The Swiss Re Global Cat Bond Index recorded a 3.4 percent return in the first quarter of 2010 despite tightening spreads and diminishing collateral returns, according to the Zurich-based reinsurer.
The price return measured by the index was 1.6 percent for the same period.
Prices on catastrophe bonds have been recovering slowly from the 2008 financial crisis. Current returns are a result of price improvement for bonds that were trading at “distressed levels” the Swiss Re report says.
There has also been a significant amount of new assets entering the catastrophe bond market which — coupled with low issuance — has driven demand for catastrophe bonds on the secondary market.
That resulted in the index recording a 13.5 percent return for 2009 — the second-highest return for any calendar year in the index.
New issuance has remained constrained in the first quarter of this year, but the market is poised for a rebound, says Richard Pennay, vice president of Swiss Re Capital Markets.
“Cat bond issuance in the first quarter of 2010 may have been lower than what some had predicted. As we approach the U.S. wind season, however, the market is experiencing significant issuance activity in the second quarter,” Pennay says. “When we complete the first half of the year, the market will be well ahead of issuance levels for the first half of 2009.”
There are currently 94 bonds in the Swiss Re Global Cat Bond Index, down from the peak of 117 bonds in May of 2008.
Collateral Questions Remain
Swiss Re says that while investors have benefited from the higher stated spreads that benefit has been offset by declining returns on cat bond collateral. While returns have stabilized the market continues to search for a collateral solution that will offer credit stability and acceptable returns for investors.
Prior to the financial crisis, catastrophe bonds used total return swap (TRS) structures tied to the London Interbank Offered Rates (LIBOR) as a way to invest in collateral programs. But following the collapse of Lehman Brothers, four bonds guaranteed by the investment bank were downgraded.
Currently, 75 percent of the Swiss Re index (weighted by market value) is compromised of cat bonds with TRS collateral structures issued prior to the financial crisis. That fact — coupled with a decline in the three-month LIBOR rates — has had a negative impact on total returns.
The market is attempting to identify an acceptable solution to the collateral issue by finding alternatives.
Swiss Re says Treasury money market funds (TMMF) appear to be “the new standard.” TMMF, the only collateral solution brought to the market this year, makes up approximately 20 percent of outstanding market value.
Other solutions include structured notes (using World Bank and KFW reference debt) that represent 3 percent of the market. An additional 2 percent have used new forms of TRS structures.
Swiss Re argues that the trend away from existing TRS structures will continue since the current alternative are offering similar returns to LIBOR.
“At this stage we haven’t seen anything other than the Treasury money market fund collateral structures,” Pennay says. “Both investors and cat bond sponsors are currently content with Treasury-based collateral returns.”
“That’s not to say that it won’t change and return to a LIBOR-based solution moving forward. It simply reflects what the market is comfortable with,” he adds.
