With cat bond spreads widening in recent weeks due to market dynamics and expectations of rising interest rates, it is currently possible that an investment in a cat bond fund could yield up to to 8% to 9% next year.
So says Florian Steiger, Catastrophe Bond and ILS Portfolio Manager at Zurich-based specialist asset manager Twelve Capital.
Steiger believes that with forecasts for the average US Fed Fund rate now hovering over 3% in 2023, this, in addition to an attractive catastrophe bond price, means a particularly strong opportunity to deploy capital in the sector.
Recall that catastrophe bonds are floating rate securities, so their return to investors includes the coupon, or equivalent of the online reinsurance rate, plus the return of the collateral, which is typically invested in U.S. Treasury money market or similar.
Which means that the ultimate return earned by an investors allocation to a catastrophe bond fund will float higher on top of rising interest rates.
Explaining the context of the current cat bond investment opportunity, Steiger told Artemis: “Cat bond spreads have widened significantly over the past few weeks, due to an overall shortage of liquidity in the market and a large volume of issues on the primary market”.
This momentum is widening spreads, but already this year the average coupon paid for newly issued catastrophe bonds is also higher as reinsurance markets have tightened, another factor that makes the investment opportunity attractive in this moment.
“Investors entering a broadly diversified cat bond fund today can expect to earn spreads of around 550 to 600 basis points above money market rates. It’s one of the best entry points we’ve seen in a long time,” Steiger said.
The entry point into catastrophe bonds looks even more attractive considering their floating rate nature.
“Short-term interest rates in the United States are expected to rise significantly over the next few months. As cat bonds are floating rate notes, any further increase in money market rates would almost immediately increase the coupons of the cat bonds,” Steiger explained.
Steiger went on to say, “Interest rate derivatives imply that short-term rates could even exceed 3% in 2023.”
This would take the ultimate return on an investment in a cat bond fund to a much higher level.
But for sophisticated investors, there is an opportunity to take that yield and try to lock it in as well.
Steiger said: “Investors who are able to convert some of their floating rate bond coupons into fixed rate bonds today via interest rate swaps could already lock in some of this anticipated development.
“Such a strategy, which would then of course have some duration risk, could potentially return around 8-9% in USD.”
With catastrophe bonds currently in demand anyway and investors looking very favorably on this segment of the insurance-linked securities (ILS) asset class, this prospect of even higher yields could serve to attract even more capital. in the space.