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.
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
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
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.
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