(Pictured: John Seo)
In the search for genuinely uncorrelated assets, especially those with a coupon attached, catastrophe bonds are attracting more interest from Australian super funds and other defined contribution funds, alongside the instruments’ traditional customers among insurance companies and defined benefit pension funds.
Of the top 20 pension funds in the world, consisting of a mix of DB and DC schemes, more than half now have an allocation to catastrophe (cat) bonds. Fermat Capital Management, a US-based manager which specializes in the bonds, has raised about A$450 million in Australia and New Zealand, in both commingled and discrete mandates, in the past few years.
According to one of the Fermat founders, Dr John Seo, there are more than 400 investors across all their commingled funds, which include the Australian ‘Fermat ILS Yield Fund’. The investors represent a full spectrum of pension funds, family offices, high-net-worth investors, small institutions including small banks and life offices. They are also spread throughout the world. Fermat also manages a number of discrete accounts, which include sovereign wealth funds in the mix. In Australia, the manager is represented by Brookvine.
Seo and several of his colleagues at the Connecticut-based boutique worked at Lehman Bros in the 1990s where the use of cat bonds and other insurance-linked securities (ILS) as mainstream investments was pioneered. The 13-person staff includes as many scientists as traditional managers. The latest hire, just this month, is a seismologist who will be looking to add value in the assessment, especially, of earthquakes.
Seo says the scientists do not try to predict natural disasters, although many before them working for governments from the US to China, have attempted to do so, and still do. The Fermat scientists assist in the immediate assessment of a disaster, hopefully before the rest of the market, and act accordingly for their portfolio. The firm’s senior researcher, Dr Anqi Liu, did the first investment modeling on catastrophe bonds dating back to 1994.
Fermat is an interesting firm in ways apart from its asset class specialty. John Seo says they are all family or friends who are as trusted as family. Two other brothers work there – Dr Michael Seo, who is chief technology officer, and Nelson Seo, who is also a managing principal. “The biggest risk for a start-up funds manager is not market risk but partner risk,” John Seo says. The business was launched in 2001 and has about US$4 billion under management.
The main attribute investors usually focus on with a cat bond mandate is its lack of correlation with other asset classes. The main question after that will often be: where does it fit in the portfolio?
Seo says there are two types of correlations: statistical and fundamental. There is no fundamental reason why a cat bond should have anything other than zero correlation with other markets. But it actually does have a very slight positive correlation with US equities because of the “September effect”. The strange-but-true fact is that many of the most significant market corrections or outright crashes, have occurred in September. And this coincides with the peak of the hurricane season.
Cat bonds have different defining moments to the equities or sovereign bond markets. The devastation from Hurricane Katrina, in 2005, on the Gulf Coast, from central Florida to Texas, has been a defining moment. A total of 1,833 people died, with most of them occurring in New Orleans. Total property damage was estimated at US$81 billion. Katrina hit southern Louisiana, near New Orleans, on August 29.
Seo says statistical correlations are used mainly as a flag to fundamental correlations. After using significant “sleuthing techniques” analysts can see that the statistical correlations may not reflect the fundamentals in a time of crisis, such as in the 2008 global financial crisis, where many hedge funds and other alternatives turned out to be highly correlated with the markets. Not so cat bonds.
“It is a very transparent asset class,” he says. “If there is a major catastrophe you will lose money. If Tokyo were to be destroyed by a tsunami, you could lose 10-20 per cent of your portfolio. But you get compensated for that. There is no duration risk, no interest rate risk, because they are floating rates, no credit risk and no leverage.”
Fermat is currently advising clients to expect a return of cash plus between 5-7 per cent. Over the very long term, Seo believes, the asset class should deliver cash plus 4-6 per cent.
After Katrina, the market in cat bonds became a “hard market” to use an insurance term for the past eight years. This now appears to be softening. Beta returns fell post Katrina but the opportunities to add alpha increased. Katrina was a catalyst for increased diversity in the previously narrow market and previous sameness about the managers who worked it.
“There was not much trading volume (pre-Katrina) and the investors were all pretty similar,” Seo says. “We all knew each other and there wasn’t much diversity in our styles… Post-Katrina there is more diversity as managers developed distinct styles.”
There is also not much commonality among investors as to how they perceive cat bonds in a portfolio construction sense, Seo believes. For instance, ESG-style investors are attracted to it. It has a feel-good factor. “There are very different groups of investors who act differently,” he says. “In the so-called collateralized insurance securities we see money coming from private equity and hedge fund allocations. Different parts of the one institution find reasons for investing in ILS in general. We’re even seeing money from equities, looking for ‘alternative growth investments’.”