How secondary catastrophe bond spreads tightened in 2012

2012 saw rollercoaster-like conditions for secondary catastrophe bond trading as the market saw ups and downs over the course of what was a very good year for primary cat bond issuance. With primary cat bond issuance high and capital readily available to put to work in new transactions at the start of the year, the secondary market suffered as trading was scarce and spreads widened. That trend soon changed though, leading to spread tightening that persisted through the remaining year

In its recent insurance-linked securities market report, reinsurer Swiss Re looked at the trends which emerged in the secondary cat bond market in 2012. The start of the year saw the continuation of a trend which had begun in late 2011, of spreads widening as secondary trading levels adjusted to the higher new issuance of cat bonds that was a feature of late 2011 and early 2012. Strong new cat bond issuance, combined with sponsors wanting to upsize deals led to investors focusing on primary allocations and pushing spreads to the wide end of guidance or higher.

This was a trend that continued through Q1 of 2012 and resulted in some consistent decreases in the cat bond price return index during the first few months of the year. Secondary trading conditions changed in Q2 as confidence in the market, combined with strong new inflows of capital, led to investors and funds seeking new secondary marks to augment and diversify their portfolios across both peak and non-peak perils.

From that point up until later in Q3 strong demand for cat bonds continually pushed spreads tighter. Swiss Re said that liquidity for sellers in the market was strong and their secondary trading desk saw multiple aggressive bids come in for positions. Then hurricane Sandy came along and caused a reduction in primary issuance and changed the sentiment in the secondary market.

After Sandy, Swiss Re still saw strong bids for non-peak bonds and those which were unlikely to be exposed to Sandy but bids for U.S. hurricane bonds tapered off as the uncertainty surrounding the impact of hurricane Sandy kicked in. Spreads widened out slightly from the lows seen mid-year but remained below levels seen a year earlier. As the uncertainty reduced when loss estimates came in slowly confidence in the market returned and cat bond spreads returned to pre-Sandy levels and appetite for new issuance grew.

As the year drew to a close, little effect remained from Sandy and demand for secondary cat bond marks was in general high. Swiss Re said that over the course of 2012 it saw $800m of secondary trading volume across its desk, which it said was in line with average years. The volume continues to show the liquidity in the market, according to Swiss Re, with this liquidity only tempered by buy-and-hold investors and the significant demand for positions (which we’re seeing in Q1 of 2013).

The graph below shows the pattern of secondary market cat bond spreads over the course of 2012 and clearly shows the early year widening pattern, followed by strong tightening over the remainder of the year and the slight blip caused by Sandy.

Weighted average secondary catastrophe bond spreads in 2012 - Source: Swiss Re Capital Markets (As of Dec 31 2012)

Looking ahead to this year, Swiss Re expect the spread tightening trend to continue for the near and medium term, even going so far as to say that if a flood of new issuance occurs it still expects strong demand to exist in secondary marks. It puts this down to the diversification and strong returns of cat bonds as well the inflows of new capital being raised by managers and funds. Interestingly Swiss Re note that the disappointing January renewals for collateralized reinsurance may cause an additional shift of capital into the cat bond market as collateralized players seek out better and that this may put additional downward pressure on spreads.

As we wrote yesterday, the lack of primary issuance, combined with strong capital bases of funds and investors has actually led to secondary cat bond trading opportunities being elusive in January, according to one investment manager.

Read our other articles on Swiss Re’s recent report:

– The death of the total return swap in the cat bond market is almost upon us

– 2012 a unique year for the insurance-linked securities market

– Increasing numbers of pension funds and asset managers participating in ILS

– Over 50% of catastrophe bond volume issued in 2012 used indemnity triggers