The return advantage provided by an investment in catastrophe bonds, over an investment in other forms of yielding debt instrument, has narrowed over the last two years, largely due to pricing pressure lowering yields on cat bonds more quickly.
Reinsurance firm Munich Re shared a very interesting chart in its latest quarterly ILS market report showing the difference between ‘BB’ rated cat bond yields and ‘BB’ rated U.S. corporate bond yields. Historically the two have roughly tracked each other, with yields on both assets declining over recent years almost in tandem.
Munich Re’s chart shows what it terms the ‘Cat Bond Yield Advantage’, the difference between the yields of the two assets, one of the key reasons some institutional investors are increasingly learning about and allocating capital to the ILS asset class.
The gap has narrowed a little over the last two years, according to the data, but Munich Re said; “We do not believe a further decline in ILS risk spreads to be supported by the investor community, which does not want to be seen as the source of cheaper capacity,” suggesting the reinsurer thinks cat bond spreads will flatten.
Munich Re highlights that as yields in mainstream debt markets have declined, so investor demand has been boosted in ILS and that, as more capital flowed into ILS, naturally the yields on catastrophe bonds have declined too.
The narrowing of the cat bond yield advantage is also evidence of investors increasing acceptance of catastrophe risk and reinsurance as an asset class, giving them the confidence to accept a lower yield advantage over similarly rated asset classes.
The chart from Munich Re is another interesting way to view the returns of the ILS and cat bond market, how it compares with other similarly rated asset classes and how the cat bond yield advantage has changed over time.
Reinsurer Swiss Re is also aware of the advantage that cat bonds have over other high-yield assets currently, with investors searching for sources of yield in a low-interest rate environment. Swiss Re said; “Comparing the spreads available in the high-yield markets provides strong evidence to substantiate why the ILS market has been the beneficiary of large inflows from institutional investment managers with broad investment mandates.”
Swiss Re’s data on this, from its latest ILS market update report, shows that ILS continue to offer investors a good advantage over other high-yield instruments, approximately double the returns are available from ILS when compared to a typical high-yield bond measure.
Based on a comparison of Barclays Capital U.S. high yield instruments versus the weighted average seasonally adjusted spread of all catastrophe bonds with a U.S. wind component currently outstanding as at the end of 2013, Swiss Re shows BB rated high yield bonds at 2.69% while BB rated ILS are at 4.53%, while B rated high yield bonds are at 3.64% with B rated ILS at 6.85%.
So the yield advantage of an investment in ILS over these high yield bonds is clear, but Swiss Re has also seen this advantage shrink and its chart below shows a similar story to Munich Re’s, one of steeply declining primary cat bond spreads at issuance.
Read our other coverage of Munich Re’s latest ILS market report:
Read our other coverage of Swiss Re’s recent ILS market update: