K2 “strongly overweight” cat bonds & private ILS on pricing

On still improving prospects for the sector, hedge fund specialist manager K2 Advisors has updated its view to “strongly overweight” for catastrophe bond and private insurance-linked securities (ILS) investments, saying that pricing indications for the January renewals look strong as well.

Over recent quarters, the investment research team of K2 Advisors, a hedge fund focused asset manager which is a unit of investment firm Franklin Templeton, has been highlighting the relative value in catastrophe bonds and other ILS or reinsurance linked investments.

The K2 Advisors team has recently been advising its clients to focus hedge fund investing in the areas where alpha generating non-directional strategies can be sourced, one of which they believe is insurance-linked securities (ILS).

It appears the researchers are becoming a little more selective though, as overall on the ILS sector they are now neutral, having dropped this down from overweight in the last quarter.

But on specific segments of insurance-linked securities (ILS), particularly catastrophe bonds and private transactions, the K2 Advisors investment researchers have actually upgraded their views from overweight to now “strongly overweight”.

In addition, the view on retrocessional reinsurance has also been upgraded, from underweight to now neutral, but industry-loss warranties (ILW’s) are static at neutral as well.

The updates to the views and outlook for the segments within ILS are seemingly down to recent loss activity, in particular hurricane Ida, as well as the potential for more rate increases at the all-important January 2022 reinsurance renewals.

In fact, private ILS and cat bonds are currently in the top four rated sub-strategies of any of the asset classes K2 Advisors reviews in its quarterly hedge fund strategies reports.

On the loss activity, the K2 Advisors team noted that lower-risk catastrophe bond strategies have performed well despite the hurricane season, as they’ve avoided anything other than mark-to-market losses in the main.

They highlighted that ongoing inflows into the ILS market from investors have helped to buoy catastrophe bond issuance and also created a more active secondary market, while the lower-risk strategies that have avoided loss are offering attractive relative valuations.

However, they also see a potential opportunity in the higher-risk parts of the ILS market as well, as, “We note that as fewer investors favor higher-risk strategies due to prior performance, lower levels of competition could lead to a more favorable environment for investors.”

Looking to the renewals, “Loss development from prior years’ events, further insight into the impact of Ida and the July European flooding, and overall investor demand will be key in determining the final price increases at the January renewal period,” the investment research team said.

While importantly, “Initial January 1 pricing indications appear strong following Hurricane Ida and the European flooding in Q3.”

As readers will be only too aware, cat bond pricing has softened somewhat through 2021, but the K2 Advisors team do not see that as a negative at this stage, still feeling the asset class offers relative value.

“Despite tightening over the course of the year, cat bond pricing remains attractive on an absolute basis and relative to high yield instruments,” the K2 Advisors team said.

Part of the reason for the overweight rating on cat bonds and private ILS also seems to be related to global macroeconomics, with recent research from K2 Advisors team suggesting they still find ILS a good source of alpha in an uncertain global marketplace.

A strongly overweight rating is bullish, but this aligns with the broader thinking around investment markets that alternative fixed income type products are only going to face increasing demand, especially as some areas of financial markets look a little uncertain and potentially frothy, or volatile, at this time.

K2 Advisor’s opinion on the asset class reflects the strong demand still being seen for cat bonds, as well as the fact those ILS fund managers that can originate and source attractive private transactions and demonstrate alpha generation in doing so, may be the most likely to succeed in terms of capital raising over the coming months.

Earlier this year, K2 Advisors said that current cat bond and ILS market conditions present an attractive point of entry for investors, leading the hedge fund specialist manager to give an ‘overweight’ assessment for P&C ILS and catastrophe bonds within portfolios.

It’s encouraging that the investment manager believes spreads remain attractive on this relative value basis, as that should continue to build investor interest and appetite in the asset class.