Elevated catastrophe bond yields that are a result of investor demand for higher returns following heavy loss years and Covid-19-induced market disruption, “cannot be called the new normal,” according to John Seo of Fermat Capital Management, LLC.
Prior to the pandemic, insurance-linked securities (ILS) investors and funds were already demanding higher returns after a spate of losses and subsequent adverse development.
Now, it seems that the disruption caused by Covid-19, which has helped to drive reinsurance rate increases at the recent renewals, has amplified the current trend in the catastrophe bond market, resulting in high spreads.
In a recent article to investors on GAM Investments website, Seo, Co-Founder and Managing Director of ILS and catastrophe bond focused investment manager, Fermat Capital, notes the high yields currently on offer in the space but warns against this trend persisting over the long-term.
“With the market upheaval somewhat behind us, we are left with spreads at historic highs, indicating disrupted conditions in the insurance system. While we believe these attractive spreads will persist in the short-to-medium term, it is our opinion that such high yields cannot be called the new normal.
“Even after Hurricane Katrina, the most disruptive event in the history of the market, yields peaked around where they are now, but reverted down towards ‘normal’, structurally supported levels. We would anticipate this pattern – also seen in the wake of the global financial crisis – could repeat itself in due course,” says Seo.
One of the key attractions of the catastrophe bond space for capital markets investors is the non-correlation with wider financial market volatility. As Seo explains, “a market crash (or virus) cannot cause a hurricane or earthquake to occur.”
This natural independence from traditional market turmoil meant that during the 2008 global financial crisis, the asset class performed well and preserved investors’ capital. And, according to Seo, the cat bond sector is once again demonstrating its value.
“We believe the cat bond market’s innate independence from traditional market risk and ability to reap returns even in the face of economic meltdowns is exemplified by today’s Covid-19 crisis.
“In March, when investor panic reached its peak, multi-strategy investment funds sold off liquid assets in the secondary market. Cat bonds, being liquid, were affected by this rush to sell, with the price levels on some bonds decreasing by approximately 3%.
“Consequently, attractive secondary market buying opportunities were created for active cat bond managers and, soon after, the market stabilised with minimal long-term damage. We believe this illustrates the potential benefits of cat bonds – namely, their liquidity, which allows them to be traded in any environment, as well as their fundamental non-correlation to traditional markets,” says Seo.
Of course, and as highlighted by Seo, with yields trending higher it could be an interesting and opportune moment to enter the catastrophe bond market.
Reinsurance rates are on the rise and ILS are seen as an increasingly influential source of capital when it comes to pricing in the catastrophe space. Additionally, forecasters predict an above-average level of hurricane activity in the weeks and months ahead, and should this come to fruition, investors might have even more impetus to drive up rates.
“Having demonstrated their value to both investors and sponsors alike during these chaotic times, we believe ILS represent a permanent and growing source of capital for managing the world’s insurable risks, and may possess the dynamic needed for a substantial market growth trajectory ahead.
“With a unique set of drivers and the benefit of being fundamentally uncorrelated with the broader market and the economic turbulence, ILS are filling the disaster gap left by the reinsurance industry and can offer genuine diversification for investors in return,” says Seo.