We've written before that bonds today are unusually unattractive. For example, the ten-year Treasury bond currently yields only 1.85%. For ten years! There’s a pretty good chance that this return may actually be negative after inflation. Over the past five years (and 15 years), bonds have outperformed the S&P 500 stock index. And over recent years (until the past few months), mutual fund investors have highly favored bond funds over stock funds. But with such low yields today, bonds now offer greater than average risk and lower than average return. The question is: what are we doing about that?
To diversify bond holdings away from unappealing traditional bonds, we’re now in the process of purchasing positions in two new non-traditional bond mutual funds in virtually every managed account. These bond funds are expected to exhibit no relationship to stock or bond markets, to offer better returns than regular bonds, and most importantly, to carry no interest rate risk or credit risk. These funds are the Stone Ridge Reinsurance Premium Fund Class I (SRIEX) and the Stone Ridge High Yield Reinsurance Premium Fund Class I (SHRIX). These are bond funds, but they are unlike any other bond holdings you have.
These funds will invest in insurance-linked securities (ILS), primarily catastrophe bonds (or ‘cat bonds’). When an insurance company wants to free up reserves by reducing its overall risk exposure, it buys reinsurance from a reinsurer such as Swiss Re. When a reinsurance company wants to do the same, it issues cat bonds or other ILS. Cat bonds are corporate bonds that transfer event risk from reinsurance companies to the bond owners in exchange for an above-market rate of interest. The market for cat bonds has existed for more than 15 years and now exceeds $15 billion. These bonds pay a floating short-term interest rate (like LIBOR or T-bills) plus a significant fixed premium. They generally have 1-5 year maturities (most are 3 year bonds). Each cat bond has a specific insurance trigger attached, typically associated with one of the four primary “perils”: Japanese earthquakes, California earthquakes, US hurricanes, or European wind storms (but some bonds are “multi-peril”). Cat bonds pay interest quarterly and return principal at maturity unless the specific trigger event occurs, in which case, interest stops and part (or all ) of principal is not returned.
Because of this structure, investment in an individual cat bond can be risky. However, because the various perils are not correlated to each other (or to financial markets) the key in investing in this asset class is very broad diversification.
It should also be noted that the trigger events are very precisely defined and the thresholds are quite large. For example, only one cat bond had partial losses triggered by Hurricane Katrina in 2005. One cat bond suffered partial losses in 2009 due to Hurricane Ike. Four cat bonds out of more than 100 outstanding suffered losses in 2011, the worst year yet for cat bonds (two due to the earthquake in Japan, two due to US tornadoes). Last year, Superstorm Sandy hit New York City and New Jersey causing an estimated $65 billion in damage, but the impact on the Swiss Re Global Cat Bond Index (an index of cat bonds) was modest as the index ended the year with a return of more than 10%.
Previously, only hedge funds and insurance companies have accessed this market (Warren Buffet’s Berkshire Hathaway has been an active buyer in the past). Now we have access via mutual funds: SRIEX and SHRIX (they are available now only as a “package”). Both funds will be managed by a team with ILS market experience in the hedge fund world. We qualify for the Institutional class shares and each fund will have fees of 1.75%. Both funds may be redeemed daily and will have daily pricing, but they will only be open to purchases on two days (one in early February and another in early April), and each will be closed to additional investment after that.) Investment in these funds is not open to retail investors except via an investment advisor such as F&M, and out of many thousands of registered investment advisors, only a few dozen have gone through the due diligence and required training to become qualified by Stone Ridge to invest client assets in these funds. At this point, these are the only two mutual funds investing in cat bonds.
Our analysis suggests that the most likely long-term return of these two funds combined is about 7% net of fees annually (taxable), given the current interest rate environment and more than 100 years of detailed history of seismic and meteorological data. Such a long-term return would be more than 2.5 times the return likely from traditional bonds. In our analysis, future loss experience would have to be about 70% greater than the historical experience for these bonds to produce a long-term return on par with that of traditional bonds.
Prospective returns appear attractive, but their primary attraction is diversification. Since cat bond proceeds are held in T-bills, the return of these funds should be unaffected by credit risk, interest rate risk, or stock market risk. They also provide some inflation protection since T-bill rates are a component of their returns and T-bill rates are usually related to inflation.
These bonds are taxable, so it’s preferred to hold them in tax-deferred or tax-exempt accounts such as an IRA or Roth IRA. Where that’s not possible, we’ll still buy these for fully taxable accounts as their after-tax yields are likely to be more than competitive with tax-free munis.
An allocation of approximately 2% to these new funds will neither “make nor break” any portfolio, but these innovative funds should add a small bit of uncorrelated return while replacing some traditional bonds. This is one step among many designed to mitigate portfolio risk while improving returns.
For more information, here’s a link to a cat bond overview from a firm that is a leading expert:
And here’s a link to the prospectus:
http://www.sec.gov/Archives/edgar/data/1559992/000089843213000088/a497.htm
And to their Statement of Additional Information:
http://www.sec.gov/Archives/edgar/data/1559992/000089843213000089/a497.htm