Cat and mouse - Insurance-linked securities is yet another area where value is in short supply
From time to time – though admittedly with what, in recent months, has felt like a good deal greater frequency – The Value Perspective likes to highlight an asset class that looks to be overpriced. This time, our attention has fallen on the relatively young and still relatively small sector that is the non-life catastrophe bond – or ‘cat bond’ – market.
Cat bonds are issued by individual companies – usually insurers – and pay a regular yield or ‘coupon’ to their holders. They can work in various ways but effectively, when a particular ‘trigger’ event or situation occurs – an especially severe natural disaster, say, or a certain size of loss within a certain timeframe – then some or all of the investor’s capital passes to the issuer.
In some respects, therefore, Cat bonds are similar to convertible bonds – the investor owns the bond, receives a regular income and knows a particular kind of trigger can change the nature of their investment. However, while a trigger gives an investor the option to turn their convertible bond into a predetermined amount of equity, a cat bond trigger means the investor will lose some or all of their money.
Even so, investors’ continuing desire for income has seen cat bonds grow in popularity – to the extent that, in the second quarter of 2014, $4.5bn (£2.6bn) of cat bonds were issued through 17 tranches. This compares with $3.3bn issued through 17 tranches in the same period last year and, by some distance, beats the previous record for a three-month period – the $3.5bn issued in the second quarter of 2007.
This record quarter also included the largest ever single cat bond – the $1.5bn Everglades Re 2014 – and it is instructive to compare that with the $750m Everglades Re 2012 bond issued two years earlier. For while the expected loss ratios – effectively where the trigger is set – of the two bonds are fairly similar, some other important details are not.
According to a report issued by insurance industry expert Willis Capital Markets & Advisory, at 7.5%, the coupon on the 2014 bond is less than half of the 17.75% offered by the 2012 bond. Furthermore, the basis of the trigger has been broadened so that, rather than being the losses tied to a specific event, as it was in 2012, 2014 bond holders will lose money if cumulative losses reach a certain amount over a set period.
“In the span of two years,” notes the Willis report, “risk-adjusted pricing for the Everglades deals has fallen over 50%, a clear indication of investor demand for paper.” So this is another example of investors moving up the risk spectrum in their hunt for yield and not necessarily being compensated for doing so. In the small and esoteric world of cat bonds, one would be hopeful investors would know what it is they are buying. Whether they are pricing the risks correctly at present is perhaps more open to debate.
Fund Manager, Equity Value
I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.
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