K2 Advisors raises conviction on private ILS, cat bonds, retro investing

K2 Advisors, the hedge fund focused investment management unit of Franklin Templeton, has become even more constructive on the insurance-linked securities (ILS) asset class, seeing near record high catastrophe bond spreads, as well as improved conditions in private ILS, retrocession and industry loss warranties (ILW’s).

K2 Advisors has been getting increasingly constructive on the ILS market through recent quarters, with the catastrophe bond its preferred and most recommended area of the asset class.

But now, the manager has moved its overall conviction on ILS to overweight, as it has moved from underweight to neutral on ILW’s, while remaining strongly overweight cat bonds, private ILS and retrocession.

In fact, versus all the other hedge fund related asset classes that K2 Advisors follows, private ILS, cat bonds and retrocession top its list, in terms of weighted conviction, for the first-quarter of 2023.

Scoring a wide-range of hedge fund investment strategies, private ILS transactions, so this would include most collateralised reinsurance arrangements, are scored top of the entire list, with a z-score of 2.3.

Cat bonds are scored next highest, with a z-score of 2.1, while retrocession comes next at 1.8.

The scores indicate the conviction and type of investment weighting K2 Advisors might recommend for a strategy, so for ILS assets to come higher than any other hedge fund strategy for Q1 2023, is really indicative of the significant opportunity to invest in ILS and reinsurance-linked assets at this time.

“We believe the current ILS market environment presents investors with what could be one of the best entry points since the inception of the asset class,” K2 Advisors explained.

Going on to explain that this is because, “Total yields are higher following Hurricane Ian, tighter reinsurance capital, and an increase in money market rates.”

January reinsurance renewal rate increases look significant, the investment manager explains.

While, for cat bonds, “The catastrophe (cat) bond market spread remained elevated near all-time highs, combined with a significant increase in money market rates, which provides attractive total yield potential.”

K2 Advisors notes that historically ILS market returns rise following major catastrophe events and this looks to be no different after hurricane Ian.

But, what is different, is the fact an entry into catastrophe bonds right now can also recoup additional returns from recovering positions that are devalued in the secondary market, as well as recovery after spread pressures from macro conditions, plus now a much higher floating-rate return, on top of the higher yields new issues are completing at.

“Further buoying our positive outlook toward the ILS asset class is its floating-rate structure. ILS instruments are priced as a spread above the risk-free rate.

“With a sizable increase in money market rates, the forward- looking total yield expectations are near the highest since the inception of the asset class,” K2 Advisors explained.

The investment manager expects returns to remain higher in cat bonds and ILS, with elevated reinsurance pricing expected to buoy returns.

It’s a particularly constructive outlook for Q1 2023 from K2 Advisors, as the manager joins others in believing the ILS investment opportunity is nearly, if not already, as good as it has ever been.