Why should I enter the cat bond market now?
Several factors - the diversification challenge in a low interest environment, expected new emissions and increasing supply of new perils on the market - indicate that cat bonds presently are an interesting option.
Any investor about to enter a market (or a single position) faces the issue of market timing. When is the right time to enter the market? Cat bonds are no different from other markets in this aspect; finding the optimal timing is easy ex post facto, but hard ex ante. This is one of the reasons why we recommend investors to have a holding period of 5 years or more.
This said, I would argue that several external factors currently contribute to make cat bond investments an interesting alternative
The case for diversification
One of the most common reasons for investing in cat bonds is the diversification benefits they bring to a traditional portfolio, with equity and bonds. As cat bonds are uncorrelated, they dampen effects of volatility of equity markets and interest rates in a traditional portfolio. In the present low-interest environment, many investors are weighted towards the equity market, with few attractive uncorrelated options. Cat bonds offer such an alternative with historically good risk adjusted returns.
New issuances are set to increase
Largely due to the low-interest climate, we have seen a strong demand for insurance linked securities (ILS), not necessarily with a corresponding increase of supply of issuances. Still, the risk spreads have remained stable since 2014, demonstrating investor discipline in the field. While 2015 and 2016 can be seen as “off years” in the trend of increasing outstanding market volumes, the market is expected to grow further in 2017.
The first two quarters of 2017 will bring in excess of USD 7 billion in maturities, providing for an active primary market, which will also drive activity in the secondary market. For a manager like Entropics this probably gives more opportunities to optimize a portfolio.
In addition to sponsors replacing maturing cat bonds we also expect that increasing regulatory demand will drive new sponsors to the market. This applies to Solvency II in Europe, and to similar regulatory initiatives in other parts of the world. Hence, direct insurers and reinsurers facing harder regulations will look to transfer parts of their risks to the capital markets to obtain fully collateralized protection.
The diversification discount will probably decrease over time
The supply of bonds covering other perils than high-yielding US cat bonds increases. One example is Japan, where we have seen a steady increase of issuances of cat bonds in the past years. Another example is China, which issued its first cat bond last year. We have also seen a broader range of perils coming to the market, offering further diversification within the asset class. For diversification reasons, non-US perils have historically benefited from a discount, as many investors have competed for these bonds to diversify their cat bond exposure. With a continuous growth of new perils around the world, this discount will probably decrease over time.