Cat bond market averages 8.33% annual growth since 2002: Swiss Re

The catastrophe bond market has averaged a very impressive 8.33% on a compound annual growth rate basis since 2002, according to the Swiss Re Global Cat Bond Total Return Index, displaying significantly less volatility than other asset classes.

Swiss Re’s indices track the performance of the outstanding catastrophe bond market over time. As such they provide a great way to compare the volatility of the cat bond asset class versus other key financial market benchmarks.

In its latest ILS and catastrophe bond market report reinsurance firm Swiss Re looks at how its index has performed over twelve years, versus the Barclays Ba US High Yield index and the S&P 500 Total Return Index (SPXT).

So the Swiss Re cat bond index has seen an average annual gain of 8.33% across the period, while the Barclays Ba US High Yield index has seen slightly lower at 8.24% and the S&P 500 Total Return Index (SPXT) just 6.54%.

So just on a performance basis, over the period in question, catastrophe bond portfolios have enjoyed better average annual growth in value than these two benchmarks.

As impressive as that may be, where catastrophe bonds really stand out is when you look at how volatile (or not) the cat bond index returns have been versus the benchmarks. The chart below speaks volumes.

Catastrophe bond index total returns over time vs benchmarks - Source: Swiss Re

As you can see from the chart, the catastrophe bond total return index displays significantly less volatility than the other two benchmarks, a much smoother line which has not experienced a negative year and from its lowest to highest point has moved only a little more than 10% (comparing 2005 to 2007).

By comparison, the Barclays Ba US High Yield index moved around 65% between 2008 and 2009, while the S&P index moved more than 70%, having dropped a massive 40% in one year. That volatility, while an opportunity to profit for savvy investors, is perhaps not as attractive for a long-term investor looking for more stable returns, such as a large global pension fund.

Catastrophe bonds clearly offer a very stable return over the timeframe examined. They exhibit much lower volatility and also much lower correlation with the events that caused the two benchmarks to dive.

Of course the returns are now much lower for cat bonds in the last year. In fact in 2014 Swiss Re’s index only returned 5.92% for the full-year, which is way down on the 10.85% seen in 2013.

This lower return, as a result of spread compression, has narrowed the gap between catastrophe bonds and other similarly rated corporate bonds in the last year. However the lower volatility as well as lower correlation with broader economic and financial market factors, continue to make cat bonds an attractive place to invest.

Over the last three years the spreads of comparably rated catastrophe bonds to high yield corporate bonds have tightened considerably. As recently as the start of 2012, Swiss Re notes that the spread between cat bonds and corporate bonds was around 4.5%, however demand for cat bonds and an absence of large catastrophe events has narrowed this to as little as just 1% now.

It’s notable however that once again catastrophe bonds have out-performed these corporate bond benchmarks again (as they have consistently), demonstrating that even in a lower-priced catastrophe risk market an investment in cat bonds is still attractive purely based on return (compared to benchmark assets).

Comparative Catastrophe Bond and High Yield Corporate Bond Spreads - Source: Swiss Re

“Throughout this period it had been debated how these investors would react once rates or other asset classes began to widen out. Many believed that this investor base would pull out from the ILS sector in favor of their more traditional investments. However, at least for the time being, this does not appear to be the case,” Swiss Re said.

But the lower-volatility of catastrophe bonds remains apparent and this is likely to be a key driver for continuing inflows into the ILS asset class from investors who seek the portfolio benefits and qualities that the insurance-linked asset class offers.

Swiss Re explains; “Over the last six months, B-rated corporate bond spreads have become increasingly volatile and have widened by approximately 60% while B-rated catastrophe bond spreads have remained relatively flat.”

As a result investors may not demand as much of a premium, in terms of return, preferring instead to focus on the clear qualities of a low-volatility and low-correlated asset class such as that in reinsurance risks, ILS and catastrophe bonds.

Swiss Re continued; “This has further strengthened our view that money managers appreciate the uncorrelated returns offered by this asset class, making it a staple of their overall portfolios and therefore leading to them demanding less of a spread premium over other assets as the ILS sector becomes more main-stream.”

In fact some of the largest investors in the ILS and catastrophe bond space place a portfolio theory premium on their ILS assets, considering the benefits of low-correlation, low-volatility as worth an additional point or two to their overall portfolio mix.

It is these attractive features of the catastrophe bond and ILS asset class, plus their benefit to overall portfolio theory, that show that investors are not just the “yield hungry” return chasers that some would like to imply. ILS investors are largely a very sophisticated group of large global institutions and pension funds, who manage their portfolios using theory and for whom ILS and cat bonds, as a small component of their overall assets, remain very attractive even at lower overall yields.

You can access a copy of Swiss Re’s latest ILS and catastrophe bond market report via its website here.