Pricing dynamics in the fourth quarter of 2015 were mixed, with bonds trading in different directions based on the risk level, peril exposure and relative market size rather than the market shifting categorically in one direction across all names. The typical fourth quarter “Dead Cat” market (in which bonds prior to their scheduled redemption date that have little to no remaining modeled risk exposure are still paying their full scheduled coupon) was active. Notably however, the required return for Dead Cat liquidity providers in the fourth quarter of 2015 averaged 255 basis points per annum, whereas in the fourth quarter of 2014 the required return was averaged closer to 220 basis points.
As was the case throughout 2015, and particularly the second half of the year, continuing rate compression and sponsors bringing top (remote) layer transactions prompted some investors, on the margin, to rotate their investment portfolios towards higher risk, higher return positions. Importantly, market discipline remained intact as was demonstrated in November/December with Everest Re’s Kilimanjaro Re Series 2015-1 Notes and SCOR’s Atlas IX Series 2016-1 Notes. The 144A catastrophe bond investor base’s willingness and interest in adding risk in exchange for more yield is worth noting as it presents an interesting value proposition to sponsors. Long-term market constituents (across the full spectrum of sponsors, dealers, investment managers and ultimate capital providers) should take comfort that pricing and capacity dynamics indicate additional risk is being added where additional compensation is deemed adequate and not at any price. The willingness of the investors to sensibly price and deliver capacity on more junior layers represents a healthy and productive broadening of 144A markets risk appetite, in other words, they incent incremental additional capacity from cedents. This occurs instead of a secular and sustained shift away from low risk transactions towards higher risk transactions.
Looking towards 2016, absent a major market disruption, our expectation is that risk spreads in the 144A property and casualty (P&C) catastrophe bond and private cat bond marketplace will remain flat to slightly down depending on investors’ perception of available forward supply of investment opportunities relative to the market’s redemption schedule. We expect the 144A P&C catastrophe bond market issuance to be similar to the last several years with further growth in the private cat bond market (relative to 2015) as new sponsors incorporate alternative capital. In addition, particularly in a compressed rate environment where the margin for error is low, investors will likely look to overweight their books toward higher “quality” risks, all else equal. This preference set is relevant for indemnity trigger transactions, for which we would expect a widening of the pricing gap between offerings for portfolios deemed to have a high degree of data capture, transparent modeling and established performance track records relative to those with a less verifiable exposure set. The composition of risk metrics rather than the risk metrics themselves will become all the more relevant to investor decision making. Overall, we view these patterns as a long-term net positive for the stability and reliability of the 144A and private cat bond marketplaces.
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