The death of the total return swap and the rise of the Treasury money market fund

Here’s an interesting graph which shows how rapidly the catastrophe bond market has moved from one which was dominated by transactions with collateral structured as a total return swap to one predominantly using Treasury money market funds. Swiss Re shared this graph during their insurance-linked securities media event last week and it shows how the diversity of collateral structures has changed over time using data from their Global Cat Bond Performance Index.

Of course total return swaps lost favour due to the intrinsic link to a counterparty acting as guarantor, a theory which came unstuck during the 2008 financial markets crisis. Total return swap structures involved a high-rated counterparty, usually an investment bank, essentially acting as a guarantor for the bonds. The demise of Lehman Brothers proved that no counterparty can be 100% safe under extreme financial pressures and the use of this type of collateral arrangement ended.

Only four ILS structures used a total return swap during 2009 and from that year on we haven’t seen any other TRS cat bonds come to market.

Now, the collateral structure of choice for ILS and cat bonds tends to be investments in U.S. Treasury money market funds. These assets, while not offering attractive returns these days (the sovereign crisis hasn’t helped on that score), offer a level of security which is believed to be immune from all but the most catastrophic financial shocks.

The graph below shows the demise of the total return swap which continues to shrink as a percentage of collateral types involved in ILS and cat bonds as existing deals mature. Treasury money market funds on the other hand have risen in use consistently to now make up more than 60% of all deals collateral structures.

Other collateral solutions which have gained in favour since the demise of the total return swap began have been structured note arrangements and trip-party repo agreements. After a swift rise to favour it looks as if Treasury money market fund use will continue to rise as total return swaps eventually disappear altogether from the cat bond and ILS landscape.

Swiss Re Global Cat Bond Performance Index Diversity of Collateral Structures