Shorting Catastrophe Bonds:
Catastrophe Bonds are a way for insurers to access capital and secure a portfolio of risk. Insurers spread their risk to other investors by securitizing the potential obligations to pay out in the form of the CAT bonds. Investors receive a slice of the premiums through coupons, but these bonds’ value is decreased in the event of a pay out by the insurer. There are various triggers and duration of these bonds depending on the underlying business.
Investors are more comfortable with this asset class. Investor comfort level is signified through the increased duration in the market, according to Artemis.
We are seeing an increased appetite from investors. According to Artemis, we have seen increased demand from the secondary market and investors looking to continue to rollover capital into these securities. “The catastrophe bond market reached a new high at the end of 2015, with the level of issuance during the year outstripping a record high level of maturities, resulting in the market reaching the end of the year with cat bonds on-risk standing at an all-time high, according to Aon Securities.”
We have had an unique period of low Catastrophe loss experience in the recent years, coupled with low interest rate environment which we believe is driving the demand and decreasing spreads.
In these situations we are reminded of the following quote:
- “Whenever you find yourself on the side of the majority, it is time to pause and reflect” – Mark Twain
With duration of these bonds reaching a 7 year high (~3.61 years) and spreads over expected losses continuously decreasing, it may present an opportunity for contrarian trading strategy – i.e. shorting individual CAT bonds.
Investors opting to short these securities have to hold their position during the quiet Catastrophe periods but as soon as there is a hint of an event, the price of these bonds can start to drop rapidly as the potential payouts can be multiples of the initial investment (i.e. 6 to 1, depending on the coupon and when the event occurs). Others have discussed this strategy back in 2011 for example Roger Pielke, Jr.
Valuation of the individual securities is in the eye of the beholder but we ask the following:
- The question remains what is the value of a CAT bond with no coupon due to loss activity and principle potentially going to pay losses?
Predicting a reversion to the mean of hurricane/CAT activity is a difficult position and a short can be costly when there is a non-event year but as we know, anything can happen with Mother Nature.