Will the use of treasury bills limit market growth?

So far this year, issuance stands at $2.45bn (£1.5bn) from 11 transactions, making it highly likely that the market will fall within the expected $3.5bn and $5bn of issuance in 2010. Issuance last year was $2.4bn from 18 transactions. The market could even reach $5bn.

One factor is that because of tight spreads, securitisation can offer cedants coverage at a similar price to traditional reinsurance.

A second is that investors have capital to invest. Halsband estimates that nearly $5bn of funds are expected to be returned to investors before the end of the year as outstanding cat bonds reach maturity. This money could in theory be reinvested.

Halsband says: “New issuance in 2010 has absorbed nearly all of the $2.8bn of maturing transactions to date, at spreads that were for the most part tight to 2009 pricing. As sponsors take note of that, and anticipate an additional $1.2bn yet to mature, they may, particularly given the current spread environment and how tight risk spreads have come in, come to market and take up some of that capacity.”

Keeping the market back

But the use of treasury bill funds as collateral could limit growth. Before the financial crisis, cat bonds were typically collateralised using a total return swap mechanism. In a catastrophe bond transaction, a special purpose vehicle (SPV) is set up to reinsure the sponsoring company.

To provide this coverage, it issues bonds to investors. The money investors pay to the SPV in return for the bonds is then invested. The returns from these investments are managed by a third party, which enters into a total return swap with the SPV.

The total return swap takes place at either Libor (London Interbank Offered Rate) or Euribor (Euro Interbank Offered Rate). This, in part, allows the SPV to pay interest to the investors, paid at Libor or Euribor plus a spread to reflect the risk of the bond.

Post Lehman world

Following the collapse of Lehman Brothers, which acted as a swap counterparty on cat bonds, sponsors became wary of the total return swap mechanism. Since then the trend is to invest the collateral fund in ultra-secure US Treasury bill funds and pay investors interest at a spread over the rates of these treasuries.

All cat bond transactions issued in 2008 paid investors a spread over Libor or Euribor. So far this year, however, all transactions issued have paid a spread over money market funds.

While the counterparty risk is lower, the lack of a Libor reference is less appealing to investors. Halsband says: “The notion here is that this Treasury money market structure was more or less as safe as one might get in reaction to the meltdown of the credit markets and the default of Lehman as swap counterparty.

“The unfortunate consequence is that in the absence of a Libor reference, you end up narrowing the potential investor base, which puts a frictional element on the continued growth of the cat bond sector.”

He adds: “We are of the view that for the market to truly expand and continue to broaden and deepen the investor base, investors and sponsors alike must be comfortable with cat bonds returning to a Libor reference rate.”

Pleasing everyone

But Halsband suggests that everybody could be happy with the use of tripartite repurchase agreements or total return swaps with daily, independent third-party valuations and additional margining of the assets.

“With such conditions, one is able to achieve a Libor reference rate and also provide a tighter construct than what was seen in pre-Lehman swaps,” he says. “Indeed, the market has seen and indicated its comfort with at least two transactions utilising this method in 2009.”

For example, the $175m Montana Re deal that Goldman Sachs created for Flagstone Re, which launched in November last year, used such a structure.

The deal’s class A notes paid investors a 975 basis point spread over Libor, while the class B notes paid Libor plus 1,325 basis points.