If it’s too hot, consider buying a CAT

25 Jul 2016

Key takeaways

  • The CAT market was created in the mid-1990s following hurricane Andrew and the impact it had on the insurance industry, left with substantial losses.
  • CAT bonds acted as an additional source of “reinsurance” capital for primary insurers, providing an outlet to transfer excess loss of property to the capital markets.
  • The Insurance-Linked Securities market may offer investors a unique opportunity to diversify their portfolio from traditional credit risk.

Full commentary

Financial markets globally climbed last week while continuing to shake off concerns of Brexit, a Turkish coup, economic data and earnings season. Here in the US, local media seemingly oblivious that it is late July, took to the airwaves, social media and print to proclaim that a Heat Dome had arrived across much of the country. But it is not just the US experiencing the heat as Europe too had above average temperatures last week. But nowhere was hotter than Mitribah, Kuwait having reached a sweltering 129.2 degree Fahrenheit (54 Celsius) which is likely the hottest ever recorded temperature outside of Death Valley. These types of headlines almost inevitably came with taglines of global warming and climate change which got me thinking about the Catastrophe Bond market and the opportunities which investors may want to consider.

The Catastrophe Bond (CAT) market was created back in the mid-1990’s in the United States following the devastation caused by Hurricane Andrew and the impact it had on the insurance industry. The insurance industry was left with substantial losses and was unable to offer insurance at the same price level prior to the hurricane. What followed was the introduction of the Insurance Linked Securities (ILS) market with CAT bonds being the main component. These bonds acted as an additional source of “reinsurance” capital for primary insurers. This new market provided insurance companies with an outlet to transfer excess of loss property risk to the capital markets. From an investor perspective, the market provides a diversifying asset class less correlated to economic data, corporate business cycles, and bond-holder unfriendly boardrooms. CAT bonds are floating rate fixed income instruments referencing predefined perils. The bonds are structured with trigger mechanisms which determine when a bond would begin taking losses and pay-out formulas, which determine the amount of loss. The two main types of trigger events are Indemnity and Parametric. Indemnity triggers refer to attachment points which can be thought of as different levels of loss subordination. The bonds begin to take principal losses if the issuing insurer realizes pre-defined losses upon certain catastrophic perils occurring.

Corporates bonds primarily compensate investors for default risk while a CAT bond is compensation for a natural catastrophe occurring and trigger losses in excess of insurance loss levels. CAT bond investors have historically received on average 160-340 basis points more spread than similarly rated BB and single-B corporates, respectively. There are a couple of reasons why this anomaly exists. First, the market is relatively small when compared to other similarly rated asset classes and many investors are still unfamiliar with the CAT bond market. Secondly, CAT bonds are only issued to qualified institutional buyers which excludes the retail investor community.

Being a fixed income instrument with a stated coupon, there naturally is some degree of correlation with similarly rated bonds. CAT bond exposure is property reinsurance risk, which is generally not correlated with the macroeconomic or systemic market events as was proven during the 2008/2009 crisis. Corporate bonds are exposed to business cycles, Treasury securities are subject to economic and monetary policy, while the mortgage market is broadly tied to the jobs market and level of interest rates. The total return graph on the following page shows that during periods of market stress where both the Loans and High Yield market had large negative returns, the CAT bond market remained relatively resilient and provided attractive portfolio diversification benefits.

With the US bell weather market proxy, the S&P500, hitting all-time highs and with nearly 90% of the JPMorgan Global Diversified Government Bond Index yielding less than 2%, investors may want to consider diversifying away from hot markets and into something a bit more defensive.

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