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Active Thinking: Seeking to unlock value beyond core credit markets

With tight spreads across credit markets seemingly priced for near-perfection and distinctly out of kilter with many economic forecasts, Ralph Gasser asks whether interest rate and credit markets are singing from the same hymn sheet. Against the backdrop of these apparent contradictions, Ralph also assesses the role cat bonds can play in optimising returns and improving diversification in fixed income portfolios.

02 February 2024

Federal Funds futures are currently priced for a total of 125 basis points of rate cuts in 2024. This scenario hinges on a marked deceleration of economic activity and inflation, or in the aggregate, a 2024 real GDP growth rate of no more than 1.5% for the US.

Corporate credit markets, however, appear to suggest a very different view. High yield bond markets, for instance, currently trade at around +340 basis points (bps) over government bonds in the US and +375 bps globally, which would suggest a 2024 real GDP growth rate of closer to 4%. But at the same time, the latest baseline forecast by Moody’s assumes that the global speculative-grade corporate default rate should peak at 4.9% in the 1st quarter before retreating to 3.7% to 4.0% in the 3rd and 4th quarters. Such a scenario would be more closely aligned with GDP growth of around 2% and a corresponding fair value range of +600 to +700 bps for high yield bond spreads.

Corporate credit may not appeal, but cat bonds do

With traditional corporate credit markets looking stretched and misaligned with underlying economic fundamentals, are there better value opportunities in fixed income spread assets? One asset class that stands out both strategically and tactically is catastrophe (“cat”) bonds.

Such bonds are risk-linked securities that transfer a specific set of insurance risks (typically catastrophe and natural disaster risks) from a sponsor (typically a [re-]insurance company) to capital market investors. Cat bonds usually have maturities ranging from one to five years, with the weighted average life of bonds at a portfolio level typically averaging around two years or less.

To illustrate the significant valuation advantage of cat bonds over traditional corporate bonds, a fully invested “live” reference portfolio* of publicly traded cat bonds currently trades at an average spread of approximately +850 bps. An equally “credit” risk and maturity weighted US corporate bond portfolio, in contrast, only delivers an average spread of about +305 bps, or a hefty 545 bps less compared to the cat bonds reference portfolio*, as illustrated in chart 1.

Chart 1: Cat bonds reference portfolio* average spread vs. like-for-like corporate bonds

Cat bonds reference portfolio* average spread vs. like-for-like corporate bonds 
Note: Monthly data as of 31-Dec-23. One-three year US corporate bond sub-indices spreads used to best match cat bond maturity and duration profile. Average spread of one-three year US corporate bond sub-indices based on corresponding month-end rating profile of cat bonds reference portfolio*. Cat bond implied ratings based on expected loss. There are no guarantees that forecasts will be realised. Source: BofA, GAM

If we now take this analysis one step further and compare not just like-for-like absolute spread levels of cat bonds with corporate bonds but also incorporate corresponding capital loss risk into the equation, the stand-out value proposition of cat bonds becomes, in my opinion, even more apparent.

Chart 2: Cat bonds reference portfolio* expected loss-adjusted spread multiple vs. like-for-like corporate bonds

Cat bonds reference portfolio* expected loss-adjusted spread multiple vs. like-for-like corporate bonds 
Note: Monthly data as of 31-Dec-23. One-three year US corporate bond sub-indices spreads used to best match cat bond maturity and duration profile. Average spread of one-three year US corporate bond sub-indices based on corresponding month-end rating profile of cat bonds reference portfolio*. Cat bond implied ratings based on expected loss. Cat bonds reference portfolio* Bond multiple is calculated as follows: Average Portfolio Spread / 12-month Expected Loss. Equally ratings weighted one-three year US corporate bond multiple is calculated as follows: Average Spread / (12-month Default Rate – 12-month Recovery Rate-adjusted Loss Rate). Source: BofA, Moody’s GAM. There are no guarantees that forecasts will be realised.

As chart 2 illustrates, the cat bonds reference portfolio* currently features a high one-year forward expected loss-adjusted spread multiple of 3.9 times compared to only 1.3 times for an equally “credit” risk and maturity weighted US corporate bond portfolio. Very clearly, cat bonds provide for a much higher compensation per unit of risk taken. Besides, one should also bear in mind that forward modelled risk does not necessarily equal realised risk. In the case of the cat bonds reference portfolio*, the one-year forward expected capital loss equals approximately 2.2%. The realised annual capital loss for cat bonds over the past 20 years, however, averages only about 1%, ranging between 0% to 4% per single year.

As shown, spreads for cat bonds are still high by historical standards and are expected to remain elevated for the foreseeable future. The key driver behind this is the supply/demand mismatch in the market for cat bonds. For 2024, for example, we expect to see planned issuance totalling about USD 20 billion, while bond maturities and coupon payments are set to total approximately USD 15 billion. For all planned issuance to be placed successfully, investors will need to be lured with attractive spreads to cover the expected shortfall.

Combining return optimisation with risk diversification

Based on absolute and relative valuation, cat bonds remain, in my view, a compelling asset class to include in a fixed income portfolio allocation. And not just for return optimisation, but also risk diversification, given the low qualitative and quantitative correlation of cat bonds to most other traditional asset classes as well as little interest rate duration risk.

*Key parameters of cat bonds reference portfolio are: (a) fully invested in cat bonds, no derivatives, no leverage; (b) publicly listed cat bonds; (c) focus on “peak perils” but a rational level of diversification; (d) focus on natural disaster risk, namely wind (c75% of portfolio over time), earthquake (c20%) and other (c5%) risks; (e) mostly US-related natural disaster risk (c90% of portfolio over time) with remainder being Europe, Japan, Latin America or global risks.
Important disclosures and information
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Past results are not necessarily indicative of future results. Investors could lose some or all of their investments.

The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.

Ralph Gasser

Investment Specialist
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