Cat Bond Markets Resist Credit Crunch

June 24, 2008

Forced asset sales that have frozen major markets in the credit crisis have caused barely a ripple in the $22 billion catastrophe bond market this year and instead only enhanced its liquidity.

Goldman Sachs estimates secondary trading volumes are up 35 percent over a year ago. Dealer Swiss Re’s volumes amounted to about $1 billion to March versus $2 billion in all of 2007, said Managing Director Albert O. Selius. “I have been trading for more than seven years, and I have never had a problem selling a bond,” Selius said.

While the credit crisis led to waves of asset sales and created price distortions in major triple-A markets such as U.S. government agency debt, yields for catastrophe bonds, most of them junk-rated, stayed on a three-year tightening trend.

Trading has increased as some investors shifted allocations to take advantage of opportunities in other distressed areas and as some hedge fund groups such as Peloton Partners and D. B. Zwirn & Co. had to liquidate assets.

U.S. money manager Pioneer Investments was disappointed that the Peloton sell-off in March did not enable it to add much cheap catastrophe risk to its $181 million Diversified High Income Trust, said Michael Temple, head of U.S. fixed income research. “We were hoping it would affect the market more. Within a month (spreads) had settled back to tighter than we would like.”

Jerry Ouderkirk, Goldman Sachs’ head of catastrophe bond trading, said: “In none of the cases where we have received multiple-line entries on bid lists thus far this year can I say that any of those sales processes materially moved the market.”

While the crisis has improved liquidity, another aspect of the catastrophe bond or cat market has helped insulate it from financial turmoil: Dealers had provided little or no leverage.

At most, a large investor might be able to lever a diversified portfolio of, say, 10 different perils by as much as three times, versus 30 to one in other markets, Selius said.
“That’s what saved the market, and I don’t see it changing in the future,” he added.

Said Pioneer’s Temple: “With a high-yield bond or loan, there is some recovery … With cat bonds, it’s usually all or nothing. It’s a low-probability event, but when it does happen, you can get wiped out.”

Cat prices are also relatively immune to general market sentiment and to short-selling strategies dependent on market technicals. “Sentiment is not a primary driver in the cat marketplace but a secondary driver,” said Barney Schauble, a partner at Nephila Capital, a Bermuda-based hedge fund specializing in insurance risk with about $2.4 billion under management. “Either you are going to have a hurricane or not. No one can make those things move against you,” he added.

Liquidity provides reassurance to investors, who look to cat risk mainly for diversification. “One of the prerequisites of getting into this market was determining that there was enough liquidity,” Temple said.

Bid/offer spreads range from 10 to 35 basis points, according to Selius. That’s in a market where most bonds are issued in amounts of $50 million to $250 million.

Ouderkirk put the typical range at 20 to 40 basis points. “I also run the CLO (collateralized loan obligation) trading desk, which is a much larger secondary market by market volume, and thus far this year the bid/offers in cats have been tighter.”

Strong demand has done little, however, to boost supply. Issuance is down this year to about $2 billion as of mid-June.

“Growth has flattened out going into 2008”, after ending 2007 at $23 billion, said Mike Millette, Goldman’s head of structured finance. “We expect issuance to exceed maturities and the market to be larger than $23 billion at year-end.” Insurers are transferring all the risk they need to transfer.

“The amount of risk transfer is huge”, because the riskiest pieces at junk and low investment-grade levels go into the market, while insurers keep AA and AAA exposure, Selius said. “On a risk-transfer basis, this market is as large as some other markets”, which sell the entire capital structure such as asset-backed securities, he added.

A jump in supply could occur depending on two factors, Millette said. One would be a costly disaster, which would refocus insurers’ attention on potential losses and increase demand for protection. The other is the supply of protection available through the traditional reinsurance market.

In the year following the three large storms of 2005, which included Katrina, prices for U.S. wind risk doubled or tripled. Since that time, they have fallen roughly 10 percent each renewal, Schauble said. “Spreads are still high relative to the 2002 to 2004 period and the asset class is still extremely attractive,” he added.

Insurer USAA in May sold $125 million of BB-rated three-year U.S. hurricane and earthquake risk at 675 basis points over Libor [London interbank offering rate] and $125 million of B-rated at 1,150 over.

By comparison, the Merrill Lynch BB corporate bond index yields 345 basis points over mid-swaps and the B-rated 578 over, both with weighted average life of more than five years.

Even so, at Pioneer “we’re being cautious right now about increasing exposure,” Temple said. “Two to three years ago, spreads were extraordinarily wide and attractive, but there has been no major event since, and everybody is looking to buy in.”

(Editing by David Holmes)

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