Two Queen Street catastrophe bond transactions, sponsored by reinsurance firm Munich Re, have been downgraded by S&P over a heightened risk that investors will not receive back 100% of the outstanding principal amount at maturity.
The two cat bonds, Queen Street II Capital Ltd. and Queen Street III Capital Ltd., were both placed on CreditWatch over two months ago due to concerns that investors could face a reduction in capital returned after both cat bond suffered a loss of principal in the collateral account due to a decline in the collaterals per-unit mark-to-market value.
The reason for the loss of value in the collateral assets was due to the uncertainty created by the U.S. debt ceiling issue. Both of the Queen Street cat bonds collateral trust funds saw a decline in per-unit mark-to-market value. The funds were designed to hold the collateral until the cat bonds matured or a payout was required, meaning that the funds faced strict asset value guidelines which stated that the per-unit value could not fall below $100.00.
Because the per-unit value of both funds fell below this guideline amount the indenture trustee, Bank of New York Mellon, requested the liquidation of the funds and reinvested the remaining assets into Federal U.S. cash reserves.
For the Queen Street II cat bond the loss of principal from the liquidation of the MEAG Queen Street II fund faced by investors amounted to $20,242.13, or 2 basis points. The cash proceeds from the liquidation, $99,979,757.87, were reinvested into U.S. Treasury Cash reserves.
For the Queen Street III cat bond the proceeds from the liquidation amounted to $149,969,566.47, resulting in a loss of principal of $30,433.53, or two basis points and the proceeds were reinvested in the same way.
Standard & Poor’s said that the reinvested assets are not expected to regain their original net asset value. As a result S&P now believes that investors in both of the cat bond transactions face a heightened risk that they will not receive back 100% of the outstanding principal amount on the redemption date for each cat bond.
As a result S&P has downgraded the rating on the $100 million principal-at-risk variable-rate notes issued by Queen Street II Capital Ltd. to ‘CC (sf)’ from ‘BB- (sf)’ and downgraded its rating on the $150 million principal-at-risk variable-rate notes issued by Queen Street III Capital to ‘CC (sf)’ from ‘B+ (sf)’. Both cat bonds tranches of notes have been removed from CreditWatch negative status.
S&P explained; “Since we received the notice of default, we have monitored the performance of the Federated U.S. Treasury Cash Reserves in which the proceeds have been reinvested, and we consider that it is unlikely that the fund will regain the original net asset value on the redemption date.”
S&P also noted about both of the cat bonds; “Moreover, the transaction structure does not ensure that noteholders will receive back 100% of the outstanding principal amount when the notes redeem.”
For the Queen Street II Capital Ltd. cat bond S&P said it expects a shortfall of $20,242.13 on the proceeds returned to investors at the redemption date and that it expects to lower the rating to ‘D (sf)’ (default) from ‘CC (sf)’ on April 9th 2014, when it anticipates investors will get back $99,979,757 of the original $100m of principal.
For the Queen Street III Capital Ltd. cat bond S&P said it expects a shortfall of $30,433.53 on the return of principal to investors at redemption date and that it also expects to downgrade this cat bonds rating to ‘D (sf)’ (Default) from ‘CC (sf)’ on July 28th 2014, when we anticipates investors will receive back $149,969,566 of the original $150m principal.
As we said when these two cat bonds were put on ratings watch, this is a prime example of how vagaries in financial markets can have a knock-on effect on catastrophe bonds, demonstrating that nothing is completely uncorrelated. Cat bonds are extremely low correlating assets but there can always be an impact from a major macro issue like the debt ceiling, especially in complex financial transactions like securitizations.
The question this leaves behind is whether the cat bonds wordings should protect investors from a reduction of principal which is not related to a triggering event. Perhaps someone should be responsible for topping up the collateral again to always maintain 100% of principal? Or perhaps some entity should be responsible for more actively managing the trusts investments to ensure this does not happen?
The strict investment guidelines that the two MEAG Queen Street funds had to follow forced them to liquidate the collateral assets when the per-asset value fell below 100.00. Had this not been the case the assets may have recovered their value once the debt ceiling issue had passed, resulting in 100% of principal being restored. U.S. collateral funds have this luxury, of being able to wait to recover value or to be more actively managed, but European funds like the MEAG Queen Street ones did not.
In reality, investors are exposed to the risk of the collateral assets declining in value and therefore situations like this are possible, however rare and unlikely. For the investors in these two cat bonds this is a very small loss, but it does show that nothing is ever fully uncorrelated in this complex financial world.
The collateral assets are often forgotten once a catastrophe bond has been issued. The value of assets in collateral accounts can go up and down and even the secure U.S. treasuries, that collateral is typically invested in, will not be immune to the largest financial market shocks, as this example shows.
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