Cat Bonds - BNP Paribas Investment Partners

3
FOR PROFESSIONAL INVESTORS
CAT BONDS: WHY THEY ARE NOT A
CATASTROPHE FOR YOUR PORTFOLIO
Dan Singleman, Portfolio Manager
US Credit Markets
September 9, 2014
While their name might be peculiar, we believe the diversification opportunity catastrophe bonds offer investors is compelling. There are
few fixed income securities in today’s market that are not dependent on economic data, business cycles and/or political state of affairs.
Issuance of these B to BB rated bonds is expected to increase by over 40% in 2014 as investor demand grows. These bonds historically offer
a spread of more than 160-340 bps versus similarly rated corporate securities. However, there are barriers to investing, such as the need to
be a qualified institutional buyer (QIB) investor and statistical models to value the implied risk associated with a portfolio of holdings. If one
has the resources and qualifies as a QIB, they should consider the diversification benefits of these instruments in a multi-strategy, absolute
return or higher yielding credit portfolio.
WHAT ARE CATASTROPHE BONDS?
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 that 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.1
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
1
Source: Swiss Re, The Fundamentals of Insurance-Linked Securities, 2011
CAT Bonds | September 2014 - 2
certain catastrophic perils occurring. For example, a bond may attach at $750 million before taking losses, meaning if a hurricane hits an
insured area but realized losses to the insurance company are only $500 million, the insured losses attributable to the bond are not triggered.
Indemnity bonds can take several months and even 3 years to determine whether a trigger event has occurred because of the time required
to calculate all the insured losses. Parametric triggers are clearly deﬁned exposures to a speciﬁc region. For example, a bond may reference
a 7.9 Mw or higher earthquake at a depth below 200km in Ventura County, California before it would trigger the bond to cover losses. These
types of characteristics can be veriﬁed relatively soon after an event as opposed to months or years after, such as indemnity triggers.
Bond Specifics:
A. Maturity: typically 3-4 years
B. Type: ﬂoating rate securities
C. Rating: typically rated between B and BB by reputable
rating agency
D. Other: expected loss calculation modelled by an
independent ﬁrm at time of issuance
Source: Swiss Re, 2011
Roughly 75% of the global market is represented by three types of perils. 40% is multi-peril, meaning the bond is exposed to a number of
events (hurricane, severe storm, wild ﬁre, earthquake, and meteor). Another 25% of the market is purely exposed to US wind (hurricane) while
10% is exposed to earthquakes in California. The remaining 25% is a wide combination of European Wind, Extreme Mortality, and earthquake
risk from Asian and Mexican markets.
Multi-peril
25%
40%
US Winds
California Earthquakes
10%
25%
Euro Winds, Extreme
Mortality, Asian/Mexican
Earthquakes
Source: Swiss Re, 2011
HOW BIG/DEEP IS THE MARKET AND HOW DO WE EXPECT THIS TO CHANGE OVER TIME?
At the end of July 2014 there was roughly $25bn of outstanding securities. By humble comparison the US High Yield and US Bank Loan
markets are roughly $1.2tr in size. While these markets clearly dwarf the ILS market they have been around for many years developing an
investor base and issuing companies while the CAT market is still a rather new market that has been growing with investor demand and the
insurance community looking to use the market for re-insurance.
FOR PROFESSIONAL INVESTORS
CAT Bonds | September 2014 - 3
With global yields near all-time lows investor demand for CAT bonds has been stronger than previous years with market participants
expecting nearly $10bn of new issuance in 2014 versus $7bn of new issuance in 2013. CAT bonds trade OTC and recently became TRACE
eligible helping to further their price transparency. Average weekly trading volume is around $60mm.
WHY ARE CATASTROPHE BONDS A GOOD INVESTMENT IN TODAY’S MARKET?
CAT bonds offer investors a diversiﬁed set of returns independent from macroeconomic data, political uncertainty, or business risk associated
with traditional corporate bonds. They are ﬂoating rate instruments with minimal duration risk which typically reset every 3 months on USD
Libor. The stability of returns in the CAT bond market demonstrated its resilience during the height of the credit crisis in 2008-2009.
Total Return Indicies
275
255
235
215
Index
CAGR
175
S&P BB Loans Index
4.2%
6.3%
.7x
155
BAML US HY BB
8.2%
8.5%
1.0x
SWISS RE BB CAT INDEX
7.1%
3.2%
2.2x
195
135
Source: Bloomberg, FFTW, 2014
115
95
Annualized Ratio
Volatility
S&P BB Loans Index
BAML US HY BB
SWISS RE BB CAT INDEX
75
Source: Bloomberg, FFTW, 2014
WHAT RISKS DOES AN INVESTOR NEED TO MANAGE OR BE AWARE OF REGARDING THIS CLASS OF BONDS?
Investors need to entrust their manager with selecting a diversiﬁed set of bonds and managing exposures to any one geographic region or
issuing insurer. We believe CAT bonds should be used to gain portfolio diversiﬁcation in existing funds (multi-strategy, absolute return or
higher yielding credit portfolio) rather than a dedicated CAT fund mandate. Lastly investors need to be comfortable with the ﬂoating rate
nature of the securities and while we are currently in a low rate environment, should rates tighten further, it is possible ﬁxed rate securities
could outperform ﬂoating rate instruments.
HOW DO THESE SECURITIES DIFFER FROM OTHER CREDIT SECURITIES SUCH AS INVESTMENT GRADE OR
HIGH YIELD BONDS?
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 160-340bps 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
FOR PROFESSIONAL INVESTORS
CAT Bonds | September 2014 - 4
bonds are only issued to QIBs which excludes the retail investor community. Lastly CAT bonds generally require a different set of resources to
effectively value the implied risk of a portfolio of securities, such as proprietary or third-party loss modelling software, which can make the
investment and research into the asset class prohibitively expensive.
There is a notion that CAT bonds are illiquid which further discourages new investors to the asset class. In fact the ILS market was conceived
as a tradable market, and according to SwissRe, following the 2011 Tohoku Japanese earthquake, secondary volume increased as uncertainty
surrounding total losses prompted trading desks to sell their bonds to more optimistic buyers, who held a different view on losses.2
ARE CATASTROPHE BONDS CORRELATED WITH ANY OTHER TYPE OF INVESTMENT?
Being a ﬁxed income instrument with a stated coupon there naturally is some 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 previous 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.
Correlation Coefficients
S&P BB
Loans Index
BAML US HY BB
S&P BB Loans Index
1.00
BAML US HY BB
0.74
1.00
SWISS RE BB CAT INDEX
0.27
0.27
SWISS RE BB
CAT INDEX
1.00
(Jan 2003 - May 2014)
Source: Bloomberg, FFTW, 2014
WHAT MARKET CONDITIONS ARE IDEAL FOR THIS TYPE OF INVESTMENT OR IS IT GOOD IN ANY MARKET
CONDITION?
We would argue the CAT bond market is suitable for investors looking to diversify their asset cash ﬂow of returns away from traditional
economic and business cycle sensitive asset classes. Additionally we would advocate CAT bonds should be considered for absolute return
and credit opportunity funds as a means of diversifying risk exposures and providing an asset class which performs independently during
times of traditional credit market underperformance. As previously illustrated above, the CAT bond market proved its uncorrelated nature to
the 2008/2009 ﬁnancial crisis.
2
Source: Swiss Re, The Fundamentals of Insurance-Linked Securities, 2011
FOR PROFESSIONAL INVESTORS
CAT Bonds | September 2014 - 5
BIOGRAPHY
Dan Singleman
Portfolio Manager, US Credit Markets
Dan is a Portfolio Manager on the Credit team at FFTW. He is responsible for the management and performance of
US investment grade credit portfolios. Prior to his current role, Dan was the assistant portfolio manager for US credit,
focusing on optimization strategies, risk modeling, and portfolio management. Before that, Dan was a credit analyst
for the US leveraged loan team, after completing a two-year associate program which enabled him to gain exposure to
various investment centers. He has been with FFTW and one of its afﬁliates, BNP Paribas Asset Management, as well as a
predecessor ﬁrm, Fortis Investments, since 2006 and is based in New York. He has over 8 years of investment experience.
Dan earned a BS in agricultural business from Iowa State University (2003) and an MSc from the ICMA Centre University
of Reading (England) in international ﬁnance and investment banking (2006).
FOR PROFESSIONAL INVESTORS
CAT Bonds | September 2014 - 6
DISCLAIMER
This material has been prepared by Fischer Francis Trees & Watts, Inc (“FFTW”) and is made available in Australia by BNP Paribas Investment Partners
(Australia) Limited (“BNPP IP”) AFSL 223418 ABN 78 008 576 449 (“BNPP IP”). In Australia, FFTW is exempt from the requirement to hold an Australian
ﬁnancial services license under the Corporations Act 2001 in respect of certain ﬁnancial services. FFTW is regulated by the SEC under US laws, which differ
from Australian laws.
This material is produced for information purposes only for the exclusive use of wholesale investors and does not constitute ﬁnancial product advice. You
should consider obtaining independent advice before making any investment decision in relation to any ﬁnancial product referred to. The value of investments
can go up and down. Past performance is not necessarily indicative of future performance.
Any opinions included in this material constitute the judgment of the material’s author at the time speciﬁed and are subject to change without notice. Such
opinions are not to be relied upon as authoritative or taken in substitution for the exercise of judgment by any reader and are not intended to provide the sole
basis of evaluation of any investment. Given economic, market and other risks, there is no guarantee that any investment strategy referred to in this material
will achieve its objectives. The contents of this material are based upon sources of information believed to be reliable, but no warranty or declaration, either
explicit or implicit, is given as to their accuracy or completeness.
BNPP IP and FFTW to the extent permitted by law, disclaim all responsibility and liability for any omission, error, or inaccuracy in the information or any
action taken in reliance on the information and also for any inaccuracy in the information contained in the material which has been provided by or sourced
from third parties.
FOR PROFESSIONAL INVESTORS

Download Report