Spread compression makes some cat bonds less attractive: Plenum’s Schmelzer

The high-levels of activity and investor interest in the catastrophe bond market has resulted in tightening of spreads for many issues this year so far, leading to some cat bonds becoming less attractive to invest in, as they no longer adequately compensate for the risk assumed, according to Dirk Schmelzer of Plenum Investments.

Schmelzer is a Partner and Senior Portfolio Manager at specialist catastrophe bond and reinsurance linked investments manager Plenum, which is based in Zurich.

In a recent interview with Artemis, Schmelzer explained that 2021 has been a positive year so far for the ILS fund management business, but the softening trends may be moving too far, in some cases.

Discussing the year-to-date, Schmelzer said that at Plenum, “The year 2021 started very positively for our business. In an environment where client interest in investing in ILS was coming back again, we have been able to expand our business by launching new products, growing our asset base and winning new investors.”

Given Plenum’s focus on catastrophe bonds and insurance debt the company has been immune to some of the effects of losses related to the COVID-19 pandemic and also more insulated from some of the frequency weather and catastrphe losses that the reinsurance market has suffered, Schmelzer explained.

One of the factors that investment managers have had to watch in 2021 so far is spread compression, or tightening, of catastrophe bond and reinsurance pricing.

This makes deal analysis and portfolio management increasingly important, to separate the transactions based on risk/return appetites and the qualities that an ILS fund manager like Plenum looks for.

“We value cat bond positions not only from a bottom up perspective, but always account for the benefit, that a position brings to the overall portfolio. Although risk spreads have come down compared to 2020, we still found interesting opportunities in the catastrophe bond market, that helped us to achieve a better diversification, while maintaining an attractive premium income,” Schmelzer told us.

On the subject of underwriting discipline, across reinsurance and ILS markets, Schmelzer said in the main it has been positive this year.

But he cautioned that by answering, “Mostly yes, as ILS and cat bond investors seem to differentiate more between investments, which is a healthy development. However, demand for cat bonds has been very high and has compressed spreads to levels and in some cases to levels where we feel not adequately compensated for the risk. ”

Schmelzer also noted the challenges in some areas of the ILS market, particularly collateralized reinsurance, where losses and loss creep have impacted positions for managers.

This, he believes, has also driven investors and other managers more to the catastrophe bond market.

Saying that, “The loss experience also made investors aware of structural issues such as valuation uncertainties and the trapping of collateral in collateralized reinsurance. This has led to an increased interest in cat bonds and investors seem to accept lower compensation in order to mitigate these structural disadvantages.”

While spreads have been compressed, or tightened, of late, this isn’t always an issue, Schmelzer believes.

“While cat bond spreads have tightened markedly in general, it seems that investors differentiate more between bonds; e.g. riskier, loss-aggregating covers with exposure to secondary perils tightened loss than less risky, per occurrence covers, which is a healthy development,” he told us.

Adding that, “We think that the catastrophe market shows faster and more pronounced swings in pricing, compared to other, less liquid market segments. Without major events (natural disasters or financial market stress), we anticipate that other ILS market segments will follow the cat bond market and see more competition and lower premiums.”

Read all of our interviews with ILS market and reinsurance sector professionals here.