Active December secondary cat bond trading sees risk spreads widen

An active month of trading activity in the secondary market for insurance-linked securities (ILS) and catastrophe bonds was observed again in December, as ILS investors continued to free up capital for new cat bonds and reinsurance renewals.

December saw a continuation of the main trends observed in November, with strong levels of trading of short-dated cat bonds as investors looked to capitalise on available yields.

The other trend driving active levels of trading in December was the high level of new issuance that completed during the month, leading to investors adjusting their portfolios to accommodate new paper, as well as some activity to free up capital for reinvestment into reinsurance renewal deals on a collateralized basis.

There is a definite trend emerging of investors offloading short-dated positions in favour of allocating capital either to new cat bond issues or into collateralized reinsurance and private ILS deals. Those allocating to new cat bonds likely require the liquidity offered by a security, while those shifting allocations to private deals are often searching for either diversification or a higher returning asset.

At the same time risk spreads have been noted as widening, according to Zurich-based ILS and catastrophe bond investment manager Plenum Investments, who said; “A widening of risk spreads could be observed in the last few weeks of the year, especially for US perils.”

Some of this widening will be due to the seasonality of off-risk U.S. wind or hurricane cat bonds, however Plenum also believe it reflects the stabilisation of the premium environment, perhaps hinting once again that ILS investors are nearing a floor on the pricing of some catastrophe risks.

“This effect is partly due to seasonal factors, but also an expression of a stabilizing premium environment,” Plenum explained.

This widening of risk premiums will result in lower returns at many catastrophe bond focused ILS funds in December. In fact the trading prices on secondary cat bonds have been on the decline over recent weeks, as seasonal rises from earlier this year are scrubbed off the market.

Craig Bonder, Managing Director and Head of ILS Trading at AK Capital, noted the active month at his secondary trading desk; “It was a busy end to 2014 as December was an active month for both new issuance and secondary market trading to make room for this issuance.”

Performance for 2014 especially at catastrophe bond focused funds has dropped considerably compared to 2013. Bonder explained some of the reason for this; “As bond demand remained strong throughout the year we saw deals price tighter and tighter and coupons reduced. Not an unexpected development especially in light of overall low digit yields in other fixed income markets.”

It’s easy to focus on the reduction in catastrophe bond and ILS yields, which to some investors can make the market currently unattractive. However, when compared with other fixed income markets the potential returns of ILS and cat bond portfolios remains a very attractive investment, with the added value investors attribute to a low-correlated asset class ensuring the ILS markets continued growth.