ESMA said not in discussion on cat bond eligibility for UCITS funds

For a few weeks now we’ve been hearing rumours and receiving messages from contacts related to the fact the European Securities & Markets Authority (ESMA), a financial regulator, had restarted an exploration of catastrophe bonds and whether they should be an eligible asset for UCITS investment funds.

Previously, the European Securities & Markets Authority (ESMA), an independent European Union Authority, had looked at catastrophe bonds from a diversification stand-point.

As a result, ESMA’s so-called 20/35 diversification (or perhaps concentration risk) rule was applied to cat bond funds in certain domiciles.

But earlier in 2023, we began to hear rumours that ESMA was looking at whether catastrophe bonds should be considered eligible assets for UCITS fund strategies at all.

We were told this was after the sell-off in financial markets through 2022 and liquidity issues seen in some capital markets. That meant regulators were set to look closely at any asset classes where liquidity was not as abundant, or guaranteed, as a UCITS investment fund strategy might require.

We’re also told that the fact cat bond market liquidity was not seen to be as abundant (as some thought it should be) after hurricane Ian, had sparked a general awareness of the asset class again.

In our research and discussions on this topic, we were told that the broad subject of eligible assets for UCITS funds is on the European Commission’s agenda this year.

Responding to our enquiry following that, ESMA told us directly that there was no information to share at the time, but confirmed the EC’s interest in eligible assets for UCITS fund strategies.

We’ve undertaken further analysis and outreach, discussing the issue with industry contacts and other interested parties.

The latest we’ve been told is that ESMA is not in any active discussion on catastrophe bond eligibility for UCITS funds.

Apparently an issue related to cat bonds had been submitted as a proposed discussion item, but this has not been progressed or tracked as an issue by ESMA, so is assumed to be a non-issue now.

It’s possible that what’s happened here, is that the wider European Commission assessment of liquidity in asset classes and whether they should be eligible for UCITS has been conflated out to potentially include catastrophe bonds, as one unknown party raised cat bonds as a type of asset that could be looked at under this lens.

Of course, UCITS catastrophe bond funds are in some cases quite large and it’s clear catastrophe bonds are a very popular asset for UCITS investors.

As we recently reported, the main UCITS cat bond funds grew their overall assets by 7% in the first-quarter of 2023, to reach a new record of $9.37 billion.

On the topic of liquidity, catastrophe bonds have proven themselves to be a relatively liquid asset class in times where it is needed most, particularly during broader financial market crises.

But in the main they are a largely buy and hold asset for sophisticated investors, with trading more closely linked to portfolio management, than to any need to frequently change up their portfolio mix.

With a functioning secondary marketplace, but a largely sophisticated manager base, cat bond funds may not always require significant liquidity right after a major catastrophe loss event and, in the case of Ian, the recovery seen in cat bond values shows that the way managers opted to hold their portfolios steady at that time was the right move, with most rewarded for doing so.

We’d say it’s important not to anticipate that every asset class will exhibit the same liquidity characteristics all the time, especially in times of market stress in that particular vertical, or more widely.

While it’s also key to recognise the way catastrophe bonds have traded during times of broader financial stress, at which times they have clearly evidenced their usefulness as a component of diversified investment holdings, with liquidity and their lack of general correlation abundantly evident.

Should we hear any more on this issue we will update you.