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CAT bonds an alternative in correlated markets

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During a year when equities, corporate bonds, commodities and hedge funds of various strategies and stripes fell simultaneously, it is clear that these asset classes become correlated in extreme market conditions. In this milieu, an emerging asset class is sharpening its claws as a relatively uncorrelated market: catastrophe (CAT) bonds.

CAT bonds, which first appeared in the mid 1990s, depend not on economic, credit, corporate, sovereign or foreign-exchange factors. Rather, they are “triggered” by environmental events such as hurricanes, typhoons and earthquakes. In brief, CAT bonds expose investors to infrequent, extreme weather.

If the defined events do not occur, CAT bond investors typically make gains of LIBOR plus 3% to 14%. The average maturity is three years.

In the 12 months to January 2009, the Swiss Re Cat Bond Total Return Index gained 2.9%, while similarly BB-rated corporate bonds sank 22%.

Christophe Fritsch, Head of the ILS (insurance-linked securities) team at AXA Investment Managers, figures that a diversified ILS portfolio can return 300 to 400 basis points more than investment-grade corporate bonds. “We can build a diversified CAT bond portfolio optimising the 5% value at risk in order to preserve the capital in 95% of the case; returns are an average 10% per annum,” Fritsch says.

The relative stability of CAT bonds is proving to be an attractive factor at this time, when long-term investors such as pension funds, institutions and high-networth individuals are seeking capital preservation plus cash flow. “People were disappointed with alternative investments in 2008 because in a strong downturn, most asset classes become highly correlated. In 2008, CAT bonds were the only asset class outside of government bonds to have made gains,” says Pierre Emmanuel Juillard, Head of Structured Finance Division, AXA Investment Managers.

CAT bonds’ outstanding risk capital has been growing steadily from US$344.6 million in 2003 to US$13.8 billion last year, according to Guy Carpenter, a reinsurance intermediary. AXA Investment Managers expects CAT bonds to have US$30 billion outstanding by 2016, as a result of various demand and supply factors, including reinsurers’ growing appetite to transfer risk to the capital markets and increasing demand from large institutional investors.

AXA Investment Managers started the ILS service in 2007, when it figured that the CAT bond market had gained sufficient depth. But currently, the CAT bond market is not large enough to have significant liquidity in the secondary market and price transparency, among other issues.

“The entire CAT bond market is two to three times the size of the liquid market, so the original expectation that the CAT bond market would become a trillion-dollar market should be realized within a couple of decades, which is probably par for the course when one looks back at the history of the mortgage-backed securities market or even the options and derivatives market,” said John Seo, co-founder of Fermat Capital Management, in a testimony before the US House of Representatives in September 2007. 

There are other risks, primarily modeling methodologies, counterparty risks and portfolio construction. Even so, CAT bonds are beginning to enter the mainstream marketplace. In recent years, a growing number of mutual funds and hedge funds focusing on CAT bonds have emerged, such as the A Square Fund, Bank Leu’s Prima Cat Bond Fund, among others.

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