With yields on fixed income securities at or near historical lows, today’s retirees and those planning for retirement are facing major challenges. Not surprisingly, many individual investors as well as pension funds increasingly are turning to high-yield bonds and bond funds to meet their income requirements. So what’s the problem? An increasing number of bond funds, pension managers, and other institutional investors are loading up their portfolios with an untested and unproven product about whose long-term performance we know very little: the event-linked security or catastrophe bond (CAT bond).
We were first warned about the potential pitfalls of these unusual securities back in April 2008, by the Financial Industry Regulatory Authority (FINRA). But as Ben Edwards of the Wall Street Journal recently has suggested, more investors are being attracted to these investment vehicles given their high returns in today’s low yield environment. According to Edwards, total returns on these financial instruments were almost 9.5 percent this year, thus swamping investment grade corporate bonds returns of only 1.3 percent over the same period. Is it any wonder that these insurance products are attracting attention?
So exactly what are CAT bonds? They are high-yield debt instruments used by insurance and reinsurance companies, governments and corporations (all known as sponsors) to cover large losses that they might incur from hurricanes, typhoons and windstorms, or natural disasters like earthquakes. These bonds cover major events that are believed to occur once every 100 or 200 years. CAT bonds allow their sponsors to package such risks into securities which are then sold in the capital markets via structured investment vehicles (SIVs). And not only do CAT bonds transfer the risk of natural disasters from the sponsors to bond investors, but as with the banking conduits of the financial crisis of 2008, the sponsors need not report SIV assets or liabilities on their balance sheets. Wow! History repeats itself yet again on Wall Street…I’m shocked!
Yes, it’s been only five years since we witnessed financial institutions recording over $150 billion in losses for their “off-balance sheet” SIVs. And now investors find themselves being tempted by another potentially ruinous alternative risk transfer (ART) product. The similarities are frightening: off-balance SIVs, reliance on derivatives, untested asset valuation and loss assumptions, and potentially inflated rating agency ratings. The “frosting on the cake” is just how little we really know about these investments, i.e. the SIVs, their assets, the sponsoring relationships, valuation assumptions, etc. While regulators and standard-setters have been busy fighting yesterday’s sub-prime lending battles, financial reporting transparency for CAT bonds appears to have been overlooked. This means that investors may not fully understand the risks they are assuming when they “hedge” the natural disaster risks assumed by SIV sponsors.
Recently, Berkshire Hathaway Inc.’s Franklin “Tad” Montross summarized one significant transparency concern as follows:
Sound familiar? How big a problem could this be? Well, the CAT bond market has grown over the last decade with total issuances of over $40 billion and almost $19 billion currently outstanding. And while pension funds historically have been major buyers of these “risky” bonds, high-yield mutual funds (e.g., Pioneer Diversified High Income Trust) also are buying together with money managers, hedge funds, and banks.
To better appreciate the lack of transparency that concerns this Grumpy Old Accountant, a brief review of CAT bond mechanics is in order. CAT bond sponsors rely on offshore special-purpose vehicles (SPVs) to issue these bonds. The SPV is generally considered sufficiently independent that insurers are not required to consolidate the SPV’s assets and operations in their financial statements. Not consolidating benefits the sponsors by reducing their capital requirements and masking the complete extent of assumed risk. In a typical transaction, as depicted below, the CAT bond sponsor creates an SPV, which then issues the sponsor a reinsurance contract for a premium. Simultaneously, the SPV issues bonds to investors. To minimize credit risk for the investor, the SPV invests bond proceeds received from investors in high-quality, short-term securities and deposits them into a security account to protect bondholders, the sponsor and any future swap counterparties. This asset collateralization feature makes CAT bonds just another form of collateralized debt obligation (CDO).
CAT bond yields are higher than similarly rated corporate securities because the sponsor pays the SPV a premium for its reinsurance coverage. The remaining “normal” return paid to investors is generated by the underlying asset collateral purchased by the SPV. And to reduce interest-rate risk, CAT bonds generally are structured as floating-rate securities based on a floating-rate index (e.g. LIBOR). This is done using interest-rate swap derivatives. Once SPV bond proceeds are invested and placed with a securities custodian, the cash flows received from periodic fixed dividend and/or interest payments related to SPV investments are exchanged for variable cash flows negotiated with a swap counterparty.
Once the CAT bond sponsor decides to issue these securities, it selects a risk modeling firm to perform a risk analysis and create a loss distribution for the relevant exposure among the various perils and regions exposed. Then, the sponsor works with an investment advisor to structure, design and place the CAT bonds. Once the sponsor has identified the desired protection strategy, the modeling firm and investment advisor prepare securities offering documentation for potential investors. This prospectus or offering circular then is given to the rating agencies who rate the bond.
According to Reuters, only eight of approximately 200 CAT bond transactions since 1997 have been “triggered,” four from natural disaster losses and the others by damage to collateral from the 2008 financial crisis. Nevertheless, since CAT bonds are relatively new to the markets, their rating system is less developed than that used for corporate bonds and continues to evolve. Adam Alvarez, senior vice-president at Bermuda-based insurer and reinsurer Hiscox has warned that:
So what are the risks to the investor? Well the most obvious is the loss of principal and future interest if an “insured” event should occur. The SPV pays the CAT bond sponsor the resulting loss amount from the collateral available in its securities account, and the outstanding CAT bond principal due investors then is reduced by the loss amount. Investors then receive interest for the remainder of the bond term based on the new lower principal amount.
Also, investors also bear significant credit and liquidity risks. As with a typical bond investment, the CAT bond buyer looks to the debt issuer (the SPV) for timely interest payments and the ultimate retirement of outstanding principal. Unlike a traditional bond purchase, however, the buyer’s sole source of repayment is tied to the SPV’s asset investment decisions. Therefore, CAT bond investors must “somehow” periodically satisfy themselves that SPV security values are sufficient for debt repayment absent any event trigger.
Investors also face another form of credit risk via the SPV’s use of interest-rate-swaps to manage interest rate risk. Should the counterparty fail to honor its variable-rate-swap obligation and interest rates increase, the market value of the SPV’s fixed-rate investments will decline, resulting in insufficient collateral to fund future bond retirements.
Finally, the relative newness of the CAT bond market increases liquidity risk for purchasers. While the interest-rate premium over similar corporate securities offers some compensation for this risk, CAT bond investors must recognize that there may be little or no market for these securities should disposal be necessary to achieve portfolio realignment.
Clearly, CAT bond market participants need information to evaluate both current and future investments. However, current financial disclosures for these debt instruments are woefully inadequate. CAT bonds are generally exempt from registration with the Securities and Exchange Commission (SEC) and its related financial reporting requirements. As the CAT bond investor market grows, so do information needs of the general investing public. So, specifically what information do investors need?
- Periodic market-value data to evaluate SPV investments and assess the quality of the underlying collateral for the CDOs.
- Information to evaluate swap counter-party strength, which directly impacts interest-rate risk.
- Information to evaluate liquidity risks.
- Information that provides assurance that CAT bond ratings reflect the risk inherent in these securities.
- Information on the history and accuracy of models that define loss exposure.
And the need for more financial reporting transparency does not end with the needs of CAT bond investors. Investors in the sponsors themselves need expanded disclosures for these transactions since the SPV structures are reported off balance sheet. Sponsor stakeholders need information to evaluate the numerous risks (basis, credit, interest-rate, liquidity, systemic and legal) inherent in CAT bond transactions that are currently hidden off balance sheet. This includes:
- Transaction volume data the general terms of any outstanding CAT bonds issued by sponsored SPVs, together with historical interest costs, and the current outstanding balance.
- Information on the SPV assets that are collateralizing CAT bonds to determine whether sufficient funds will be available to honor the sponsor’s reinsurance contract should a triggering event occur.
- Information that fully describes the nature of the sponsor’s relationship with the SPV to assess whether off-balance-sheet treatment is appropriate.
To minimize the likelihood of yet another off-balance-sheet capital market meltdown (once a decade is enough), better information is desperately needed for investors and sponsor stakeholders.
And I don’t appear to be alone in my grumpiness toward CAT bonds. As Ben Edwards indicated recently:
For those of you that think that CAT bonds are the answer to today’s retirement planning woes, let me remind you of the losses that hammered retiree portfolios in past decades after investing in what then were new and innovative bond investments: high-yield junk bonds and mortgage backed securities (purchased at premiums).
We simply need more information and transparency on CAT bonds…so, retirees beware!
This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.