Cat Bonds Rally With Hurricane Season Advancing: Credit Markets

By Charles Mead | August 21, 2013

Gains on catastrophe bonds are poised to exceed returns on speculative-grade company debt by the most since 2008 as the Atlantic hurricane season heads into its fourth month.

Notes designed to protect insurers from payouts on damage linked to powerful winds are on pace to return 10 percent this year, more than double the 4.6 percent annualized gain for the Bank of America Merrill Lynch U.S. High Yield Index. Prices on the disaster-linked securities have increased 0.66 cent this month to 99.71 cents on the dollar, the biggest rise since September as measured by the Swiss Re U.S. Wind Cat Bond Price Return Index, which accounts for about 28 percent of catastrophe debt worldwide.

“Every week of the hurricane season that goes by without an event will typically result in a supercharged return for the cat bond market,” John Brynjolfsson, the chief investment officer at Irvine, California-based hedge fund Armored Wolf LLC, which oversees about $1 billion, said in a telephone interview. “The reason cat bonds are so appealing to me as an addition to a portfolio is that there’s virtually zero correlation between cat bond returns and financial market returns.”

Nine Hurricanes

The securities have held their value better than high-yield company obligations even as the U.S. National Oceanic and Atmospheric Administration predicts an above-normal season with as many as nine potential hurricanes. Corporate debt with junk credit grades in the U.S. has dropped 5.3 cents since their peak in May as speculation mounts that the Federal Reserve will begin to curtail unprecedented stimulus measures as soon as September.

The $16.8 billion of outstanding cat bonds linked to worldwide perils that include earthquakes have returned 6.4 percent this year, compared with 6.1 percent for the $4.7 billion of securities limited to U.S. wind-related damage, according to Swiss Re index data. Both indexes have outperformed versus the same period last year, and each are delivering more than double the 2.8 percent gain from junk debt in 2013.

“It is pretty phenomenal, these returns,” Judy Klugman, a managing director in New York at Swiss Re Capital Markets, which issues and underwrites the securities, said in a telephone interview. “For those investors that have bought into the cat bond asset class, they really do believe in the non-correlation story.”

Default Swaps

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. declined, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreasing 2.6 basis points to a mid-price of 81.7 basis points as of 11:28 a.m. in New York, according to prices compiled by Bloomberg.

The measure typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, fell 0.47 basis point to 18.78 basis points as of 11:29 a.m. in New York. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.

General Electric

Bonds of General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.7 percent of the volume of dealer trades of $1 million or more as of 11:31 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Cat bonds linked to U.S. wind damage are headed for the best returns relative to junk debt since the height of the financial crisis. While high-yield debt lost 26 percent in 2008 as the collapse of Lehman Brothers Holdings Inc. caused a credit seizure, disaster debt gained 1.8 percent. The cat bonds gained 11.3 percent in 2012.

The $17.4 billion of dollar-denominated cat bonds tracked by Bloomberg, which include $200 million of notes from New York’s Metropolitan Transportation Authority designed to guard against storm surge damage, now pay about 7.87 percentage points more than short-term lending rates. That compares with an average yield of 6.77 percent for the $1.2 trillion junk-bond market.

Assurant Bonds

Assurant Inc., the New York-based insurer of foreclosed homes, said last month it obtained $185 million of hurricane protection from Ibis Re II Ltd., which issued bonds including a $110 million portion due in 2016 that pays 400 basis points more than quarterly Treasury bills.

The risk of major storms lasts from June through November, according to the National Hurricane Center, and each day that passes without a hurricane boosts the value of a bond whose principle provides coverage against storm damage.

Credit: NASA GOES Project

Credit: NASA GOES Project

NOAA, which is part of the U.S. Commerce Department, said Aug. 8 that the Atlantic hurricane season “is shaping up to be above normal” with the possibility of as many as five major storms with winds of at least 111 miles per hour. The peak of the season lasts from mid-August through October.

Tapering Haven

While cat bond investors face the prospect of losses from natural disasters, the securities have been a haven compared with corporate debt as the Fed considers when to cut back on its stimulus. Sixty-five percent of economists in a Bloomberg survey said Fed Chairman Ben S. Bernanke will probably reduce the central bank’s $85 billion of monthly purchases of Treasuries and mortgage bonds in September.

The Federal Open Market Committee’s first step will probably be small, with monthly purchases tapered by $10 billion to a $75 billion pace, according to the median estimate in a survey of 48 economists conducted Aug. 9-13. The Fed will end the buying by the middle of 2014, they said. In a survey last month, half of economists predicted a Fed reduction in bond buying at the next scheduled meeting Sept. 17-18.

Junk bonds have lost almost 1.9 percent since April as 10- year Treasury yields surged 1.21 percentage points to 2.88 percent as of yesterday. Wind-linked cat bonds returned 2.4 percent in the same period.

Sales of dollar denominated cat bonds have climbed to $5.37 billion this year from $4.55 billion in the same period of 2012, data compiled by Bloomberg show. A record $7.8 billion was issued in 2006.

“We’ve had a lot of new money flow into this space,” Nelson Seo, co-founder of Westport, Connecticut-based Fermat Capital Management, which oversees more than $4 billion, including cat bonds, said in a telephone interview. “2008 highlighted the fact that people were paying for diversification that wasn’t really there — this asset class has shown itself to be uncorrelated, and institutional investors are much more comfortable with it.”

(With assistance by Mary Childs and Krista Giovacco in New York. Editors: Alan Goldstein, Faris Khan)

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