(Bloomberg) — As hedge funds rake in record profits in one of the riskiest parts of the bond market, the products that underpin those returns are now attracting more mainstream investors.
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Catastrophe bonds were the cornerstone of some of the best-performing hedge fund strategies last year, delivering more returns than other high-risk fixed income products. In 2023, the security rose 20%, compared to a 13% rise in U.S. high-yield corporate bonds. U.S. Treasuries rose about 4%.
Niklas Hilti, head of insurance strategy at Credit Suisse's investment arm, now part of UBS Group AG, said such impressive returns have led to so-called “cats” that are beyond the realm of hedge funds. He says this is stimulating demand for bonds.
“Recently, there has been increased interest among institutional investors,” Hilti said. “Even if we believe these gains will not be replicated in 2024, we believe a small allocation to the asset class makes sense for investors to diversify their investment portfolios.”
Catastrophe bonds are used to protect against losses that are too large for the insurance industry to cover. That risk is instead transferred to investors who are willing to accept the possibility of losing some or all of their capital in the event of a disaster. In return, they can earn huge profits unless a contractually predetermined catastrophe occurs.
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The cat bond market has existed for decades, but has recently experienced a resurgence as a result of weather events caused by climate change. Coupled with decades of high inflation that increases the cost of rebuilding after natural disasters, cat bonds have driven issuer and investor activity to record levels.
At the same time, some cat bonds are written with stricter trigger clauses, lowering the probability of payout, favoring investors and cat bond funds.
Hedge funds that made big profits on cat bonds and other insurance-related securities last year include Fermat Capital Management, Tenax Capital and Tangency Capital.
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Niche hedge fund investors continue to dominate the cat bond market, while more mainstream institutional investors are increasing their presence, according to data compiled by Bloomberg. These include Schroders Plc, GAM Holding AG and Credit Agricole SA. This coincides with an increase in the supply of these securities, with insurers increasing their issuance by 50% last year.
Daniel Yneichen, head of portfolio management at Schroders, which oversees about $5 billion in insurance-related securities, said high returns and the appeal of cat bonds as a portfolio diversifier are driving the asset manager's business. . He noted that a quarter of investors seeking exposure to Schroders' cat bonds in the past six months have joined the firm's catastrophe bond team for the first time.
Ineichen said much of the new interest is coming from institutional investors and asset management platforms.
He said the Schroders Cat Bond Fund, launched in the middle of last year and aimed at U.S. investors, has already raised $100 million. “We can clearly see that cat bonds are the hallmark of this year,” and “we see a very attractive return pattern in 2024.”
Swiss Re has long been involved in proprietary trading of cat bonds and is expanding that strategy. In July 2022, he established an investment management company called Swiss Re Insurance Linked Investment Advisors Corporation, which oversees third-party capital and currently manages approximately $1.5 billion in assets.
Given the current market trajectory, these assets could exceed $2 billion by 2025, said Maria Giovanna Gattelli, the group's chief investment officer. Returns have been in the double digits and there is growing interest among professional investors outside of ILS, she said.
Indeed, investors entering cat bonds are taking on highly complex and risky products that are not linked to the rest of the market. And when payment provisions are triggered, large losses can occur.
According to estimates by insurance broker Aon, the global insurance-related securities market reached approximately $100 billion at the end of the third quarter of 2023. According to Artemis, which tracks the ILS market, cat bond issuance alone reached an all-time high of more than $16 billion in 2023, including non-real estate and private transactions, bringing the total securities market to $45 billion. That's what it means.
“The market is in a more favorable position than it has been recently, as risk premiums have widened significantly over the past two years and, most importantly, structural risk has been reduced,” Hilti said.
Last year, everything fell into place for cat bond investors. Brett Houghton, managing director at Fermar, which manages approximately $10.8 billion in assets, predicts 2023 will be a year of “high investor interest and the need for the insurance market to issue more and more insurance.” “Unicorn Year”.
Cat bond spreads “tightened significantly” in January, driven by strong investor demand, according to a recent Bank of America analyst report.
Recent gains were boosted by a milder hurricane season than in 2022, with bondholders having to cover fewer losses. While the consensus view is that these uniquely supportive conditions will be difficult to achieve again, Mr Houghton said investors were still seeing “attractive returns”.
Hilti said the security does not need to repeat its 2023 gains this year to remain an attractive investment.
Hilti said cat bonds will always remain a “niche investment.” But investors willing to take on risk are looking to gain a foothold after the long-awaited “stronger momentum and higher risk premium” arrives, he said.
(Added line from Bank of America report in paragraph 19.)
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