Cat bond investment proposition holds, as ILS outperforms: Twelve Capital

The central catastrophe bond investment proposition has held during the extreme financial market volatility created by the coronavirus pandemic, with the ILS asset class positively outperforming other traditional asset classes, according to Twelve Capital.

The overwhelming majority of catastrophe bonds are fundamentally unaffected by the current Covid-19 coronavirus crisis, as only a small fraction of the market is directly exposed to pandemics, mortality risks and health insurance claims, according to specialist ILS and reinsurance investment fund manager Twelve Capital.

With little direct exposure to the coronavirus pandemic and being relatively uncorrelated to broader financial market factors, catastrophe bonds and other insurance or reinsurance linked securities (ILS) have had a chance to shine in recent weeks.

“The central Cat Bond investment proposition has held during this period of extreme COVID-19 led market volatility, with the asset class positively outperforming whilst exhibiting a low correlation to broader financial markets,” Twelve Capital explained.

The majority of the catastrophe bond market cover natural catastrophe perils, typically a securitisation of reinsurance or retrocession, meaning they are not at risk of direct losses due to the crisis.

Compared to substantial losses suffered in the majority of asset classes in recent weeks, the Cat Bond and ILS market continues to see much better performance, with many flat after Cat Bond selling pressure or even up on the back of reinsurance premium increases.

That’s far better than the -20% to -60% declines some assets have seen and the steep falls in equity markets driven by the coronavirus.

While the majority of Cat Bond funds are relatively flat through the start of the year, key benchmarks are sharply down, such as the MCSI Index that is down almost -30% and high-yield bond indices which are down -15% to -20%.

However, “Whilst the asset class is largely unaffected fundamentally, technical market factors have been a drag on performance year to date,” Twelve Capital explains.

Adding, “Twelve has noted that some investors have been selling Cat Bonds in secondary markets in recent weeks. In Twelve’s view there could be a variety of reasons to sell Cat Bonds in the current market. Some investors, such as multi-asset fund of funds, may have received margin calls and therefore may need to liquidate holdings across asset classes to generate liquidity; other investors may have experienced passive breaches in their maximum allocation limits to Cat Bonds due to other major asset classes delivering substantial negative performance.”

This is the flight to cash that we’ve been documenting in recent articles, but as we explained here this could actually result in greater interest in time, as the Cat Bond and ILS asset class demonstrates its lack of correlation.

Cat bond funds are already factoring in the mark-to-market decline in pricing seen as a result of all this selling activity, which explains the fact it is only flat so far this year.

But fund managers such as Twelve also have a chance to buy the bonds that have been on offer at below-par prices, putting their portfolios of Cat Bonds in even better shape for delivering future returns.

Looking ahead, “Twelve expects relative Cat Bond outperformance to continue if market volatility persists throughout 2020, making the asset an attractive option for defensive investors,” the investment manager said.

“Investor demand remains solid and the recent losses and volatility in traditional financial markets again highlights the benefit of having a minimally correlated strategy as part of any multi-asset portfolio. It is clear that Cat Bonds assist in reducing volatility in portfolios as evidenced over the last weeks.”