With catastrophe bond spreads having widened in recent weeks due to market dynamics and interest rates forecast to rise, it’s currently possible that a catastrophe bond fund investment could yield as much as 8% to 9% next year.
This is according to Florian Steiger, Catastrophe Bond and ILS Portfolio Manager at Zurich-headquartered specialist asset manager Twelve Capital.
Steiger believes that with forecasts for the United States average Fed Fund rate now pointing to more than 3% in 2023, this on top of attractive catastrophe bond pricing means a particularly strong opportunity to deploy capital into the sector.
Recall, catastrophe bonds are floating rate securities, so their yield to investors comprises the coupon, or reinsurance rate-on-line equivalent, plus the return of collateral, which is usually invested in US Treasury Money Market Funds, or similar.
Which means the ultimate yield earned by an investors allocation to a catastrophe bond fund will float higher on top of rising interest rates.
Explaining the backdrop to the current cat bond investment opportunity, Steiger told Artemis, “Cat bond spreads have widened considerably in the past weeks, due to an overall shortage of liquidity in the market and heavy primary market issuance volume.”
This dynamic pushes spreads wider, but already this year the average coupon paid for newly issued cat bonds is also higher, with reinsurance markets having hardened, another driver that makes the investment opportunity compelling at this time.
“Investors entering into a broadly diversified cat bond fund today can expect to earn spreads of around 550 – 600bps above money market rates. This is one of the best entry points we have seen in a long time,” Steiger said.
The entry point into catastrophe bonds looks even more attractive when you consider their floating-rate nature.
“Short term interest rates in the US are expected to increase considerably in the next months. As cat bonds are floating rate notes, any additional increase in money market rates would almost immediately also increase cat bond coupons,” Steiger explained.
Steiger continued to say, “Interest rate derivatives imply short-term rates might even exceed 3% in 2023.”
Which would take the ultimate yield earned from a cat bond fund investment to a much higher level.
But for sophisticated investors there is an opportunity to take that yield and attempt to lock it in as well.
Steiger said, “Investors who are able to convert some of their floating rate cat bond coupons into fixed-rate today via interest rate swaps could already lock-in some of that anticipated development.
“Such a strategy, which would then of course have some duration risk, could potentially yield around 8-9% in USD.”
With catastrophe bonds currently in-demand anyway and investors looking very favourably at this segment of the insurance-linked securities (ILS) asset class, this prospect of yields rising even further may serve to attract even more capital to the space.