The increasingly popular catastrophe bond market is unlikely to suit the majority of NZ investors due to opaque risk disclosures and byzantine fee arrangements Makao Investments argues in a new paper.
Published last week, the Makao analysis says while ‘cat’ bonds can act as a good portfolio diversifier, underlying product nuances render the asset class problematic for all but a few investors.
“We believe there is merit in considering cat bond strategies as an alternative asset class. However, as always it is important to keep an eye on the basics. Diversification, transparency, and appropriate fee structures should be top of mind for investors interested in cat bonds,” the Makao paper says.
“Cat bonds likely meet the first criteria, but in our view, the second hurdle is still difficult to overcome for most New Zealand investors.”
Local institutional investors including the NZ Superannuation Fund and the Annuitas-run Government Superannuation Fund have a decent exposure to cat bonds – albeit via different third-party managers – as well as other insurance-linked securities.
Cat bonds operate like a credit security with a spread above market rates but investors can be washed out if any of the – typically hurricane or earthquake – events specified in contracts occur during the term.
Following a tough 10-year period leading up to the Hurricane Ian in 2022, which triggered an estimated US$15 billion to US$18 billion of cat bond payouts, the market boomed last year as issuance and spreads soared.
Returns of 20 per cent or more in 2023 whetted investor appetite for cat bonds with issuers also stepping up to the plate, according to specialist Bermuda-based publication, Artemis.
Artemis reported this month that “the cat bond market is on track for a record first quarter in 2024, with issuance in the period poised to exceed [US]$4 billion for just the second time ever and approach the [US]$4.5 billion mark”.
Noah Schiltknecht, Makao co-founder, said while only a few clients have enquired about the asset class, the growing buzz around cat bonds suggests a need for more education around the risks and, potential, benefits.
“There is not much product availability in NZ either,” Schiltknecht said.
Investors need to dig deep into product clauses to understand the risks of various subtle payout trigger points and the extent of diversification in the underlying bonds, the Makao study says.
The papers says performance fees, a common feature of cat bond products, are also nonsensical in the asset class.
“Skilled security selection is close to impossible to measure in a market that is dominated by binary outcomes,” the report says. “And without the ability to assess skill, performance fees are meaningless: investors end up paying additional fees for the simple fact that managers got lucky.”
Launched in 2019 by ex Russell Investments head of institutional, Schiltknecht, and former colleague there, John Horrell, Makao is now an established presence in the NZ wholesale consulting market with clients spanning charities, iwi, wholesale investors and financial advisory groups such as the former AMP-aligned Wealthpoint.