Collateral returns, cash and its influence on the catastrophe bond market: SIFMA ILS

Given the high levels of return on collateral in the catastrophe bond market cash has built up and the market has been expanding on the back of this, which has an effect on the supply and demand balance, which can be viewed both negatively and positively, speakers discussed at the SIFMA ILS conference in Miami last week.

With the return on collateral at and above 5% at times this year, the $40 billion plus market of catastrophe bonds is generating $2 billion of cash per-year, or $500 million per-quarter, which still needs to be put to work as cat bond fund managers are largely retaining those earnings.

Richard Pennay, CEO Insurance-Linked Securities at Aon Securities, the investment banking and ILS arm of the insurance and reinsurance broker, moderated a panel featuring ILS investment managers and asked them how they felt this cash effect has been altering market dynamics.

Richard Godfrey, Deputy Underwriting Officer & Portfolio Manager (Cat Bond Funds) at Securis Investment Partners LLP, noted how this has affected supply and demand.

He explained, “We’ve seen a slight, maybe an aberration, at the start of this year when we had a very high volume of deals reaching their maturity dates at the first week of January, putting a lot of excess cash into the market which caused spreads to quite noticeably tighten in the early part of the year.”

But Godfrey went on to say, “That’s now levelled out, as we see ahead to a very full pipeline. I’ve lost count of how many deals are in the marketplace at the moment, we’ve got over $4 billion worth of deals that have either priced or are in the market at the moment already this year. That’s absorbing that cash and return.

“In terms of wider inflows into the market, I don’t see so far this year we have any new sort of particularly large inflows. There’s certainly a drip of new money coming in as well, but my sense at the moment is that, certainly in the near term future, that the supply of investment opportunities is going to absorb that and I think will underpin spreads around the levels that they are at the moment.”

John DeCaro, Founding Partner at Elementum Advisors LLC, further explained, “I think it’s a negative factor. I mean it’s distorting the price discovery mechanism, because with the quantity of cash that’s coming in the market, it forces a number of investors to actually, by mandate of their funds, put cash to work basically without regard to the level of risk premium they’re accepting for the risk that they’re taking.”

He continued, “So we have a situation where, when the returns are really good because the bond prices have been marked up due to the secondary trends we’re seeing, that has kind of a knock on effect on the sell-side when the dealers are trying to provide price guidance to their clients about trades in the market, this is where pricing is for a comparable security.

“I think it poses a challenge, for both sponsors and investors, to really discern what is the appropriate level of risk premium for new transactions. Because, we may think that the right pricing is a 5% margin and then the sponsor may come out based on the guidance from the broker and say, well, we think the market is between 350 and 450 based on secondary trades that have been distorted because cash has to be put to work.

“It will be interesting to see how that continues to play out over the next quarter, given the size of the pipeline.”

Pennay added the broker-dealer view, “We certainly see that from our side. There tends to be, over a multi-year period, there’s a relationship between the amount of maturities and the coupon return that investors are receiving, that broadly resembles the size of the new issuance in a given year.

“I think, to your respective points, it’s the recycling of that cash that the market is using in order to further grow.

“It’s not necessarily incoming funds that are supporting that growth, it’s the recycling of that cash which has been super important for the further growth.”

Godfrey further said, “I think that we’re fortunate that we’re in an environment at the moment where there’s such strong sponsor demand and firms have been so successful in originating and introducing new sponsors to the market and upsizing deals. The happy confluence where the supply is balancing the demand, more or less, with temporary aberrations as already mentioned.”

Pennay added, “We’ve been fortunate, because you do have that additional cash, that we’re able to bring new sponsors to market and it feels as though this market is kind of at this critical mass now. where it’s evolved and matured.

“It’s almost mainstream to do a cat bond now.”