Recent cat bond market volatility evident between triggers and perils: Tenax

Tenax Capital, the London based hedge fund investment manager that operates a UCITS cat bond strategy, has analysed what it calls the “unusual” peak in volatility seen in recent weeks, which has resulted in the net risk margin gap widening between various perils.

As well as a widening of the gaps between net risk margin of different perils in the catastrophe bond market, Tenax Capital also notes a “spread dispersion by trigger type” over recent history, especially since hurricane Ian, which is particularly evident between index-trigger cat bonds and indemnity cat bonds.

This spread dislocation across perils and triggers has been driven by a range of factors and is seen as both unusual and significant.

It began with an initial widening of spreads after hurricane Ian, but that transformed into tightening as investors moved to capitalise on increasingly attractive catastrophe bond spreads.

“Once it became clear that Ian would not significantly impact catastrophe bonds, managers were eager to increase exposure in a segment proven to withstand such an event. At those levels, the attractiveness of the trade-off embedded in almost all index trigger bonds became apparent. This trade-off involves adding tail and concentration risk on one side, and the absence of secondary perils on the other,” Tenax Capital explains.

In the wake of the period of very strong new issuance earlier this year, Tenax Capital notes that market capacity became stretched, and a subsequent “sharp repricing in the segment.”

While this appeared to coincide with a specific index-trigger cat bond that failed to price within guidance, Tenax Capital notes that it’s important to consider the broader picture of market conditions and other factors playing into pricing.

“It may be prudent not to focus too heavily on the specific issuance that acted as a catalyst for the widening spreads, as the demand for higher risk premia did not arise from idiosyncratic features of that deal,” the investment manager explained. “Instead, we might consider this a matter of timing—a bond offering non-diversifying peril exposure came to market just as a period of abundant new issuances was concluding, making it less appealing to investors facing capacity constraints ahead of an anticipated active Atlantic Hurricane season.”

Tenax Capital then goes on to explain how the model update of the RMS hurricane V23 also had an effect on spreads after this time, which we already explored in more detail in this article and further explored in this piece from last week.

The results were the spread widening that we’ve discussed in recent articles, which Tenax Capital noted “may present a significant buying opportunity” for some cat bond funds.

“In conclusion, the catastrophe bond market has experienced a peak of volatility that is unusual in a non-event scenario,” Tenax Capital states.

The manager says that, “A general pattern we have observed across the entire catastrophe bond market is increased spread volatility, stemming from various challenges the sector faced in early 2022, which culminated with Hurricane Ian. However, upon closer examination, a greater degree of dispersion becomes apparent once we isolate specific triggers and perils.”

Gaps between the perils, on a net risk margin basis, with Net Risk Margin (NRM) defined as the catastrophe bond spread net of the expected loss, have widened over the last two years, with “each peril behaving differently compared to past post-event environments.”

The recent widening of net risk margin has been “more persistent for US perils, particularly Florida wind and atmospheric peril,” Tenax Capital’s analysis shows.

Which it believes means that, “The relative attractiveness of Florida versus diversifying perils has substantially increased, and it is currently even above the recent lows reached at the end of 2023.”

In fact, Florida continues to show structurally higher volatility, while some diversifying perils such as from Japan have reverted back to around the historical mean.

Tenax Capital explains, “We conclude that the demand for non-peak perils is less influenced by general market sentiment, as the ongoing need to diversify portfolios away from U.S. wind risk continues to cap spreads in these areas. Insurance-Linked Securities (ILS) themselves offer significant diversification from traditional equity and credit asset classes. Therefore, the necessity to diversify further within the ILS sector remains a topic of debate, largely depending on the specific objectives of an investor’s ILS allocation.”

The dispersion of spreads by trigger is also analysed and while the direction has not been surprising, Tenax Capital says the magnitude of the movement seen recently has been.

But now, a more balanced relationship has emerged, Tenax says and expects future deviations over coming months will be event driven from here.

The manager goes on to explain that, “Index trigger bonds have been disproportionately impacted, initially moving from being expensive to cheap compared to indemnity bonds, before settling back into a more balanced range. Looking ahead, we expect index trigger bonds to remain more subject to volatility, especially if the upcoming wind season produces as many events as consensus forecasts predict.

“Within this category, however, there is a variety of risk profiles, allowing managers to precisely shape their preferred positioning.”

The investment manager goes on to note that the firm advises caution in assuming that indemnity triggers are “structurally more expensive than index triggers.”

Tenax Capital explains, “Indemnity deals often include secondary perils within their scope, where risk models typically lag in reliability compared to peak perils and may underestimate the risk. Indemnity trigger bonds also expose investors to single sponsor risk, potentially leading to moral hazard through poor underwriting and claims handling. While most loss projections from sponsors have decreased since Hurricane Ian, there have been notable instances where loss projections have unexpectedly increased. Such surprises are less frequent with index trigger bonds, emphasizing their comparative predictability.”

Adding that, “Finally, data shows that index trigger bonds default far less often than indemnity bonds. While we have shown that they are more susceptible to mark-to-market swings, by avoiding loss-making bonds and strategically capitalising on this volatility, the potential for generating alpha has been demonstrated in the subsector’s performance in recent years.”