Credit spread developments could drive surge in catastrophe bond inflows: Jefferies

A developing situation in the corporate bond market has the potential to drive a significant increase in interest in insurance-linked securities (ILS) and has the potential to drive more inflows to the catastrophe bond market, analysts at Jefferies have suggested.

“At last week’s Jefferies Asia Forum, we were presented with the interesting possibility that high-quality US corporate bonds could trade at a yield below that of US Treasury bonds of similar duration.

“If this were to occur, we believe that the catastrophe bond market would be considerably more attractive, boosting capital supply in reinsurance and ultimately negatively affecting reinsurance profitability (and share prices),” the insurance focused equity analyst team at investment bank Jefferies stated.

Two important facts were highlighted at the Jefferies event in Hong Kong, that US Treasury bonds are relatively short duration, with 31% scheduled to mature in 2024 and over half maturing within the next three years, and that at the same time US corporate bonds are now relatively long-duration, with most maturing after 2029.

“As such, the US government is disproportionately dependent on near-term market conditions and the willingness of the market to refinance maturing Treasuries. While there is little doubt that they will be refinanced, this large supply of bonds, combined with any sudden shift in consensus views due to macroeconomics, political uncertainty, or geopolitical tensions could materially increase the yield on US Treasuries,” Jefferies analyst team explained.

Adding that, “By way of comparison, the relative lack of supply of corporate bond issuance could keep yields in check.

“The result is that it is possible that high-quality US corporate bonds could trade with a lower yield than US Treasuries – effectively creating a negative credit spread.”

The analysts continued to explain that, “It’s our view that it would have a material impact on the supply-and-demand dynamics of the catastrophe bond market.

“Catastrophe bonds are fully collateralised with US Treasury bonds and are priced with a yield that comprises an insurance premium layered onto the US Treasury yield. Crucially, this means that the opportunity cost of owning a Catastrophe bond is largely credit spreads. If spreads were to become negative, this would make catastrophe bonds disproportionately attractive, prompting flows into this asset class.”

It’s an interesting and astute observation, as certainly conditions in traditional bond markets can serve to make catastrophe bonds more, or less attractive.

The floating rate nature of catastrophe bonds, in offering a yield tied to the insurance risk premium and also the return on the collateral means they can ride out cycles in the bond market, or broader global economy and hence their attractiveness as a diversifying asset class that can deliver meaningful returns as well.

In this case though, what is particularly interesting is the fact that some of the investors that will have billions allocated to just the type of corporate bonds Jefferies analyst team are referencing, have actually become more active in the cat bond market over the last year or two anyway.

A number of the world’s largest fixed income investors are now allocating to cat bonds, some in a relatively minor way, others more meaningfully beginning to layer cat bonds within their multi-asset fixed income strategies.

Should there be a reason for some of these investors to begin to reduce their weighting to corporate bonds, if credit spreads did become unappealing, now they have access to and some experience in the cat bond market, they may well look to this market as a relatively more attractive alternative that shows more stability through a period where corporate bond credit spreads are relatively less so.

The Jefferies analysts highlight this potential scenario in the fixed income markets as they believe any significant flow of capital to catastrophe bonds, or other insurance-linked securities (ILS), could be detrimental for the reinsurance sector.

“If the Catastrophe bond market were to see a surge of inflows, this would put competitive pressure on the retrocession market and give insurers and reinsurers an incentive to issue new bonds instead of buying traditional cover for extreme tail risks,” the analysts said. “This in turn would shift retrocession market capital further down the risk curve, competing directly with reinsurance capital.

“Ultimately, this capital inflow would have the potential to materially shift the capital supply of the industry, putting pressure on prices.”

Going on to say that, “Should new capital disrupt the currently favourable supply and demand dynamics of the global reinsurance industry, this would have a negative impact on the share prices of listed reinsurers. The non-life reinsurance market is considerably larger than the life reinsurance market, so few reinsurers would be able to divert capital to more productive uses.”