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Cat Bonds Beating Corporates Most Since November: Credit Markets

Cat Bonds Beating Corporates Most Since November
Crews work to clear rubble from Route 100 in Killington, Vermont, on Aug. 31, 2011. While insurers are boosting yields on cat bonds by selling riskier debt as the U.S. hurricane season progresses, chances of a major storm lasts every year through November, according to the National Hurricane Center. Photographer: Scott Eisen/Bloomberg

Returns on catastrophe bonds are exceeding those on corporate debt by the most in nine months as investors facing record-low yields chase returns detached from economic performance.

The bonds, designed to protect insurers from payouts on natural disasters such as hurricanes, have gained 1 percent this month, compared with a loss of 0.9 percent for company debt, according to the Swiss Re Cat Bond Total Return index and Bank of America Merrill Lynch data. Returns on dollar-denominated cat bonds were half those of corporates in 2011 as an earthquake and nuclear accident in Japan sparked record losses.

Issuance in the $15 billion market for catastrophe bonds is growing at the fastest pace in five years as investors seek securities that don’t depend on payrolls growth in the U.S. or a solution to Europe’s sovereign-debt crisis. An average yield of about 9 percentage points more than short-term lending rates compares with 5.89 percentage points on junk bonds in the U.S.

“It’s not related to how the U.S. economy is doing, to how the global economy is doing, the concerns about growth, currencies or deficits,” Shiv Kumar, a managing director and head of financial institution structured finance at Goldman Sachs Group Inc., said in a telephone interview from New York. “The sector itself has proven to be a diversifying, objective, clean play compared with debt and equity markets.”

Hurricane Season

While insurers are boosting yields on cat bonds by selling riskier debt as the U.S. hurricane season progresses, chances of a major storm lasts every year through November, according to the National Hurricane Center. That means higher coupons and investor demand is accounting for accelerating returns, according to Fermat Capital Management LLC’s John Seo.

“The proven track record, especially through recent broader market volatility, has also helped establish the credibility of cat bonds,” Seo, managing principal at the Westport, Connecticut-based firm overseeing $3 billion of the debt, said in an e-mail.

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. declined for a fourth day, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreasing 1.2 basis point to a mid-price of 97.3 basis points as of 11:32 a.m. in New York, according to prices compiled by Bloomberg.

Swap Spreads

That’s the lowest level on an intra-day basis since May 4 for the measure, which typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, decreased 0.43 basis point to 20.32 basis points as of 11:33 a.m. in New York. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.

Bonds of Caracas-based Petroleos de Venezuela SA, or PDVSA, are the most actively traded dollar-denominated corporate securities by dealers today, with 77 trades of $1 million or more as of 11:45 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Cat Bonds

Cat bonds have returned 5.3 percent since the end of March, following a 0.45 percent gain in the first quarter, according to the Swiss Re index.

Company debentures from the most creditworthy to the riskiest have returned 4 percent since March 31, following a 3 percent gain in the first three months of the year, according to the Bank of America Merrill Lynch U.S. Corporate & High Yield Master index.

The outperformance this month is the most since cat bonds lost 0.03 percent in November while company debt plummeted 1.94 percent, according to Swiss Re and Bank of America Merrill Lynch index data.

While issuers of U.S. corporate bonds are obtaining record-low borrowing costs, reaching an unprecedented 3.9 percent on Aug. 2, cat bonds are enticing investors with higher yields.

Sales Rise

Cat bonds issued in dollars in 2012 paid an average 915 basis points more than short-term benchmarks, up from 899 basis points last year and 881 in 2010, Bloomberg data show. High-yield bonds in the U.S. pay a spread of 589 basis points, down from an average 607 in 2011 and 630 the prior year.

“The yields on cat bonds are actually relatively normal, which relative to everything else means attractive,” said John Brynjolfsson, chief investment officer at hedge fund Armored Wolf LLC, which oversees $735 million and owns cat bonds.

That’s helped boost issuance of the debt, which insurers sell to reduce the risk of claims from hurricanes and floods to pandemics, to $3.6 billion through the first six months of the year, the most since 2007, according to Swiss Re data. Companies have sold $887 billion of dollar debt this year.

“When you’re seeing a growing asset class that’s still offering yield, that’s what attracts folks,” said Cory Anger, a managing director at broker-dealer GC Securities. “When you’re looking at the absolute return you’re getting in other asset classes, people are concerned about the level of income that they’re able to generate.”

Investor Appeal

Citizens Property Insurance Corp., Florida’s state-owned insurer, more than tripled its target amount in a debut sale of obligations designed to protect against losses from hurricanes to $750 million in April, the biggest offering on record of cat bonds. Goldman Sachs managed the sale.

“We absolutely did not know that we would have the opportunity to upsize this thing three times,” Sharon Binnun, chief financial officer of the state’s largest property insurer, said in a telephone interview. “In the interest-rate environment that we’re in now, investors are looking for another vehicle through which to park at least a portion of their investment portfolios.”

The debt, effective for two years, priced to yield 17.75 percentage points more than a money-market fund of Treasuries in which the proceeds will be stored.

Payrolls, Retail

If insurance losses in the 2012 and 2013 hurricane seasons pass a threshold, principal will be transferred to Citizens Property Insurance and bondholders will lose that portion of their principal and the future interest payments allocated to it, according to an April 20 document posted on the insurer’s website.

Payments linked to natural disasters help insulate the debt from the risk that a fragile U.S. economic recovery will hinder companies’ abilities to boost sales or generate the cash required to pay off obligations.

Employment increased by 163,000 last month, helped by a pickup at automakers and health-care providers, after a revised 64,000 June advance, Labor Department data showed. The median estimate of 89 economists surveyed by Bloomberg called for a rise of 100,000.

The jobless rate, based on a separate survey of households, climbed to 8.3 percent in July, marking the 42nd straight month above 8 percent. Retail sales by auto dealers to department stores rose 0.8 percent more in July, the biggest since February and first gain in four months, according to Commerce Department figures released on Aug. 14.

Portfolio ‘Diversifier’

Cat bonds, which gained 3.3 percent last year even after a 4 percent drop in the weeks following Japan’s 8.9-magnitude temblor on March 11, have posted positive gains every year since at least 2002.

The debt returned 2.3 percent in 2008, when the collapse of Lehman Brothers Holdings Inc. contributed to a 37 percent tumble in the S&P 500 index of U.S. stocks and an 11 percent loss for corporate debt.

“It’s a diversifier to almost any other asset class out there,” Judy Klugman, a managing director at Swiss Re Capital Markets, which issues and underwrites the securities, said in a telephone interview. The bonds “provide real value for issuers and investors, so that can only mean it has real legs for the future.”

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