Cat bond pricing: where to now?

For cedants, cat bond pricing has rarely been more attractive, with a raft of new and repeat issuers all coming to market in recent months. For investors however, margins are growing increasingly thin, even as interest remains strong among pension funds increasingly comfortable with the convergence space.

As Paul Schultz, CEO of Aon Benfield Securities, explained: “Conditions in the first half of 2014 led to a number of transactions coming to market where clearing spreads for buyers of capacity proved very attractive.” Conditions resulted in significant downward pressure on pricing in 2014, Schultz said. Cat bond issuance and pricing has steadied during the quieter middle part of the year, but it is evident that further downward movement is possible later in the year.

"I believe we are going to see more minimum price transactions come out in the second half of the year."

Pete Cangany, senior partner at EY, Bermuda, agreed. “While it is hard to imagine a continued downward trend, I suspect we are going to see further rate compression in 2014,” he said, and singled out a lack of catastrophe activity being the lead driver, but added that a point will appear when rates will stop declining.

Edward Hochberg, executive vice president and global head of analytics, banking, and advisory at JLT Towers Re, said that cat bond pricing reflects macroeconomic spread compression, which is “spilling over into our market”. This coupled with an oversupply of capital entering the space has led to an imbalance of supply and demand, compressing investor returns in the space.

“However, on the lower yield US wind bonds (below a 4.5 percent coupon rate), we have recently hit a point where the market is somewhat saturated, at least temporarily. This has had a corresponding effect on those bonds, where the bid/offer point is harder to cross. It will be interesting to see if the market revisits and tests those lows later in the year,” said Hochberg.

"ILS managers will continue to attract money into existing vehicles and they will naturally expand as their business models achieve success."

Luca Albertini, CEO of Leadenhall Capital, agreed that the market is experiencing pricing pressure, but questioned whether this pressure will be sustained. “Secondary market pricing this year is following a very similar trend to the one of last year. Last year by the end of September the market recovered all losses and went beyond, thus pointing to softer conditions which we have then seen confirmed at December renewals.

“I cannot predict if the same will occur again, but what I can reasonably expect is that the market will recover most if not all of the secondary pricing which was lost in the first half of the year.”

The secondary market has a bearing on pricing, particularly as issuance volumes increase and the level of potential liquidity grows. But as Bill Dubinsky, head of ILS at Willis Capital Markets & Advisory explained, cat bond activity and liquidity aren’t always the same. “Investors tend to trade around a catalyst such as a loss, new issuance or broader financial market developments.” He said that while secondary market trading can be a guide to pricing “we tend to place less credence in secondary pricing if there is less activity in the market”.

Dubinsky said that the market is “reaching a phase of dynamic equilibrium”, with some areas experiencing price firming, while others continue to soften. He said that it was difficult to characterise the market at this point, even if there had been general softening at the start of the year.

Schultz explained that this is a feature of the ILS cycle, with a quiet period apparent during the middle part of the year. “Trading tends to be down and pricing flat because unless someone is trying to rebalance their portfolio or put significant capital to work, it tends to be a little quiet during the middle months.” He predicted flat to down rate movement during the second half of the year.

“The whole market is at a price point now that is very attractive. At some point there are minimum return requirements for any type of market—be that capital markets or traditional reinsurance—and that has been tested a fair amount in the first half of the year. I believe we are going to see more minimum price transactions come out in the second half of the year,” said Schultz.

Investor appetite

With the price coming down and the potential for further downward movement, the question then becomes: are investors beginning to walk away? It is apparent that in some instances ILS funds are turning investors away aware that they cannot meet minimum return hurdles in the current environment, but there nevertheless continues to be strong interest in convergence investments.

As Dubinsky explained: “There are some areas where investors, for the moment, have as much as they want of certain risks and at certain prices, but there are other areas where they have unmet needs and plentiful capacity. A functioning market corrects prices to address that.”

Addressing specifics, Dubinsky said that for non-US hurricane risk such as Japanese earthquake and European windstorm with a 50-year return period, there remains “plentiful demand and continued downward pressure on spreads”. However, with remote, 200-year return period US hurricane risk, there has been a “stepping back” by the market which has perhaps felt that it needs to be paid a little more for that risk. Despite general conditions however, well-priced bonds will continue to attract considerable investor interest, Dubinsky citing the scaling up of Citizens’ Everglades Re transaction as a case in point.

Hochberg said it would be hard to generalise whether investors are pulling back from the market. He explained that the risk:return profile of the various funds and managers would likely dictate appetite for future issuance, adding that pressure has been applied by traditional markets becoming “more aggressive to protect their positions vis-à-vis the capital markets”. Nevertheless, the non-correlation advantages of cat bonds and good returns on a relative basis, will likely lead to a “pause to digest, rather than any pullback” from the sector.

Diversifying the market

Meanwhile, the past 18 months have seen a raft of new issuers as cedants have grown increasingly comfortable with the capital markets and have sought to benefit from increasingly attractive pricing. Their entry has helped to diversify the market, grow its capitalisation and provide a greater diversity of risk for investors hungry for convergence capacity.

As Michael Popkin, managing director and co-head of ILS at Jardine Lloyd Thompson Capital Markets, explained: “Given the current supply:demand dynamic, it is important for prior issuers to return with larger size and for new issuers to come to the market, bringing new perils and geographies.” Popkin said that he had seen particularly strong interest for diversifying bonds, with ILS managers “looking for ways to manage their funds in a relatively more diversified way”.

He added that the current environment would likely mean that “higher coupon and higher risk deals may prove to be relatively more attractive than the current string of remote risk product which hit the market this past spring”.

Dubinsky said that while investors always welcome new sponsors, it tends to be the incumbents who have communicated with investors, been transparent regarding their risks and told their story well that can expect to strike the best deals in the market. “New sponsors have to overcome a presumption that ‘You are new. Why are you here?’”

Market diversity is also being delivered through so-called cat bond lite transactions. Popkin said that their impact on pricing has been limited, but said “They are an excellent way to bring more cedants and more diversifying risks to market. These private placements make it economic for cedants who would otherwise not come to the capital markets to begin to engage with these markets and start to build longer term relationships with ILS funds.

“For the ILS funds, these deals provide a valuable and necessary source of investment opportunities.”

Dubinsky added that such transactions have considerable potential, even if for now they are competing with collateralised reinsurance for market share.

Where now?

Addressing the likely future heading of the market, Cangany agreed that the pace of capital coming into the convergence market has slowed, but that capital will continue to enter the space. “ILS managers will continue to attract money into existing vehicles and they will naturally expand as their business models achieve success,” he said.

Schultz likewise argued that a slowing is likely, adding that “having discipline about where you are going to deploy your capital is healthy—a market that is cognisant of return levels and risk”.

“What is positive is that you don’t need the entire market to get deals done,” said Schultz. “Capacity is becoming more significant and you are starting to see investment preferences coming out—remote risks versus more risky bonds. Balancing those preferences is helping to bring more investor appetites into the space.”

Dubinsky said that he expects capital levels entering the market to remain steady. “Pension funds are making allocations over the long-term and know that if they pile all their money in at once they are going to put the market out of balance.” Add to this minimum return hurdles, and Dubinsky expects more of a slowdown in the levels of capital entering the space than a turning-off of the taps.

Rick Miller, managing director and co-head of ILS at Jardine Lloyd Thompson Capital Markets, concluded: “We believe strongly that pension funds and other upstream investors are here to stay. Moreover, when we do eventually see spread widening driven by a cat event, we anticipate that some of the dry powder will find its way into our markets to moderate any significant spread widening.”