Diversification pays off for some catastrophe bond funds

Some catastrophe bond funds have been able to moderate the impacts of broadly widening spreads through their diversification in recent weeks, with diversifying perils and regions experiencing less significant widening on outstanding cat bonds, so delivering better returns in May and June.

We’ve been documenting the spread widening seen across the catastrophe bond market in recent months, as cat bond spreads began widening in earnest in early April, with a supply-demand mismatch, as well as investor risk aversion, seen as the main drivers of this trend.

While some believe the effects of the spread widening may be felt through the rest of the year, as we’ve also reported recently, there is now some evidence that the widening has slowed, or perhaps even come to a halt.

The execution and pricing of a number of recent peak US peril exposed catastrophe bonds suggests things are more balanced in the cat bond market at this time.

Of course, with reinsurance rates for catastrophe exposed programs considerably harder than a year ago, it does seem unlikely spreads will fall back to where they sat six months or even a year ago very quickly.

While spreads widened for newly issued catastrophe bonds, which indicated price hardening in that market, the effects are of course also felt in the secondary market and wider spreads have eroded returns for many catastrophe bond funds through recent months.

However, the spread effect has definitely been most heavily felt in peak US catastrophe perils, especially US wind.

We’re now told that some cat bond fund strategies have managed to offset some of the spread pressure on their positions through their allocations to diversifying perils and regions, where the spread pressure has been less evident.

Cat bond funds with larger allocations to diversifying regions like Asia, for example, have delivered better performance as those diversifying cat bond investments remained positive in recent weeks.

We’ve even heard of some funds that attribute a positive monthly performance solely to the diversifying cat bond positions they held, as almost all else in the portfolio felt the effects of the spread environment.

The way the spread pressure has impacted peak US peril exposed cat bonds has been almost like seasonality induced effects, although this time stimulated by the broader macro environment and all of the reasons we have well-documented in previous articles.

Having diversifying sources of return can always be useful and this period has shown the utility of having some diversifying risk in a cat bond portfolio.

Of course, not every diversifier is equal and some ILS fund exposures to regions such as Australia have come back to bite managers in recent years.

But still, while many seek a more concentrated US wind focused cat bond fund exposure, there are plenty of investors that appreciate a broader spread, by region and peril, which can benefit them when conditions are right, as seen in recent weeks.

Artemis’ measure of the average spread between expected loss and coupon at issuance of new catastrophe bonds has now reached its widest since 2012.

At the same time, Artemis’ measure of multiples at market of newly issued cat bonds is also at its highest since 2012.

For full details of second-quarter 2022 cat bond and related ILS issuance, including a breakdown of deal flow by factors such as perils, triggers, expected loss, and pricing, as well as analysis of the issuance trends seen by month and year.