The Secondary Market of Catastrophe Bonds: Seasonality, Trading and Returns

Essay 1 - Seasonality in Catastrophe Bonds and Market-Implied Catastrophe Arrival Frequencies

We develop a conceptual framework to model the seasonality in the probability of catastrophe bonds being triggered. This seasonality causes strong seasonal fluctuations in spreads. For example, the spread on a hurricane bond is highest at the start of the hurricane season and declines as time goes by without a hurricane. The spread is lowest at the end of the hurricane season assuming the bond was not triggered, and then gradually increases as the next hurricane season approaches. The model also implies that the magnitude of the seasonality effect increases with the expected loss and the approaching maturity of the bond. The model is supported by an empirical analysis that indicates that up to 47% of market fluctuations in the yield spreads on single-peril hurricane bonds can be explained by seasonality. In addition, we provide a method to obtain market-implied distributions of arrival frequencies from secondary market spreads.

Essay 2 - Trading and Liquidity in the Catastrophe Bond Market

We provide first insights into secondary market trading, liquidity determinants, and the liquidity premium of catastrophe bonds. Based on transaction data from TRACE, we find that cat bonds are traded less frequently during the hurricane season and more often close to maturity. Trading activity indicates that the market is dominated by brokers without a proprietary inventory. Liquidity is high in periods of high trading activity in the overall market and for bonds with low default risk or close to maturity, which results from lower order processing cost. Finally, using realized bid-ask spreads as a liquidity measure, we find that on average 21% of the observable yield spread on the cat bond market is attributable to the liquidity premium. A magnitude of up to 141 bps for high-risk bonds suggests that steps towards an improved market liquidity would be highly beneficial.

Essay 3 - Common Risk Factors in the Cross Section of Catastrophe Bond Returns

Historically, cat bonds have provided high single-digit average annual returns, paired with a low volatility and little correlation to other asset classes. While there is an extensive literature that explains (ex-ante) cat bonds spreads, there is no factor model in the academic literature that explains this (ex-post) realized return puzzle. Based on monthly quoted prices for the complete cat bond market from 2001 to 2020, we provide insights into relevant risk factors in the cross-section of cat bond returns. After investigating a battery of possible cat bond return factors in bivariate and multivariate portfolio sorts as well as Fama-MacBeth regressions, we propose a four-factor cat bond model. Its factors are the seasonality adjusted probability of first loss, a separate seasonality adjustment factor and the two corporate bond factors TERM and DEF from Fama & French. This novel four-factor model predicts 60% of the time series variation of the historical cat bond market returns - as opposed to 4% for the Fama & French three- or five-factor model - and substantially reduces the observable alpha of the cat bond market.


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