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CATs Meet the Real World
Plus Q3 2017 Market Report

John Gorlow | Oct 13, 2017

From the vantage point of October, our July 2017 blog about the perils of CAT bonds seems downright prescient. Over the past three months we’ve witnessed three record-smashing hurricanes, two massive earthquakes in Mexico, and raging wildfires that so far have destroyed over 50,000 acres in California’s prime wine-growing country. Each disaster has left untold human misery and property damage, while ratcheting up losses in the insurance and reinsurance markets. Will CAT bond investors be left holding the bag?


Even before the California wildfires, losses from Atlantic hurricanes and Mexican earthquakes were estimated at over $100 billion. The insurance and reinsurance industries will shoulder a good portion of these costs. But in recent years, the reinsurers have transferred the most catastrophic portion of the risk to CAT bond investors, many of whom have unwittingly taken on incalculable risks.


A quick primer: CAT bonds are a darling of the insurance linked securities (ALS) industry, which crowd-sources reinsurance coverage through hedge funds and financial advisors. CAT bonds are often marketed as excellent diversifiers because they don’t correlate with equity markets, interest rates or credit risk. Buyers are repaid principal and interest at the end of their term, provided the insured catastrophic event hasn’t occurred.


As investor demand has grown, the yields on CAT bonds have plummeted. But now the risks of holding these bonds are coming into sharper focus. “Ten Hurricanes in Ten Weeks” broke a 124-year-old record, according to the New York Times (11-October). The 8.1 earthquake in Mexico was the strongest in a century. And California’s fast-moving wildfires, which continue to rage, followed the hottest summer in the state’s history.


The toll on CAT bonds after the hurricanes was swift and severe. As reported by the Financial Times on September 8 (before Irma made landfall), “The Swiss Re catastrophe bond price return index suffered its biggest drop since at least 2002, tumbling 16 per cent from the previous week. The securities that dropped included a $125m Cat bond sold earlier this year by Heritage Insurance Holdings under the Citrus Re label. It halved in value to 50 cents on the dollar on Tuesday….” After Irma narrowly missed Miami, Citrus Re rebounded to trade at 68 cents on the dollar, but was still being quoted at steep discounts to redemption value.


The storm for investors isn’t over. In fact, CAT investors may only now see their own perfect storm brewing. Reasons for concern:


A severe shortage of insurance adjustors and multiple back-to-back catastrophes means damages may take much longer than usual to assess. Investors’ funds may be held even after a bond matures in case the money might be needed to pay claims. The harder it is to assess claims and the more uncertain the final cost, the more funds can be held back. When capital is on hold it can’t be reinvested.


Losses in Puerto Rico, a US territory, are “unusually uncertain,” ranging between $30 billion and $85 billion according to Paul Davis (Wall Street Journal, 3-October). Payouts will include compensation for damage and business interruption in pharmaceuticals and electronics, Puerto Rico’s largest businesses. This means investors “may have to wait months, even years, before getting their money back.”


Then there’s the force majeure clause included in contract fine print to eliminate “liability for natural and unavoidable catastrophes that interrupt the expected course of events and restrict participants from fulfilling obligations” (Investopedia). CAT fund investors, did you read your prospectus? It’s too early to tell if this clause will be invoked which would effectively gate your funds from getting out.


When risk is not being properly evaluated and appraised, it affects us all. After a major incident, insurance rates should go up, and yields should rise for bearers of the risk. But that model is turned upside down when hedge funds and private advisors have ready pools of capital waiting in the wings. CAT bonds look great compared to T-bills. What’s not to like?  


It is lunacy on the part of investors, and the advisors who serve them, to continue to move into a space where returns do not compensate for risk. And the risk is surely rising. Global warming has been implicated in hurricanes, floods and fires. Mix in Houston’s refineries, Florida’s agriculture and tourism, California’s premium wines and pricey real estate, and Puerto Rico’s pharma industry, and risk takes on added meaning. Who’s going to be on the hook? Because CAT bonds are privately structured investments, it’s impossible to know. The whole market could collapse. And that’s a big risk to everyone who needs insurance after a catastrophe.


Do you have questions or concerns? Call me. I am here to help.


Now let’s take a look at last quarter’s numbers.


Q3 2017 Index Returns 

Global consolidated markets posted a strong September, extending their streak to 11 consecutive months of gains. Emerging markets declined, with half the markets in the red, as developed markets posted broad gains. The US performance was above the average. Interest rates moved up in September, as the Fed hinted at a December interest rate hike. The 10-year US Treasury Bond closed at 2.34%, up from last month’s 2.12%.


Market summary and data courtesy of DFA 
World Asset Classes

With broad market indices used as proxies, emerging markets outperformed developed markets, including the US, during the quarter. The value effect was positive in non-US developed markets but negative in the US and emerging markets. Small caps outperformed large caps in US and non-US developed markets but underperformed in emerging markets


Ranked Returns For The Quarter %
 MSCI Emerging Markets Index (net div.)  7.89
 MSCI World ex USA Small Cap Index (net div.)  7.26
 MSCI All Country World ex USA Index (net div.)  6.16
 MSCI World ex USA Value Index (net div.)
 6.14
 Russell 2000 Index  5.67
 MSCI Emerging Markets Small Cap Index (net div.)  5.64
 MSCI World ex USA Index (net div.)  5.62
 MSCI Emerging Markets Value Index (net div.)  5.47
 Russell 2000 Value Index  5.11
 Russell 3000 Index  4.57
 Russell 1000 index  4.48
 S&P 500 Index  4.48
 Russell 1000 Value Index  3.11
 S&P Global ex US REIT Index (net div.)  2.19
 Bloomberg Barclays US Aggregate Bond Index  0.85
 Dow Jones US Select REIT Index  0.38
 One-Month US Treasury Bills  0.24
   

US Stocks

The broad US equity market posted positive returns 57) for the quarter but underperformed both non-US developed and emerging markets. Value underperformed growth indices in the US across all size ranges. Small caps in the US outperformed large caps.


 Ranked Returns for The Quarter %
Small Growth   6.22 
Large Growth  5.90
Small Cap   5.67
Small Value  5.11
Marketwide  4.57
Large Cap  4.48 
Large Value  3.11
 
 

 Period Returns (%) 
 As of 9/30/17
 YTD 1 Yr  3 Yrs *  5 Yrs*  10 Yrs*
 Marketwide  13.91  18.71  10.74  14.23  7.57
 Large Cap  14.17  18.54  10.63  14.27  7.55
 Large Value   7.92  15.12  8.53  13.20  5.92
 Large Growth  20.72  21.94 12.69  15.26  9.08
 Small Cap  10.94  20.74  12.18  13.79  7.85
 Small Value  5.68  20.55  12.12  13.27  7.14
 Small Growth  16.81  20.98  12.17  14.28  8.47
 * Annualized          


International Developed Stocks

In US dollar terms, developed markets outperformed US equity indices but underperformed emerging markets indices during the quarter. With broad market indices used as proxies, the value effect was positive. The value effect was positive in large caps but negative in mid and small caps. Overall, small caps outperformed large caps in non-US developed markets.


 Ranked Returns for The Quarter %
Small Cap  7.26 
Value  6.14
Large Cap   5.62
Growth  5.10
 
 

 Period Returns (%)  
 As of 9/30/17
 YTD  1 YR  3 Yrs*  5 Yrs* 10 Yrs* 
 Large Cap
  19.17 18.73  4.57   7.81 1.28
 Small Cap
  23.82  20.42  9.59  11.16 4.04
 Value
  17.05  22.46  3.24  7.36  0.64
 Growth
 21.47 15.04  5.82  8.19 1.86
 * Annualized
         

Emerging Markets Stocks

In US dollar terms, emerging markets indices outperformed developed market indices, including the US, during the quarter. With broad market indices used as proxies, the value effect was negative. Across the size spectrum in the large and mid cap space, the value effect was negative; however, in the small cap space, the effect was positive. Overall, small caps underperformed large caps in emerging markets.


 Ranked Returns  For The Quarter %
Growth
 10.19 
Large Cap   7.89
Small Cap   5.64
Value   5.47
 
 

 Period Returns (%)  
 As of 9/30/17
 YTD  1 YR  3 Yrs*  5 Yrs* 10 Yrs* 
  Large Cap
 27.78 22.46 4.90  3.99 1.32
  Small Cap
 22.53 14.89 3.14 4.60 1.74
  Value
 19.87 18.55 1.62 1.34 0.67
  Growth
 36.03 26.35 8.12 6.55 1.88
 * Annualized
         

Select Country Performance

In US dollar terms, Norway (18.36) and Italy (13.65) recorded the highest country performance in developed markets, while Israel (-8.21) posted the lowest—and only negative—return in developed markets. In emerging markets, Brazil (23.78), Russia (17.40), and Chile (17.26) posted the highest returns, while Pakistan (-12.37) and Greece (-8.77) had the lowest performance.


Select Currency Performance vs. US Dollar

Currency performance was mixed in both developed and emerging markets. Among developed markets currencies, the Norwegian krone appreciated by 5%, while the Israeli shekel and the New Zealand dollar depreciated by approximately 1%. In emerging markets, the Brazilian real appreciated by almost 5%, while the South African rand depreciated by almost 3%.


Real Estate Investment Trusts (REITs)

Non-US real estate investment trusts outperformed US REITs.


 Period Returns (%)  
 As of 9/30/17
 YTD  1 YR  3 Yrs*  5 Yrs* 10 Yrs* 
  US Reits
1.75 -0.83 9.28 9.16 5.31
  Global Reits (ex US)
8.63 -0.45 3.63 5.44 0.27
 * Annualized
         


Commodities

The Bloomberg Commodity Index Total Return gained 2.52% during the third quarter. The energy complex led advancing commodities, with heating oil returning 20.97%, Brent crude oil 15.32%, unleaded gas 14.49%, and WTI crude oil 10.90%. Grains was the worst-performing complex, with Kansas wheat and Chicago wheat declining 21.15% and 19.67%, respectively. Lean hogs also experienced a decline, decreasing by 10.94%.


 Fixed Income

Interest rates increased across the US fixed income market for the quarter. The yield on the 5-year Treasury note increased by 3 basis points (bps) to 1.92%. The yield on the 10-year Treasury note increased by 2 bps to 2.33%. The 30-year Treasury bond yield increased by 2 bps to finish at 2.86%.

The yield on the 1-year Treasury bill rose 7 bps to 1.31%, and the 2-year Treasury note yield rose 9 bps to 1.47%. The yield on the 3-month Treasury bill increased 3 bps to 1.06%, while the 6-month Treasury bill yield increased 6 bps to 1.20%.

In terms of total returns, short-term corporate bonds gained 0.59%, and intermediate-term corporates gained 1.05%. Short-term municipal bonds generated a total return of 0.49%, while intermediate-term municipal bonds returned 0.83%. General obligation bonds gained 1.14%, outperforming revenue bonds by 4 bps


 Period Returns (%)  
 As of 9/30/17
 YTD  1 YR  3 Yrs*  5 Yrs* 10 Yrs* 
 Barclays Long US Government Bond Index
 6.06 -6.14 4.84 2.87 6.83
 Barclays Municipal Bond Index
 4.66 0.87 3.19 3.01 4.52
 Barclays US Aggregate Bond Index
 3.14 0.07  2.71 2.06 4.27
 Barclays US Corporate High Yield Index
 7.00 8.88  5.83 6.36 7.84
 Bloomberg Barclays US TIPS Index
 1.72 -0.73  1.62 0.02 3.90
 BofA Merrill Lynch 1-Year US Treasury Note Index
 0.55 0.60  0.46 0.39 1.05
 BofA Merrill Lynch Three-Month US Treasury Bill Index
 0.57 0.66  0.32 0.22 0.47
 Citi World Gov't Bond Index 1-5 Years (hedged to USD)
 1.07 0.59 1.35 1.30 2.32
 * Annualized
         

 Impact of Diversification

These portfolios illustrate the performance of different global stock/bond mixes and highlight the benefits of diversification. Mixes with larger allocations to stocks are considered riskier but have higher expected returns over time.1


 Period Returns (%)    
As of 9/30/17

 YTD  1 YR  3 Yrs*  5 Yrs* 10 Yrs*  10-Year
Stdev 
 100% Stocks
17.75 19.29  8.02 10.79 4.45  16.90 
 75/25
 13.22 14.35  6.13 8.14 3.70  12.66
 50/50
 8.85 9.60 4.21 5.48 2.76  8.43 
 25/75
 4.62 5.01  2.25 2.82 1.65  4.20 
 100% Treasury Bills
 0.53 0.58  0.25 0.16 0.38 0.22 
 * Annualized
           


1. Diversification does not eliminate the risk of market loss. Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect expenses associated with the management of an actual portfolio. Asset allocations and the hypothetical index portfolio returns are for illustrative purposes only and do not represent actual performance. Global Stocks represented by MSCI All Country World Index (gross div.) and Treasury Bills represented by US One-Month Treasury Bills. Globally diversified allocations rebalanced monthly, no withdrawals. Data © MSCI 2017, all rights reserved. Treasury bills © Stocks, Bonds, Bills, and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).