Speed key to capitalise on cat bond spreads multi-year high: Twelve

Speed key to capitalise on cat bond spreads multi-year high: Twelve

For investors considering entering the catastrophe bond market, or increasing their allocations to it, during this period of multi-year high cat bond spreads, “speed is of the essence” according to investment manager Twelve Capital, as this opportunity won’t last for long.

Twelve Capital logoIn a new paper, Twelve Capital explains its view as to what has driven catastrophe bond spreads to near record highs.

As we wrote back on April 25th, the catastrophe bond market was seeing spreads widen for practically all new issuances, while our market sources told us about a mismatch, on multiple counts, that was driving prices higher, while sending broader signals on the potential trajectory for catastrophe reinsurance rates at the mid-year renewals.

As we then explained last week, the mismatch between supply and demand in the catastrophe bond market continued and we expected the bulging size of the new issue pipeline could actually accentuate the spread widening effect, as the mismatch between demand for capital and its supply continues to be prominent in the cat bond market.

Zurich-headquartered specialist insurance-linked securities (ILS) and reinsurance asset manager Twelve Capital explains the backdrop to all of this, from its position as the manager of one of the larger cat bond investment funds in the market.

The asset manager explains that, “The perception that it might be business as usual in the reinsurance world would be a massive understatement of the issues currently facing the sector.”

Elevated natural catastrophe losses over the last few years have eroded capital of the reinsurance market, an exodus of investors from some higher risk collateralized reinsurance fund strategies, and a “massive” cash impact of foreign exchange hedging in cat bond fund strategies has all driven a “significant liquidity squeeze.”

The result is the mismatch we’ve been describing, “Record primary market issuance volumes in the Cat Bond markets, which cannot be fully absorbed by existing investors.”

Poor quality transactions cannot get issued at all, while others can only be sold at significantly higher spreads, Twelve Capital explains.

Even where the risk level hasn’t changed and the sponsor hasn’t suffered any losses, some new cat bonds are now pricing significantly higher than their predecessor issuances.

Echoing our comment that the growing pipeline could exacerbate and prolong this spread widening effect, Twelve Capital says, “With currently more than ten active deals in the primary market and with brokers indicating that there are more transactions to come, a sudden reversal in spreads also seems unlikely at this stage.”

In fact, the investment manager believes, “The current opportunity set might well persist for a few more weeks even into the start of the 2022 hurricane season.”

Spread widening has impacted the returns of outstanding bonds, which has eroded cat bond fund returns this year so far.

While cat bond funds are still beating their benchmarks, it is funds that can capitalise on the higher coupons of new issuance that stand to do particularly well as this situation unwinds.

The size of the opportunity is clear, with spreads near records, Twelve notes, “The Cat Bond market now exhibits an overall spread of more than 650 bps above money market rates. Given the steep forward rates curve in money markets, we might even see the overall yield of Cat Bonds exceeding 10% within the next year.”

Which leads the investment manager to advise investors to move quickly, if they want to capitalise on this cat bond investment opportunity.

“For investors who have yet to deploy capital in the asset class or for existing investors willing to increase their allocation, this marks an excellent entry point,” Twelve Capital believes.

But added, “Yet, one should understand that the 2022 hurricane season is approaching fast and that the ability of Cat Bond funds to absorb larger inflows could become limited very soon.

“Speed is of the essence and we would strongly encourage investors to get in touch in order not to miss this exceptional entry point into a diversifying asset class.”

Also read:

Cat bond market supply-demand mismatch persists as pipeline builds.

Cat bond spread widening & uncertainty to be relatively short-lived: Aon.

Cat bond spreads widening as market experiences mismatch.

Cat bond funds could yield 8-9% on spreads & rising rates: Steiger, Twelve.

One of the best entry opportunities to catastrophe bonds: Ramseier, Twelve.

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