CATASTROPHE BONDS – Fortune From The Disaster

Catastrophe Bonds simply were known as the “Cat Bonds” is a financial instrument where the issuer issues bonds for re-insurance against the natural disaster or a catastrophe. The insurance company issues bonds as collateral against the catastrophe insurance. Cat bonds have a high yielding feature with a duration of 2 years to 5 years. Cat bonds transfer the risk of insurance into the capital market.

History for development of cat bonds can be traced back in the 1990s when the claims filed by clients against hurricane Andrew couldn’t be acknowledged and the insurance industry suffered humongous losses. Many insurance companies that earlier provided catastrophe risks decided to leave the insurance sector and about eleven insurance companies filed for bankruptcy. Therefore, there was a need to cover the capital by catastrophe insurance-linked bonds.

Working of the CAT Bond:

As this bond transfers the risk from insurance company to the financial markets. The amount which is pooled out from the investors is transferred to the Special Purpose Vehicle (SPV). There is a reinsurance agreement between the SPV and the insurance company which dictates the terminology and clauses for the amount to be paid during the catastrophe. The SPV invests it into the capital market and to manage the security. The returns from the financial market are further passed to investors of cat bonds. They are mostly invested in money market instruments with low risk. They are high yield debt instruments. These SPVs fulfill the claims of the risk carrier i.e. insurance company if any catastrophe occurs or as the terms of an agreement are fulfilled.

For instance, a family living in Florida where hurricanes are most likely to happen they approach for Hurricane insurance from the General Insurance Company. The insurance company will provide such insurance since they get good premiums but still hang back because if the hurricane occurs they will have to pay a huge amount as indemnity. The solution to the problem is by issuing cat bonds they won’t incur huge losses. If the event is not triggered at the maturity then the collateral account by SPV will be liquidated and the proceeds will be returned to the investor. But if the event triggers then the collateral is liquidated where some or all the proceeds are passed on to the sponsor.

Figure 1: Process of CAT Bonds
Source

Investor’s Perpective:

A cat bond is a lookalike corporate bond with a pre-determined coupon rate. These bonds are not related in any way to the global markets. A financial crisis has nothing to do with the trigger of a natural disaster or catastrophe. They are built on floating rates notes where the investor benefits the return not only from the risk premium of the cat bond sponsor but also the returns from the money market where the pooled amount is invested. Since these bonds are not linked with capital markets, investors view such bonds to diversify their portfolios to minimize the risk related to markets. Over the years the cat bonds have shown great growth and seemed to be a lucrative investment option. Performance of cat bonds Index, Insurance-Linked Securities-Hedge Fund (ILS-HF), Equities and Bonds Index is shown below. Figure 2 to Figure 4 shows why cat bonds are considered to diversify their portfolio and have been alluring over the years.

Figure 2: Performance of Cat Bond Index versus other Financial Instruments Index
Source


 

CAT BOND

ILS HF

EQUITIES***

BONDS****

INDEX*

INDEX**


 


 

Total Return

166.4%

89.9%

124.3%

55.9%

Volatility

3%

3%

15%

5%

Annualized return

7.9%

5.1%

6.50%

3.5%

Sharpe Ratio

2.39

1.69

0.45

0.69

Figure 3: Comparing Returns and Volatility ( Source )


 

CAT BOND

ILS HF

EQUITIES***

BONDS****

INDEX*

INDEX**

Cat Bond Index*

1


 


 


 

ILS HF Index**

0.87

1


 


 

Equities***

0.18

0.1

1


 

Bonds****

0.17

0.14

0.39

1

Figure 4: Correlations ( Source )

Benefit for the Economy:

It is next to impossible to bear the shock of catastrophe alone by the insurance companies. The financial markets are stronger and capable to bear the economic effect of the catastrophe. So, to benefit the quantum of financial markets for the effect of catastrophe, was when the establishment of catastrophe bonds came into existence after Hurricane Andrew 1992.

The use of cat bonds is mainly to protect and manage risk associated with the disaster. The development of cat bonds is growing rapidly over the years for developing economies as well. Countries and regions in the risk-prone areas are many a time not insured or is backed by government funding for the upliftment of the economy.

This new insurance-linked product has led the World Bank providing a framework for the same known as the “MultiCat Program”. This has given aid to Mexico’s Caribbean islands to issue cat bonds by structuring themselves using the framework provided by the World Bank. The intrinsic value of these bonds is to provide for the recovery of the loss incurred and transfer the risk to those willing to take the risk. Financial investors have turned around to this investment option as an asset class with higher returns and low or no correlation with the financial markets. But today cat bonds are proving themselves as a social-driven investment instrument and new breed for this cat bonds are coming are known as the pandemic bonds which will help to combat the life-threatening diseases.

Indian Scenario about Cat Bonds:

When the world is booming and progressing on different financial products India cannot step back but indeed tries to be in the race. Yes, it is trying to come up with the debutant of its cat bonds in the Indian Economy. General Insurance Corporation of India (GIC), is the country’s foremost reinsurer that has come upon the thought of issuing cat bonds on the wakeup call of the Uttarakhand floods in 2012. GIC had to pay approx. 2000 crores of claims settlement from their treasure chest. E.g. If GIC issued cat bonds worth 1000 crores in 2011 with the maturity of three to five years, on triggering of the event they would have to shed only 1000 crores.

India being a developing economy, many parts of the country are risk-prone areas like aforesaid floods, cyclones, landslides and very rare symptoms of earthquakes in the regions of Rajasthan, etc. Let’s assume India agrees to pay at 12% – 14% coupon on cat bonds in India, it would likely get the subscription of Pension Funds, Hedge funds or high net worth individuals since they are attracted to benefiting from high-interest yields over the short tenure of the bonds. The government should try and come out with such bonds and mitigate the losses for its own.

Thus, Catastrophe Bonds a savior to the economy by passing on the risk to the risk bearing financial investors.

Author
Lorretta Gonsalves
Team Member- Alternate Investments (M.Sc. Finance, NMIMS – Mumbai. Batch 2019-21)

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The Curious Case of Quiescent Inflation & Negative Yielding Junk Bonds

One of the most important questions being asked in financial media today appears to be, “Is the Phillips Curve Dead?”

Before I go jump into the analysis of whether that is the case and what impact will it have on the future course of monetary & fiscal policy, let me give me a brief explainer about the concept of The Phillips Curve.

A.W. Phillips stated that there was a trade-off between unemployment and inflation in an economy. He implied that as the economy grew, unemployment went down, this lead to tighter labor markets. Tighter labor markets warranted higher wage increases. Companies, in order to maintain their margins, would pass this higher input cost to the consumers which would then be reflected in the CPI (Consumer Price Index- a gauge of inflation) that we refer to.

You could say this was the case before the 1980s, however, since then, the relationship between the two seems to have hit a “rough patch” or flattened out.

Source: Bank for International Settlements (BIS)

The above chart regresses PPI Inflation (%) with the growth in Unit Labour Costs (%). As defined by OECD,

“Unit labor costs (ULC) measure the average cost of labor per unit of output and are calculated as the ratio of total labor costs to real output.

A rise in an economy’s unit labor costs represents an increased reward for labor’s contribution to output. However, a rise in labor costs higher than the rise in labor productivity may be a threat to an economy’s cost competitiveness, if other costs are not adjusted in compensation.”1

Just from the chart, one can infer that the slope of the regression, R2 or the link between PPI inflation and ULC growth has flattened significantly when you compare the data pre and post 1985.

Hence, I would like to devote a major portion of this article on exploring the structural changes in world economies that have led to this compelling phenomenon.

Lower bargaining power emanating from a declining share of income that accrues to labor

  • A June 2018 research paper titled, “Productivity and Pay: Is the link broken”2 suggests, that post-industrialization (or since the 1980s), median compensation grew by only 11% in real terms, and production workers’ compensation increased by a meagre 12%, compared to a 75% increase in labor productivity. Since 2000, average compensation has also begun to diverge from labor productivity.
  • Apart from the weaker link between the above two variables, the continued sluggishness in wage growth can largely be attributed to productivity growth being far weaker than it was before the crisis.3

Globalization & The Threat of Production Relocation

  • The increased integration of production and complex supply chains connecting advanced economies with emerging market economies, outsourcing along with the relatively smooth and easy flow of money and information across borders have forced workers in rich countries to compete with those in poorer ones
  • The IMF World Economic Outlook (2017) attributes about 50% of the fall in labor share in developed economies to technological advancement, with the fall in the price of investment goods and advances in ICT encouraging automation of routine tasks

Declining Path of Unionisation

As unionization declines, the collective bargaining power of employees starts diminishing. For example, in the United States % of employees enrolled in a trade-union membership has steadily declined from 20% to 10% over the past few decades.

This makes it more difficult for the workers to capture a larger share of the productivity gains enjoyed by the firm as a whole.

Hence, we observe that wage growth in real terms has hardly seen a meaningful increase.

The shift from manufacturing to service economies and the era of automation

  • With the heightened contribution of artificial intelligence and automation in the manufacturing process, firms are able to substitute labor with capital and even the high-quality blue-collar jobs are at stake.
  • From an economic efficiency standpoint, it makes sense for a firm to get more work done for the same or lower cost than to waste resources in hiring and training employees. This could partly explain the delinking of productivity and wage growth.
  • With global PMIs crashing into contraction territory across the world economies due to a host of factors such as dollar strength seen in 2018 (80% of global bank trade credit is denominated in dollars), uncertain CapEx or investment environment due to trade wars among others, we have seen consumption stayed relatively resilient.
  • This may be partly attributed to the transition of economies reliance from manufacturing to services, as a result, the share of employment in services has also jumped in recent years.

Quantum Pricing & Long Term Inflation Expectations

  • The traditional theory states that wages are stickier than prices. If so, profit margins should ideally rise if demand increases. However, after studying firm-level behavior we observe that they tend to abstain from margin expansion for the sake of higher market share. Also, firms unable to generate sufficient sales tend not to reduce prices proportionately to avoid losing cash to meet their rising debt and interest burdens (which explains why we saw inflation falling less than expected during the GFC).
  • Firms have since been engaging in “Quantum Pricing” where firms may change the quality or composition of their products to adjust for production cost volatility instead of increasing prices across the board. This, in turn, makes prices stickier while keeping margins stable. It becomes increasingly complex for mainstream macroeconomic models to capture such structural shifts in pricing affecting inflation.4
  • In a nutshell, all the above factors along with weak cyclical pressures drag longer-term inflation expectations lower (as observed by the 5Y5Y forward breakeven inflation, etc). Lower expectations through their negative feedback loop anchor inflation lower to some extent.5

Low Rates, Asset Price Inflation & The Lure of Negative Yields: Glimpse

Markets have set their expectations in stone for rates being “lower for longer” due to the inflation dynamics stated above, secular stagnation going forward and maybe even price level targeting by central banks.

In an environment where markets will pounce on anything with a positive real yield, there may be a real risk of financial instability arising from irrational bidding of risk assets which cannot be more prominently observed than from the negative-yielding junk bonds.

You are essentially paying companies with significant credit risk for (the privilege of) borrowing funds from you!

It may sound absurd but what if I tell you that this negative-yielding Japanese/European debt may in certain cases provide you with a dollar yield that is even higher than the positive yield that you get in treasuries? In other words, (for example) -0.1% (¥) > 2.5% ($)

I shall follow up on the mechanics of how this kind of sorcery is possible (along with the risks associated with the same) in part II of this article.

References:

  1. Retrieved from https://stats.oecd.org/glossary/detail.asp?ID=2809
  2. Stansbury, A. M., & Summers, L. H. (2017). Productivity and Pay: Is the link broken? (No. w24165). National Bureau of Economic Research
  3. IMF World Economic Outlook, April 2019
  4. https://www.bis.org/events/ccaresearchconf2018/rigobon_pres.pdf
  5. IMF Blog “Euro Area Inflation: Why Low For So Long?”
Author
Harsh Shivlani
Team Leader– Fixed Income & Derivatives
(M.Sc. Finance, NMIMS – Mumbai. Batch 2018-20)

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Empirical Study of Credit Rating versus Credit Spread

Government bonds are subject only to interest rate risk. However, corporate bonds are subject to credit risk in addition to interest rate risk. Credit risk subsumes the risk of default as well asthe risk of an adverse rating change. In this empirical study, we analyze credit rating migration versus yield spread of the bond in US corporate bond market to bring about greater understanding of its credit risk.

DATA

The data for this study consists of ratings of the corporate bonds of US corporate bond market given by S&P Global Ratings and credit spread mentioned under description of the security on the Bloomberg Terminal.The sample consist of 15 corporate bonds issuer companies which have defaulted.

LIMITATION OF THE DATA

Small sample size (Representative Bias)- The sample size for the study is limited to 15 instances of corporate bond default and hence the conclusion cannot be generalized.

METHODOLOGY

One data set focused on the latest available spread of the defaulted US Corporate Bonds. Second data set focused on the before and after credit rating of those defaulted bonds. Both data sets were studied in comparison to figure out which set of data was more predictive of default.

One data set focused on the latest available spread of the defaulted US Corporate Bonds. Second data set focused on the before and after credit rating of those defaulted bonds. Both data sets were studied in comparison to figure out which set of data was more predictive of default.

RATINGS AND ITS DESCRIPTION

Following rating grades by Standard & Poor’s are used for analysis:

CREDIT RATING v/s CREDIT SPREAD FOR US DEFAULTED CORPORATE BONDS

Following table shows the changes in credit rating and latest credit spread of sampled 15 corporate bonds which defaulted for either of the reasons mentioned as under:

  1. Missed interest or principal payments: 33% of the sample
  2. Debt/distressed exchanges: 20% of the sample
  3. Chapter 11 and Chapter 15 filings–along with foreign bankruptcies—together: 40% of the sample
  4. Unknown: 7% of the sample

OBSERVATION

The sampled data set reveals that:

  1. All defaulted corporate bonds have the credit spread of 400 bps or more
  2. The ratings of 75% of the bonds were changed to D (Default) on the day or within few days after its default
  3. All the Ratings lie in the ‘Speculative Grade’ defined by S&P Ratings
  4. Following table summarises the data of credit spread (in bps) and credit ratings of the respective sampled bonds. From blue to red bands, the credit rating decreases. Therefore, red signifies that even though the bond rating was relatively better, the bond defaulted 

CREDIT RATING v/s CREDIT SPREAD FOR CURRENTLY TRADED U.S. CORPORATE BONDS

From the observation of historical defaulted bonds, it can be said that bonds with wider credit spread are most likely to default. Using these findings for currently traded U.S. corporate bonds mentioned in the above table, it can be concluded that Mohegan Gaming and Acosta Inc. may default. (As on 3/29/2018)

Author:
Durga Jadhav
(M.Sc. Finance, NMIMS-Mumbai
Batch 2017-19)

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Co-Author:
Gauri Gotaphode
(M.Sc. Finance, NMIMS-Mumbai
Batch 2017-19)

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