Tuesday, July 01, 2014
Comment from John Seo, Co-Founder & Managing Principal at Fermat Capital Management, LLC.
Investors on the hunt for yield have turned the limelight on the cat bond market, but this flurry of attention has not been the primary driver for the asset class’s growth. There is another expansionary source – a structural deficit that required sating.
Historically, catastrophe bonds were seen as an insider tip for investors looking to diversify their portfolios, as the securities are tied to the probability of the occurrence of a precisely defined natural event, such as a hurricane in Florida. Investors accept the risk of losses, and are rewarded in return with a regular coupon payment. A key advantage of cat bonds is therefore their ability to provide an income source that is truly uncorrelated to financial markets.
Cat bonds have historically offered attractive yields on par with traditional high yield bonds. But levels are now falling – why? One theory is that investors, under pressure from QE, are being forced into new markets as the yields in other bonds markets diminish. Because of this increased demand, market spectators claimed issuers were acting opportunistically, offering investors low coupons and inadequate compensation for the levels of risk they were taking on. This thesis drew attention to the asset class and some chose to look for alternative opportunities in other bond markets. What has subsequently occurred is a rebalance of interest back toward the more niche original investor base that held catastrophe bonds as those blindly hunting yield move onto other opportunities.
It is undisputable that yields on cat bonds have fallen since the financial crisis. But looking at data going back to the late 1990s, we can see that spreads on cat bonds are not collapsing, they are in the process of normalising. The financial crisis caused spreads to soar, but this was an exceptional event from which the market is now recovering.
As cat bonds are affected by the occurrence of major catastrophes, it is worth evaluating current spreads in relation to the periods between such events. Compared with, for example, the period before Hurricane Katrina in 2005 or the attacks on 11 September 2001, the current discount has reverted to a normal level, and the increase in issuance follows a similar pattern. While looking significant at first glance, an increase of 23% is expected for 2014 – hardly higher than the annualised growth rate of 21% that was reached between 2008 and 2013. And only now have the number of new issues returned to pre-crisis levels.
There is nothing to indicate that rising demand for cat bonds has contributed to irresponsibly low spreads or opportunistic issues. In fact, certain issuers with a good reputation have had problems in recent months placing bonds after the coupons in the subscription period were adjusted downwards.
The financial crisis has left investors understandably wary. Cat bonds are a very different product to the sub-prime market which caused the crisis and it is a disservice to lump them into the same bucket. A key differentiator is that issuers are inextricably linked to their issues by the regulations. They cannot simply sell on their risks as was done with problem loans, which were sliced up and repackaged into other instruments. This is particularly true when it comes to market growth, as this is structurally related to the regulatory conditions of the reinsurance market.
In order to be competitive, reinsurers need a rating from agencies such as Standard & Poor’s or A. M. Best. To obtain one, they need to comply with strict requirements that limit the sum insured within a specific sub-market. The rating agencies want to ensure that risks are not too concentrated in reinsurers' balance sheets. As a result, the sum of all traditional reinsurance capital in Florida is currently only around USD 20 billion. By way of comparison, if Florida were to be hit by a large hurricane, it could cost insurers between USD 150 billion and USD 200 billion. This means that in Florida alone there is a structural deficit of over USD 100 billion in reinsurance capital – a hole that risk-takers close with catastrophe bonds. Florida is the most important risk region in the world, but the same applies to many other vulnerable regions.
These holes – which we call ‘disaster gaps’ – form the basis for the continued need of issuers for new cat bond issues. We estimate that these gaps account for between USD 300 billion and 500 billion globally, and are set to double over the next ten years. The cat bond markets help to bridge these gaps and cover the structural deficit in reinsurance capital. As a result, catastrophe bonds and other insurance-linked securities (ILS) today cover just under 10–12% of capital needs. It is this sizable deficit that is the primary driver of growth in the asset class, rather than fresh waves of buy-side interest.