique diversification potential to pension funds, with low sensitivity to the credit cycle, to movements in interest rates and to mainstream markets. Since the asset class’ inception in the late 1990s, cat bonds have been severely tested by both natural and financial disasters, but on each occasion they have performed robustly. Since 2002 (when the Swiss Re bond indices were launched) the sector has delivered stable and attractive returns of over 7% pa, with – crucially – significantly less volatility (at around 3% pa.) than traditional asset classes.1 Market fundamentals continue to strengthen, and forward-looking growth expectations are extremely positive for the mid- to long-term. So, are cat bonds the perfect alternative investment?

Attractive yields with low sensitivity to traditional markets

With insurers under increasing regulatory pressure to divest catastrophe risk from their balance sheets, supply rather than demand is the primary driver behind both the growth of the cat bond market and of bond pricing. This dynamic has proven very positive for cat bond yields – at typically 5-15% above Libor, they are around twice that of corporate paper with a similar risk rating. Plus, since their pricing is not driven by economic or corporate events, cat bonds are largely uncorrelated to mainstream markets, making them extremely attractive to investors looking for portfolio diversification and protection from broad financial market volatility.

Bond issuances are typically structured around “super” catastrophes: events with high severity but low frequency of occurrence, usually defined as having around a 1% or 1-in- 100 years probability. It is these remote risks that impose the greatest stress on re/insurers’ balance sheets, and as such they generally offer the best risk-reward level for investors.

Low sensitivity to interest rate risk

In terms of structure, cat bonds are high-yield debt instruments, with usually a three or sometimes up to five-year maturity. They carry a quarterly coupon composed of two parts: a fixed spread, reflecting the compensation for the assumed insurance risk, plus a floating money market rate, typically Libor. Thus, in contrast to conventional corporate bonds, cat bonds face minimal interest rate risk since the money market component is adjusted at short intervals.

Low counterparty and credit risk

Cat bonds are typically fully collateralised with transparent structures and strict collateral rules designed to limit unwanted counterparty risks. The counterparty risk to underlying sponsors is minimal and typically limited to three months of coupon (and in no case is the bond’s principal exposed). If a sponsor lapses on a coupon payment, the bonds will mature early at par with no further risk exposure. However, it should be noted that in most situations in which a sponsor would default, the bonds in question would likely be trading below par, so an early maturity at par would be positive.

As with other fixed income instruments, most cat bonds are rated by rating agencies, and while ratings range from single A to single B, they have an average of BB, which means they are classed as high-yield instruments.

In a typical cat bond structure, the issuer sponsors the creation of a special purpose vehicle (SPV), within which cash raised by the bond’s initial investors is held as collateral in AAArated securities or sometimes cash. The cat bonds themselves are notes issued by this SPV. The coupon that the notes pay out is funded by a combination of the returns generated by the AAA-rated securities, together with premiums paid into the SPV by the issuer. The bonds’ coupon levels are set with reference to the probability of default as determined by specialist catastrophe risk modelling companies.

In the event that the specific catastrophe criteria set out in the bond’s prospectus are met, some or all of the cash held in these securities is paid out to the insurer to cover its potential liabilities. It is worth noting that a bond’s default criteria are often very narrowly defined, so that the simple occurrence of the named catastrophe frequently occurs without triggering default. In addition, many bonds are now issued with multi-event default triggers, which require more than one defined catastrophe to occur before losses are incurred.

The importance of an active approach

Despite these favourable characteristics, cat bonds remain a specialist asset class, requiring expert knowledge in catastrophe reinsurance, investment, legal, tax, collateral and risk modelling. In 2004, GAM teamed up with Fermat Capital Management (“Fermat”), a dedicated cat bond manager and one of the leading players in the industry. Founded in 2001 by John and Nelson Seo – active participants in the cat bond market since its inception – the firm is one of the most experienced cat bond managers in the world today, with assets of around USD 2.3 billion.2 Their experience and in-depth market knowledge, encompassing all major catastrophes over the past 10+ years, is critical to their ability to assess data inputs and underlying issuer assumptions, and to identify the true risks of each bond.

Many competing strategies, even if they are cat bond focused, seek to provide “passive” exposure to cat bond beta by buying and holding as many issues as they can access. Fermat, however, is highly discerning in its approach, seeking to include only the highest quality, most stable sources of that market beta at a given time. To do this, they apply intensive, bottom-up security selection, and ongoing evaluation of every bond that comes to market. As a result, Fermat tends to hold only about 50% of the universe and actively manages the portfolio to ensure risk is optimally diversified within it.

This approach has worked extremely well for GAM FCM Cat Bond, which has returned 8.35% per annum since inception in December 2004, putting it comfortably ahead of mainstream asset classes with much lower volatility, as summarised in Figure 1.

This has been achieved despite the fact that the cat bond market has been subjected to several severe stress tests since its inception. Hurricane Katrina, which struck New Orleans and America’s Gulf coast in 2005, is regarded as the most devastating hurricane in US history incurring property damages of an estimated USD 81 billion. Although it led to the first ever principal loss to a publicly rated cat bond, it had limited impact on market prices. The market initially declined as spreads demanded by investors on new issues pushed existing bond prices down, but the very fact that risk was re-priced meant that cat bond returns rose sharply thereafter, offsetting those short-term losses.

The sector again held up relatively well following the financial crisis in 2008 and the bankruptcy of Lehman Brothers, to whom a handful of bonds were exposed. The event caused a general widening of risk premiums in the market and widespread distressed selling by investors. Overall, the index3 experienced a maximum drawdown of just 4% over an 8-week period, compared to a 25% fall in the US high-yield index over 32 weeks, and a 52% fall in the S&P 500 index over 44 weeks (source: Swiss Re Cat Bond Performance Indices, February 2011). Furthermore, following Lehman’s collapse, structural improvements were introduced to cat bonds in 2009 that have reduced the embedded counterparty credit exposure and collateral investment risk.

More recently in 2011, despite the market falling almost 5% in its immediate aftermath,4 the Tohoku earthquake illustrated the overall health and resilience of the cat bond sector. The market recovered within six months and has now returned 1.9% year-to-date (30 September 2011). Mark-to-market losses were largely isolated to bonds exposed to Japan earthquake risk and, importantly, investor demand remained strong; over USD 690 million of cat bonds were issued in the first half of 2011 after Tohoku, including USD 100 million exposed to Japan earthquake risk (source: Swiss Re Cat Bond Performance Indices, July 2011).

As experience following Katrina and other disasters illustrates, it is often those periods following a catastrophe that offer the greatest opportunities to investors: liquidity has tended to remain high, bonds have been tradable in the secondary market and average discounts have remained modest.

Extremely strong outlook for cat bonds

Since the market’s inception in the 1990s, the volume of outstanding publicly-issued bonds had grown at a compound rate of around 20% per annum to an estimated USD 12.5 billion by the end of 2010. Several secular trends suggest that the market will continue to expand just as fast, if not faster. For one, property concentration in risk-prone areas is rising, as is the cost of reconstruction. In addition, capital adequacy requirements for re/insurers are becoming even more stringent, requiring institutions to offset ever less likely but more devastating events. Meanwhile, despite its expansion so far, the broad catastrophe risk security market still covers only 12% of total catastrophe reinsurance. Reasonable predictions put cat bond market growth at around 20-25% per year over the next three to five years, slightly above the 10 year historical rate, as insurers look to hedge out increasingly more risk. The current new issuance pipeline is healthy (over USD 5 billion of gross issuance is predicted for 2011) and those new issues are being brought to market at very attractive yields to buyers.

The perfect alternative investment or otherwise, cat bonds seem set to be a permanent fixture on the investment horizon. And with recent catastrophe events and Solvency II capital constraints likely to lead to favourable premiums, it is increasingly looking like an opportune time to consider cat bonds – particularly for pension funds seeking attractive returns coupled with low correlation to mainstream assets.

1. Since inception of the Swiss Re Cat Bond indices in January 2002. Return of the Swiss Re BB-Rated Cat Bond Total Return Index to 30 September 2011 was 7.32% per annum.

2. As at 30 September 2011

3. Swiss Re BB Rated Cat Bond Total Return Index in USD

4. Swiss Re BB-rated Cat Bond Total Return index returned – 4.86% between 11 March and 1 April 2011