No cat bond contagion risk from Middle East conflict, but linkages worth considering: Icosa

With implications of the ongoing conflict in the Middle East cascading across financial markets, investors are assessing how individual asset classes might be affected. Catastrophe bonds remain remote to such geopolitical events, but there are indirect financial market linkages investors should be aware of, according to specialist catastrophe bond fund manager Icosa Investments.

“Recent developments in the Middle East have triggered a familiar chain reaction across global markets: falling equities, rising oil prices and renewed concerns about geopolitical risk. In times like these, investors naturally reassess how different asset classes might be affected,” Icosa Investments explained in a post on LinkedIn.

The investment manager highlights that, “Cat bonds are fundamentally largely insulated from such events. The asset class primarily covers natural catastrophes such as hurricanes, earthquakes or severe storms. Risks related to shipping routes, energy infrastructure or oil processing facilities, which may become relevant in geopolitical conflicts, are typically not part of cat bond coverage. Even in traditional reinsurance contracts, war-related losses are often excluded.”

But Icosa Investments also notes that significant global events of this nature can have ramifications for the insurance-linked securities (ILS) market, given indirect linkages that exist between the asset class and global macro conditions.

In this case, the two indirect linkages Icosa Investments highlights, where catastrophe bonds could experience some correlation effects if there are meaningful disruptions across financial markets caused by the Middle East conflict, might actually be supportive, rather than negative, for ILS investment holdings.

“First, rising oil prices can feed into broader inflationary pressures. If inflation remains elevated, central banks may keep short-term interest rates higher for longer. For catastrophe bonds, this can actually be supportive: coupons are typically floating and linked to short-term rates, meaning higher base rates translate directly into higher income for investors,” Icosa Investments stated.

“Second, geopolitical instability can affect the insurance and reinsurance sector through capital markets. Insurers and reinsurers are large institutional asset owners, and falling equity and bond markets can weaken their investment portfolios and capital positions. If market stress were prolonged, this could lead to reduced risk appetite in insurance underwriting and less reinsurance capacity being deployed. In such a scenario, the supply of protection would shrink while demand for risk transfer remains strong. Historically, this dynamic has supported higher reinsurance pricing including wider spreads and improved yield expectations for cat bonds,” the cat bond investment manager further explains.

The floating rate of return that cat bond investments have benefited from has declined by roughly 1.73% in just the last two years (analyse this in our cat bond market yield chart), so there is without doubt room for this to increase and currently the inflationary environment does look primed to stay elevated.

On the second linkage Icosa highlights, this overall risk view of capital in the markets has been a key factor in ILS and cat bonds in the past. As institutional investors can perceive their own costs-of-capital as rising in a more volatile environment, that can filter through into pricing in secondary and primary markets, with ramifications for the costs of protection in traditional and ILS formats.

Icosa Investments sums up by writing, “Importantly, the core driver of cat bond performance remains the occurrence of natural catastrophes rather than geopolitical events or economic cycles. This structural independence is precisely why the asset class has historically shown low correlation to equities and traditional credit markets.

“In periods of heightened geopolitical uncertainty, diversification becomes increasingly valuable. Cat bonds remain one of the few areas of fixed income where risk is fundamentally linked to nature rather than geopolitics, a characteristic that can make them a particularly compelling allocation when global markets are driven by macro uncertainty.”

There is of course one additional weak-link that can manifest in times of global financial and capital market stress, and it’s one that the catastrophe bond market has experienced before.

During the 2008 financial crisis some hedge fund managers sold off their catastrophe bond holdings, as they were one of the only asset classes that held their full value during the challenging time, while the secondary market offered abundant liquidity still.

Should the Middle East conflict prove to be prolonged and the cascading effects worsen across other asset classes, certain investors could turn their attention once again to selling cat bonds, as a directly held asset they can sell at full values relatively easily even as such a crisis continues.

Over the last couple of years there have been a number of large, direct investors into cat bonds that come from the hedge, quant and multi-strat investment manager world. If stresses manifest across other areas of their portfolios, the ability to sell catastrophe bonds at decent valuations could prove a welcome opportunity again, to some, and an opportunity to those with capital to deploy.