Spread development lifts cat bond fund return potential, but dents May for some

Recent spread development in the catastrophe bond space has boosted the forward return potential of cat bond funds, but for those investors that had more concentrated exposure to industry-loss index trigger cat bonds, the moves have dented performance.

The catastrophe bond market has been on a relatively wild ride, in terms of market spreads, ever since hurricane Ian in 2022.

A significant rise in prices after that storm drove cat bond market insurance risk spreads from just below 7% in September 2022 to a historical high of 11.31% in January 2023.

After that, cat bond risk spreads steadily tightened, which accelerated late last year and continued into 2024, bottoming out in March at 6.62%.

Since when the market reversed its course to one of spread widening, driving the insurance risk spread of the cat bond market back up to 8.13% as of the end of May 2024.

Analyse the yield of the catastrophe bond market and its constituent parts, including risk spreads, in Artemis’ interactive chart.

Index-trigger cat bonds led the way through the recent spread widening, as we’ve documented, but there has been a general increase across indemnity cat bonds as well.

But, the most pronounced spread development was seen for the industry-loss index trigger cat bond cohort, which have widened further and faster.

A number of factors have driven the development, including the emergence of more balanced supply and demand in the cat bond market, the effects a recent hurricane risk model update has had on investor and manager perception of risk, while some also cite the forecasts for an active hurricane season as a further driver.

Zurich based cat bond investment manager Icosa Investments has analysed the movement in index-trigger cat bonds vs indemnity, finding the former far more pronounced.

Icosa explained, “Three recent index-linked transactions in the primary market faced insufficient demand, leading to increased pricing for two of those bonds and the cancellation of a third issuance. Due to the high correlation within the index-linked segment, this triggered an immediate repricing of nearly all other index-linked cat bonds and a notable rise in spreads.”

The chart below from the investment manager shows how spreads have tracked for index cat bonds vs indemnity.

As you can see in Icosa Investment’s chart above, the recent spread widening has returned the gap between the two categories of bonds.

Through the more recent tightening phase, it seems index-trigger cat bonds tightened further, closing the gap between the two categories completely.

Then, the recent spread widening has reversed that trend and the gap between the two has been restored.

While there are clear reasons for the market spread development, it does seem a contributor may have been investor desire to restore the delta between industry-loss and indemnity spreads, to a degree.

The result, with spreads also widening for indemnity cat bonds, is an improved performance outlook for all cat bonds, with higher spread returns available.

Icosa Investments said, “For investors, this development is positive. Despite short-term mark-to-market losses, this adjustment enhances long-term return prospects and is likely to attract more capital into this asset class.”

However, for those cat bond funds and portfolios that were more weighted towards industry-loss cat bonds, there has been some short term pain because of the widening.

We understand some cat bond funds have delivered negative performance for May, due to the widening of industry-index trigger cat bonds, with a number of strategies down by over a percentage point for the month.

Which, as always, makes for a disappointing message to send investors, especially at a time when returns were still riding high.

But, the repricing that has occurred will flow through in performance terms over future months, so it will be recovered and some of this is counteracting the effects of tightening that had perhaps boosted cat bond fund returns, higher they would normally have been without that tightening phase.

So ultimately, this all evens out over time and the short-term performance dent is not a long-term indicator, with broader cat bond market return potential now a bit higher again which will benefit investors in all cat bond funds.