Tight spread environment for catastrophe bonds to continue: Swiss Re

In its latest look at the catastrophe bond and insurance-linked securities (ILS) market reinsurer Swiss Re suggests that the tight spread environment seen on cat bond issues through 2013 so far is set to continue. Tighter spreads and lower pricing has been driven by investor demand providing an attractive environment for cat bond sponsors.

On Friday Swiss Re published its latest Insurance Linked Securities (ILS) Market Update report, in which it reviews the transactions issued in  the first-half of 2013, looks at some of the trends from the year so far and discusses issues such as spreads, pricing and secondary cat bond and ILS trading conditions.

As we reported on Friday, including data from Swiss Re’s report, the outstanding catastrophe bond market has hit a milestone with $18 billion of risk-capital outstanding for the first time in the markets history. At the same time, issuance of cat bonds and ILS in 2013 has now reached over $5 billion, including the latest deals which have yet to complete.

Swiss Re’s report goes into some detail on the tightening of spreads and reduced pricing seen in the primary cat bond market, as well as the pricing trends seen in secondary trading. Primary catastrophe bond spreads have tightened significantly through the first-half of 2013, according to the reinsurer, with the drop in pricing being triggered by abundant demand for new cat bond deals.

Swiss Re said that investors continue to enter the ILS sector, both as direct investors in cat bonds and ILS deals as well as through dedicated ILS investment funds. Swiss Re said that it believes investors are interested in the space due to its relative value, particularly as interest rates remain at historic lows, along with the diversifying nature of ILS as an asset class given that it is largely uncorrelated with other investments and capital market instruments.

Swiss Re notes the long research commitments that many investors make before allocating to ILS and catastrophe bonds, saying that the significant resources and time spent on research to become comfortable with the asset class, can help these investors cement a long time commitment to ILS. That’s an encouraging statement from Swiss Re and is aligned with our perspective on how pension funds, for example, view ILS as an asset class.

The ILS and cat bond market has spent much of the last few months working to keep pace with investor interest in the asset class, which has been particularly tricky as in 2013 it has not been a lack of capital but rather a lack of supply that creates issues for investment managers in the space.

Despite new-record levels of issuance so far in 2013, there has still not been sufficient supply to satisfy all potential investors in the asset class. This has led to some investment managers having to close funds to new allocations and a more active secondary market environment, than in previous years, as investors and managers sought to put money to work.

Swiss Re notes in the report the trend for spreads on primary issued catastrophe bonds to tighten as we moved through the first-half of the year. It said that spreads have tightened dramatically so far this year because new issuances have been met with an abundant supply of capital from prospective investors. This resulted in a market which has been constrained due to supply of bonds rather than any lack of capital.

The chart below from Swiss Re’s report shows ILS and catastrophe bond spreads over time. You can see that currently spreads on new issuances are at all time lows.

ILS and catastrophe bond spreads over time

The improved ILS pricing conditions, with catastrophe bonds pricing more cheaply than ever before and often more cheaply than traditional reinsurance alternatives, has led to savings for some sponsors in 2013. Sponsors such as Florida’s Citizens Property Insurance have achieved large savings over cat bonds issued a year earlier and we have seen new sponsors come to market to take advantage of pricing.

The chart below from Swiss Re’s report shows the general pattern of catastrophe bond spreads in the first-half of 2013 versus 2012 issuances. Swiss Re says this is the clearest indication of improving market conditions, with newly issued cat bonds pricing approximately 30% tighter than similar cat bonds issued in 2012.

New cat bond and ILS issues spreads 2012 vs 2013 year-to-date

You can also see the downward trend in this chart (below) showing spreads as measured by different baskets of catastrophe bonds in Swiss Re’s indices, from June 2012 to June 2013.

Cat bond basket's spread performance, June 2012 - June 2013

In the secondary market for catastrophe bonds and ILS notes, Swiss Re said it has seen a typical amount of trading volume across its trading desk so far this year, with $425m of trading volume by the end of June. It says this volume continues to prove the liquidity in the ILS and cat bond market and the only things tempering liquidity are buy/hold investors and significant demand for secondary positions.

The tightening trend has been seen in the secondary market as well, with new investors eager to deploy capital helping to accelerate the tightening trend in both the primary and secondary markets. Secondary bids became aggressive as investors awaited a primary pipeline of deals to appear and once it did more balanced market dynamics emerged.

Swiss Re notes the trend for new issues to trade above par soon after launch, with deals paying higher coupons particularly in demand as well as diversification opportunities. Investors have been willing to pay above par for these positions in the secondary market.

Looking ahead to the rest of 2013 for the catastrophe bond and ILS market, Swiss Re said that it expects the environment of tighter spreads to remain, although at stable levels or perhaps a little wider than what has been seen in issues in the first half of the year. It qualifies its forecast by saying that; “This is due to the increased value of both the diversification and strong returns and relatively low volatility that the ILS market provides, as well as the new capital being raised by dedicated funds, money managers, and multi-strategy hedge funds.”

Swiss Re expects secondary ILS and cat bond trading volumes to increase as investors balance portfolios to accommodate the latest issuance. It notes that more sellers are now being seen and this is helping to increase liquidity in the secondary market.

The chart below from Swiss Re’s report shows how the secondary market has fared in the first-half of the year and you can clearly see activity rising in June. The figures in this chart are from Swiss Re’s own secondary ILS trading desk.

Secondary ILS and catastrophe bond trading volumes to 30th June 2013

Swiss Re Capital Markets expects continued catastrophe bond and ILS issuance over the months to come, which will further strengthen 2013 issuance figures. With cost of issuing cat bonds and ILS cheaper, and spreads expected to remain low, while increasing sums of capital try to access the market we could well see a record year for issuance in 2013.

You can access the full report in PDF format from Swiss Re here.