Yes, cat bond fund returns are lower year-on-year, but there’s a good reason

A recent article in the mainstream financial press has caused some consternation among catastrophe bond fund managers and end-investors allocating to those strategies, as while it correctly highlighted that cat bond fund returns are down year-on-year in 2024, it failed to discuss the very good reason why 2023’s elevated returns were unlikely to be repeated.

2023 saw the total-return of the outstanding catastrophe bond market hit a record high of 19.69%, according to full-year data from the Swiss Re Cat Bond Performance Indices.

Catastrophe bond funds in the UCITS format averaged 14.88% for the full-year return in 2023, which is perhaps a better benchmark for what was typically achievable in the market for any larger or more diversified cat bond fund strategy.

Yes, there were cat bond fund strategies that managed a 20% return in 2023, but they tended to be smaller, more focused on certain specific instrument types and perils, or they traded actively to benefit from the one specific factor that helped cat bond fund returns on their way to record levels that year.

Over the last two years, the catastrophe bond market has been growing, raising its profile and as a result gaining greater attention from institutional investors as well as from the mainstream media.

At the same time we’ve seen spreads rise in tandem with reinsurance pricing, a good deal of spread fluctuation in terms of widening and tightening, and at the same time the return on collateral spiked and remains elevated.

All of which has driven increased investor awareness of and interest in catastrophe bond investments, at a time when demand for reinsurance protection has also risen and the sponsor-base of cat bonds broadened in response.

Over its 25 year history, each time the catastrophe bond asset class gains a more elevated profile in this way, we tend to see stories in the more mainstream press where it often seems the headline is more important than the substance, level of detail, or even accuracy of the piece.

Case-in-point, last week’s article that originally appeared with a headline saying cat bond fund returns had halved in 2024. It did not clearly explain any reason for that and did not explore the one factor that caused 2023 to deliver such high record returns to cat bond strategies.

It’s not really the media’s fault. The mandate of the mainstream press is not to understand every single niche asset class, or business, it comes across, just to create headlines of interest for their broad and widely focused readership.

We heard from cat bond fund managers and from concerned large investors, some allocators some not yet, with questions about why this story in the press seemed so at odds with what they were seeing and what we had been regularly reporting.

One allocator told me they got questions from their board asking why returns had halved with no evidence of any catastrophe events having caused cat bond losses in 2024 so far. These types of questions are troubling and generally not good for any market.

Now, it appears some of the consternation we’ve been hearing in response to the headline and article has found its way back to the publisher.

The headline has now changed, from saying returns were cut in half, to stating that returns had been hit and now citing the recent selling pressure from the second-quarter as the reason.

Still, further down the article text mentions cat bond fund returns for H1 2024 being roughly half that achieved in the prior year for some strategies, which is correct, but it still fails to discuss the why.

What really caused returns to near-halve this year?

Yes, the selling pressure that we’ve seen and the tightening of spreads that came with that reduced the returns for the first-half and even resulted in some negative performance months in Q2 for certain cat bond funds. But that was a supply-demand driven effect, along with some hesitation due to the extreme forecasts seen for hurricane season.

While those effects could have taken as much as a percent off cat bond fund return potential for the first-half of this year, it’s far from a driver of any halving of them year-on-year.

For that, we need to look further back. For our regular readers we apologise as you’ve read this all before, but it is worth reiterating when high-profile news stories are driving questions from investors and some concern among fund managers.

Recall that, hurricane Ian struck Florida in September 2022. While it has turned out to have little meaningful impact for the cat bond market overall, right after the landfall the Swiss Re cat bond index plummeted by 10%.

Effectively that wiped close to that figure off many of the largest cat bond fund portfolios, as they mark-to-market on a weekly or even more frequent basis to keep their investors informed of potential principal losses.

While hurricane Ian was a major insurance and reinsurance market loss event, at around the $50 billion level, it ultimately turned out not to be a big deal for the catastrophe bond market.

In the end the majority of the roughly 10% cat bond market decline after Ian was recovered, as prices rebounded once it became clear cat bonds were not facing the feared level of principal losses.

Some of that came back in late 2022, but the majority was earned back through the first-half of 2023 for many strategies, which was a significant driver of the very high cat bond fund returns for that period.

While the cat bond market index calculated by Swiss Re fell about 10% immediately after hurricane Ian, it had recovered a significant amount just weeks later.

Consultancy Lane Financial put some analysis time into this a few months back, concluding that after hurricane Ian at September 30th 2022 the implied cat bond principal loss, based on secondary pricing sheet data, was approaching $1.86 billion.

That’s around 5% of the total outstanding cat bond market at that point in time.

By the end of 2022 the mark-to-market implied loss was down to just over $1 billion and by the end of 2023 that had halved again.

It’s important to note that Lane Financial was only looking at cat bonds it considered distressed, so priced below 80, where it considers an actual principal loss might be priced in, rather than just uncertainty.

Which means there were numerous other bonds that were priced down by lesser amounts, but they also largely recovered at similar rates in the year after hurricane Ian.

Those recoveries, in the prices of cat bonds that had been thought exposed to hurricane Ian, continued through 2023 as well, delivering additional value back to cat bond funds that was accounted for as a component of 2023’s record returns.

Naturally, that wasn’t going to be repeated through the first-half of 2024, given there was no comparable event or cat bond price recovery to factor in.

There’s no denying that 2023 could have been a record year for many cat bond fund’s returns even without including this mark-to-market recovery, thanks to the hardening of reinsurance and commensurate increase in cat bond risk spreads, as well as the higher risk-free rate.

But, it would not have been that much higher than we’ve seen in 2024 so far, were those values recovered after Ian not incorporated into it.

How much was added, to 2023 cat bond market returns, by the recovery of value under positions affected by the threat of hurricane Ian losses? Very hard to say, but for some strategies it seems likely 2 or more percentage points could have been added to the annual return, for some it was higher and potentially around the 4% mark for a heavily US wind exposed portfolio.

So, what does this all mean?

For the first-half of 2023 the Swiss Re cat bond index delivered a return of 10.5%. For the first-half of 2024 it was just under 5.8%.

A significant reduction for sure, but if you assume anywhere from 2 to 4 percentage points were added through the first-half of 2023 due to the recovery of hurricane Ian impacted positions, plus a percentage point could have been lost this year on spread developments in Q2, then it is far from a halving of returns in 2024 so far.

The overall yield of the catastrophe bond market remains very attractive at over 13.5% as of the end of July.

The market had peaked at just under 16% at the start of 2023, some 11.37% was due to elevated risk spreads in part driven by the aforementioned recovery after hurricane Ian.

The current market yield comprises cat bond insurance risk spreads of 8.35% plus a still-healthy collateral return, and the overall 13.5% is still very attractive on a historical basis.

That’s softer than it was, but still elevated in historical terms of the cat bond market and a great opportunity for investors.

So, in summary.

Cat bond returns may have reduced, perhaps near-halved for some strategies through H1 2024 compared to the prior year.

But, there is a very good reason for that and the overlooked factor of hurricane Ian and its effect on prices, followed by their recovery, was by far the biggest contributor to the higher return in the prior year, which resulted in lower returns being booked this year.

We expect the interest from mainstream press will continue and perhaps rise further. Thankfully, investors know where they can come for straight-talking and facts on the catastrophe bond market.