Demand for diversifying perils causes significant spread tightening on recent catastrophe bonds

by Artemis on August 10, 2011

Diversification is becoming a regular theme of many of our articles as investors seek our ways to keep a good mix of perils in their insurance-linked securities portfolios. The catastrophe bond market recently found itself to consist of 71% U.S. hurricane risks, add to that the slow primary issuance and you have a difficult situation for investors to manage their diversification effectively.

Recently there has been a $700m source of relief for some investors as four new cat bonds came to market all of which offered good opportunities for diversification. Between them, Queen Street III Capital, Vita Capital IV, Embarcadero Re and Pylon II Capital (details on all four can be found in our Deal Directory) offered investors a decent chance to secure some European windstorm, California earthquake and extreme mortality risk to add to their portfolio.

According to Plenum Investments, a Zurich based investment manager, the demand for these four transactions was very high resulting in favourable pricing from the perspective of sponsors and in significant upsizing of two of the transactions (Queen Street III and Vita Capital IV). Plenum says that the effect of excess capacity for diversifying perils in the capital markets has clearly outweighed the influence of the heavy losses experienced from catastrophes during 2011 and caused the spreads of these transactions to tighten significantly while the deals were being marketed.

It does seem that the cat bond market has fully recovered from the various impacting events seen this year and has returned to business as usual. In some ways it’s a shame that this has happened during U.S. hurricane season as that means issuance is generally low, however we do expect to see some more diversifying transactions come to market over the next couple of months and then issuance should pick up as we come to the end of the hurricane season (unless there are any major landfalling events of course, in which case it is hard to predict where the market could go).

Plenum Investments said that the secondary market was more active during July, helped by the primary market activity which left some investors needing to rebalance their portfolios to accommodate the new transactions. The secondary market is increasingly being used to enable diversification as well as offering a way for smaller investors to access the market at a time when they may find it hard to get on the books of a primary deal (as they are generally over subscribed).

Most bonds in the secondary market had mark to market price increases and U.S. hurricane cat bonds showed the largest gains according to Plenum. However, they note that the seasonal tightening of U.S. hurricane bonds has been marginal to date and should accelerate as we move into peak wind season. As a result of the slower than expected price movements on U.S. hurricane positions Plenum said that their funds performance was lower than expected for July. Price increases in U.S hurricane bonds were not sufficient to offset price decreases in European windstorm and U.S. severe thunderstorm risks. This seasonal balancing of returns is another reason that diversification is so important in ILS investment. Plenum also experienced significant inflows of new cash into the fund which they say will be fully invested this month and they expect solid returns.

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