Springing Ahead: Analyzing CAT Bond Returns for 2024

In 2023, catastrophe bonds (CAT bonds) proved to be a standout performer among alternative asset classes, riding a wave of strong returns and market resilience. As we move through 2024, many investors are eager to see whether these trends will hold, especially after a spring marked by unexpected shifts in yield spreads.

In Part 2 of this series , we delve into the specific components that drive CAT bond returns. We explore how price returns, collateral yield, and floating coupon spreads each play a role in shaping the overall performance of these securities. Along the way, we’ll take a closer look at key trends from the first half of the year, including a deep dive into market dynamics from Q2. Whether you're a seasoned investor or new to the world of CAT bonds, this analysis will offer valuable insights into how these unique assets maintain their appeal amidst evolving market conditions.

Attribution of the Annual CAT bond returns

As previously discussed, the overall annual returns can be broadly categorized into three key components.?

1. Price return: Bond prices are marked to market, reflecting both yield spreads and the risk of principal loss from catastrophic events.

2. Collateral return: Refers to the yield generated from trust collateral, typically determined by money market yields or other reference rates.

3. Floating coupon return: Reflects the risk-based pricing of the underlying bond exposure over the money market yield or reference rates.

The waterfall charts below depict how the above components contributed to the total returns in the prior three years.

●????? Modest price return: In our previous article, we discussed how the 2023 returns benefitted from the rebound after Hurricane Ian-related impairments. The market's initial overreaction gradually abated as loss estimates crystallized and several bonds recovered in price through 2023. This was evidenced in the strong contribution of price (~5%) to the 2023 annual return. In 2024, the price return has been a nominal ~2% Most of it can be attributed to a compression of the yields in the bonds issued in 2022 and 2023. Any impact of Hurricane Milton and any other significant CAT events could put a further dent into this price return. While price returns in 2024 have been more modest, the story of consistent returns doesn't end there. One of the most stable and reliable contributors has been the collateral return, which continues to provide a steady yield despite broader market fluctuations.

●????? Stable collateral return: The contribution of accrued collateral return from the money market yield was almost non-existent in 2021 and 2022 but picked up quite strongly in 2023 as a direct consequence of macro rate strengthening. This component has demonstrated remarkable stability and consistency through 2024. In 2023, it contributed ~5% to the 2023 returns and is on track for similar returns in 2024. This consistency highlights the advantage of CAT bonds’ floating rate structure, providing stable returns even amidst market fluctuations.

●????? Robust floating coupon returns: In 2024, coupon spread returns remain formidable, primarily fueled by the heightened price per unit of risk associated with new issuance bonds that began to emerge in late 2022. With collateral returns proving their stability, another major factor buoying CAT bond performance in 2024 has been the strength of floating coupon returns. These have been particularly robust, thanks in large part to the richer yields secured by new issuances that emerged from late 2022 onwards.

As we note from the chart below, bonds issued in 2021, 2022 and 2023 contributed more than 75% of the total 2024 return experienced by the CAT bond index so far. The returns contributed in 2024 from the CAT bonds issued before 2024 highlight the significant impact of post-Hurricane Ian bond coupon strength and the elevated floating reference rate on the returns.

Taken together, the combination of consistent collateral yields and robust floating coupons has kept CAT bonds in a strong position. However, to truly understand the nuances of this market, we need to take a closer look at price adequacy trends, specifically, how coupon spreads compare to expected losses. These trends offer deeper insights into market perceptions and investor appetite.

CAT Bond Market Price Adequacy Trends

Price adequacy refers to the relative price commanded per unit of risk, in other words, is the coupon spread adequate given a bond’s underlying exposure. A good measure of the trends in price adequacy of the CAT Bonds is the Year-over-Year comparison of coupon spreads vs expected loss. As seen in the chart below, the coupon spreads for CAT bonds issued in 2023 were incrementally better than prior year across the range of expected losses. The trend continued to show consistency throughout 2024. This points to a continuation of the higher price per unit of risk and the relative strength in the 2024 CAT bond cohort compared to the prior years.

Price Adequacy: A closer look into 2024

As previously mentioned, the yield spreads on CAT bonds saw an unexpected spike in the spring of 2024. It was clear that the market dynamics in Q2 were very different from Q1. It is important to recognize that a blended price adequacy chart for 2024 may not fully reflect this complexity. Therefore, it is interesting to explore whether the spread widening in April/May also impacted new issuances during that period. A closer investigation of the price adequacy trends by quarter reveals that the new issuance price per unit of risk was indeed noticeably higher in the second quarter than in the first quarter. Note that the third quarter is a lean period for new issuances, so while the trend appears to hold, we should be careful not to put too much weight on its pattern. Will this strengthening trend persist into 2025? The result will be driven by a delicate balancing act of on the one hand, heightened risk perception due to the recent active hurricane season and, on the other, the quantum of new capital attracted to this asset class.

A key observation from these scatter plot charts around the fitted curves is the uncertainty around the fit. It is evident that there is a lot more that is impacting price than just Expected Loss. In a future discussion, we will look to explore finer-grained pricing models.

The question that remains is whether the stability seen throughout 2024 will persist, or if we're on the cusp of new market shifts. The performance so far paints a picture of resilience, but as we saw with the Q2 fluctuations, there are always underlying dynamics at play that can alter the landscape. In the next and final part of this series, we'll take a closer look at these core drivers and what they mean for the future of CAT bonds.

Conclusion

The performance of CAT bonds in 2024 underscores the complexity and resilience of this asset class. While price returns have been modest, stable contributions from collateral and robust floating coupon spreads have maintained solid overall returns. Q2's market dynamics brought unexpected shifts in price adequacy, suggesting a need for finer-grained pricing models to truly capture the nuances of this evolving market.

In the final part of this series, we will explore the key drivers behind these trends. Expect a deep dive into core quality metrics, from expected loss profiles to trigger types. Whether you're interested in market stability or seeking opportunities in alternative investments, Part 3 will offer a comprehensive view of what lies ahead for CAT bonds and the broader ILS market.