After an exceptionally active hurricane season, catastrophe bonds have emerged as a lucrative investment option. These bonds, which transfer risks associated with extreme natural disasters to the capital markets, have shown remarkable resilience despite the increase in extreme weather events. In 2024, they are on track to deliver about 16% returns, following a record 20% in 2023.

Key Reasons for Returns

The senior fund manager at Plenum Investments AG, Dirk Schmelzer, attributes the slightly lower returns in 2024 to the decline in Treasury rates and the rise in investor demand. This has allowed issuers to price their bonds at better terms, putting a little pressure on cat-bond spreads. Yields have slipped from almost 14% at the end of May to about 10.3% at the end of November.Plenum estimates that the volume of catastrophe bonds in funds marketed under Europe’s UCITs label has risen roughly 49% since the end of 2022 to $13 billion at the end of September. Overall issuance for 2024 is set to hit a record $16.5 billion.

Performance of Plenum Funds

Plenum’s defensive UCITS cat-bond fund, with about $400 million of assets, generated a 12% return so far in 2024. Its dynamic fund, with about $210 million of assets, gained about 15%. These figures highlight the potential of catastrophe bonds in different investment strategies.Over the past two years, the average expected loss rate for cat bond holders has dropped to as low as 2% from an average 2.5% during the previous three years. This indicates that it now takes a bigger catastrophe to significantly dent returns. The increase in the attachment point, which is the threshold at which a bond triggers and investor capital starts covering insured claims, reflects this trend.

Impact of Climate Change

This year is set to be the hottest on record, with the average global temperature soaring to 1.62°C above pre-industrial levels in November. Swiss Re AG estimates that insured losses from natural catastrophes will likely exceed $135 billion in 2024, marking the fifth consecutive year of crossing the $100 billion threshold.Much of this increasing loss burden results from value concentration in urban areas, economic growth, and increasing rebuilding costs. Climate change is also playing an increasing role by favoring the conditions leading to many of this year’s catastrophes. Higher temperatures are supercharging secondary perils such as wildfires and severe convective storms. SCSs alone are expected to add more than $50 billion to insured losses this year.

Market Response to Hurricanes

Investors in catastrophe bonds weren’t called on to cover any losses caused by Hurricane Beryl, and a lot of the impact of Helene and Milton was flood-related. This meant cat-bond investors were largely unaffected. Twelve Capital AG, a Zurich-based cat-bond investor, noted that while there were a number of strong hurricanes that made landfall, as they didn’t directly hit major metropolitan areas, the impact on the reinsurance and cat-bond markets is likely to be muted.Jeff Davis, partner and portfolio manager at Elementum Advisors, which manages about $4 billion of insurance-linked securities, believes 2024 is “setting up to be the second-best year in the market’s history” for cat bond investors. And “now that spreads have come down, sponsors are buying more coverage.”

Avoiding Secondary Perils

Specialist cat-bond fund managers are seeking to avoid exposure to secondary perils. These are aggregate rather than single-event shocks like a hurricane and are proving much harder to model. For insurers, perils such as thunderstorms, wildfires, and floods now pose the biggest risk.“We are seeing a bit more of a shift to aggregate transactions,” said Elementum’s Davis. But there’s “not enough comfort” about how secondary perils are modeled for investors to want such exposure. Plenum’s Schmelzer also said he’s aware of efforts by issuers to add secondary perils to the catastrophe-bond market but “we tend to underweight them.”

In the United States, the issuance of bonds intended to benefit the environment is likely to remain relatively subdued. Matt Lawton from T. Rowe Price Group Inc. points out that companies no longer gain a significant price advantage from selling such debt. The so-called 'greenium,' which measures the spread between green bonds and non-green bonds from the same issuer, now averages between 0 to 1 basis point for corporations, which isn't economically attractive. Sovereigns, on the other hand, get about 7 bps on average.

Republican-Led Backlash and Its Impact

Lawton also notes that the Republican-led backlash against do-good investing, especially after Donald Trump's election victory, may keep first-time borrowers away. Trump has expressed intentions to increase fossil-fuel production and undo green policies like the Inflation Reduction Act. This creates a challenging environment for the issuance of ESG-linked bonds in the US. It acts as a headwind for new sectors and issuers coming to the market.

Corporate ESG Bond Issuance in 2023

Corporate issuance of ESG-linked bonds this year through December 6 has reached $27.2 billion, which is the least since 2019. The Inflation Reduction Act was expected to mobilize private capital for sustainable solutions. However, if it is weakened under Trump, it will likely lead to less capital investment in sustainable initiatives and less bond financing in the short term.

Lawton expects less enthusiasm from potential first-time issuers. They face costs in developing a bond framework, getting external verification, and reporting on the use of proceeds annually. In a series of interviews ending on December 9 with Bloomberg News, he shared these insights. T. Rowe Price had $1.61 trillion of assets under management as of the end of October.

Tension between Yields and Spreads

When asked about the biggest takeaway, Lawton emphasizes the tension between yields and spreads in the market and how it affects issuance and demand. Spreads are very tight, but yields relative to history are attractive. The strong demand supporting the credit markets is conditional upon the macroeconomic backdrop. A slight economic wobble could lead to wider spreads as there is little cushion currently. Risks are skewed towards spreads widening.

Reasons for Diminishing Greenium

Regarding the diminishing greenium, Lawton is unable to provide a clear explanation. Despite the demand for green bonds not waning, the number of mandates and impact-focused opportunities in fixed income is increasing, suggesting a positive future demand picture.

Blue Bond Issuance and Its Significance

We are seeing more blue bond issuance to fund projects aimed at improving water resources and marine life. This is one of the unifying sustainability themes that connects globally. By 2030, cumulative issuance is expected to reach upwards of a hundred billion dollars. The blue economy is the seventh-largest economy in the world, and significant investment is needed to decarbonize sectors like shipping and offshore renewables. There is a large untapped funding potential that is starting to be realized.

Concerns about Corporate Greenwashing

The issue of corporate greenwashing remains a concern. Standards have improved and consolidated as the market gains a better understanding of what constitutes a credible green bond. However, it is still essential to be vigilant and aware of the risk of greenwashing.