Swiss Re Insurance-Linked Fund Management

PCS - Emerging Risks, New Opportunities

Secondary cat bond market sees stronger return, seasonality in August


The secondary market in catastrophe bonds and insurance-linked securities (ILS) saw strong seasonal price rises in August, as the market made much larger gains than recent months, leading to more pleasing returns for ILS and cat bond fund managers.

After a few months where secondary catastrophe bond prices stagnated or declined, resulting in lower returns for an insurance-linked securities (ILS) fund managers with allocations to cat bonds, the secondary market rebounded somewhat in July and then in August it saw much more typical, seasonal price increases and a stronger total return as a result.

Supply of new catastrophe bonds remains low, as would be expected for the time of year. This can typically lead to a wait and see mentality among ILS managers and investors, holding their cat bond positions with very little trading activity seen on the secondary market.

However in August secondary ILS trading has been reasonably brisk, we’re told by investors and trading brokers. This is perhaps a reflection that with catastrophe bond yields low and the overall yield of the market now sliding, due to recent low coupon transactions, some investors and ILS managers have more propensity to trade or to offload cat bonds to replace them with private ILS deals or collateralized reinsurance investments.

Whatever the reason for the activity the trading volume will have been welcomed by the ILS markets secondary broking desks. Craig Bonder, Managing Director and Head of ILS Trading at AK Capital, said that he saw a; “Fairly active month of August in the secondary markets when one considers the lack of events and the usual summer lull.”

Prices in the secondary market have once again been on the rise, with many outstanding cat bonds continuing to sit with pricing above par. This continues to make entry to the sector challenging for new investors seeking to build portfolios as some of the return is shaved off by paying an above par acquisition price in the secondary market.

Bonder discussed the pricing trends he saw at his trading desk in August; “As another month of US Wind risk passed us by prices again went higher and in some cases have fully recovered and surpassed peak levels seen in the spring.”

Trading has not just been driven by a need for offloading lower yielding bonds. Bonder explained that ILS investors continue to need to adjust portfolios for diversification purposes, perhaps as a result of the very U.S. wind heavy issuance in the run up to the summer.

“Portfolio re-balancing played a big role in recent trading activity with market participants in some cases swapping names to express particular credit views,” he commented.

No catastrophe events moved the secondary cat bond market in August, with the Napa earthquake not a sufficient loss to come anywhere near to concerning investors. Similarly, the Atlantic served up two tropical storms which both became hurricanes but posed no threat to land or the market.

Swiss based specialist ILS investment manager Plenum Investments noted the calm hurricane season in its latest update, saying; “As another month of the US hurricane season passed without storms making landfall, prices of US hurricane CAT bonds recovered further, while prices of CAT bonds with exposure to other peril regions moved only marginally.”

Seasonal spread tightening on U.S. hurricane bonds drives much of the cat bond and ILS fund markets performance at this time of year. However the rising secondary prices can also drive some gains for certain positions. The spread tightening would be expected to continue into September, resulting in another stronger month for the asset class.

Another ILS manager said that its funds performance in August were driven by price increases caused by a combination of the seasonality expected at this time of year, lack of primary issuance and continued robust investor demand. A scenario it expects will be repeated in September and maybe October as well.

Bonder of AK Capital reported a market total return, based on his trading desks view of secondary catastrophe bond and ILS pricing, of 0.91%. That’s almost double the number from July and the highest single monthly return since October 2013.

Another benchmark for the ILS investment market is the Eurekahedge ILS Advisers Index which so far for the month of August reports a 0.83% return, based on just over one-third of the 33 constituent ILS funds reporting monthly performance to date. At that level it would be the highest single monthly return for the index since September 2013, although with two-thirds of managers still to report that could change.

However there is a good chance that the ILS Advisers Index could actually report higher, given its mix of both catastrophe bond and private ILS focused funds. That should make its average return for the market higher than AK Capital’s catastrophe bond only focused total return.

So August seems to be showing that even in a challenging market, where reinsurance pricing has declined and cat bond yields are low, the ILS space can still deliver attractive returns to its investors. Seasonality helps at this time of year, of course, but with both September and October likely to still show some seasonality there could be two more months of much improved returns before they dip again towards the end of the year.

And you never know, by that time perhaps some primary issuance will help to lift the markets yield, if the right deals come to market and some higher risk/return catastrophe bonds are issued. On the other hand if secondary prices keep rising, with no catastrophes threatening losses and investor demand still high, could secondary cat bonds price themselves out of some investors consideration entirely?

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