Investors could purchase one or several of three classes, protecting Mexico against earthquakes, Atlantic tropical cyclones and Pacific tropical cyclones. If an event eligible for coverage occurs, some of that tranche’s proceeds go to the Mexican Fund for Natural Disasters (FONDEN).
Mexico is a pioneer in the catastrophe bond market, becoming the first sovereign to issue such debt in 2006. But this week’s trade, which settled on Friday, is something of a first for the issuer.
The sovereign’s last two catastrophe bonds, in 2009 and 2012, used World Bank’s MultiCat programme, in which World Bank acts as arranger and offers support in several other ways.
But this week’s bonds were issued under World Bank’s ‘capital at risk’ notes programme, created in 2014. Unlike other catastrophe bonds, which are issued by a SPV, under this programme World Bank is the issuer. That means the funds raised from the bonds go to the supranational’s annual funding target — the separate programme is necessary because the risk that investors could lose some of their cash means the bonds cannot enjoy World Bank’s triple-A issuer rating.
“The World Bank bonds we have launched today are not only a financial innovation — but also a milestone in our partnership with Mexico, and in our joint pursuit of preventing the human and financial tolls of earthquakes and floods,” said Arunma Oteh, World Bank’s vice president and treasurer, in a press release.
“We are leveraging Mexico’s leadership in developing risk insurance mechanisms against natural disasters, and the World Bank’s innovative use of private sector instruments to transfer risk to the capital markets, so that together we can deliver innovative financial solutions that help eradicate poverty and boost shared prosperity.”
Growth
The catastrophe bond market has enjoyed strong growth and has shown resilience even in cases where investors have lost cash, Michael Bennett, head of derivatives and structured finance at the World Bank treasury, told GlobalCapital.
“All three classes [on this week’s deal] were oversubscribed,” he said. “Mexico’s previous issues were also tranched into these three classes, and in the preceding bond from 2012, the Pacific hurricane class had an event, which caused a 50% loss for investors.
“But investors still came in heavily for that class in this new issue, which says something about the resiliency about the market and about its investors. Sometimes we are asked whether they lose interest if a bond triggers and they lose money, but it’s very much not the case, as we see with this new bond. I believe that the Pacific hurricane class was the most oversubscribed, which shows there’s still great demand out there even when previous ones have paid out.”
Pricing on catastrophe bonds, particularly for hurricanes, has tightened over the years, said Bennett. But this may be less to do with investors believing the threats from such events are surpassing, and more to do with market dynamics.
“There are several reasons why — investors are getting more comfortable with the models and sponsors and there’s also more money in this space,” said Bennett. “When the market started there was a very limited number of investors. They used to have more pricing power.”
All three classes of this week’s bonds have a trade date of July 24 and are similar in structure, but vary in size and pricing.
The Class 'A' tranche covers earthquakes, has a size of $150m and matures in August 2020. It pays a coupon of six month dollar Libor plus 412bp, with a floor set at the risk margin of 4.5%.
Both the Class 'B' and Class 'C' notes cover cyclones and mature in December 2019 — effectively providing three years of coverage, as they cover three annual cyclone seasons each. The $100m Class 'B' notes cover Atlantic storms and pay 892bp over six month dollar Libor, with a risk margin of 9.3%. The $110m Class 'C' notes cover Pacific storms and pay 552bp over the same Libor rate, with the risk margin set at 5.9%.
Novel pricing
The catastrophe bond market uses a unique system to price bonds — although in some ways, it can use the more conventional bond market method of looking at comparables in secondary markets.
“Investors look at the annualised expected loss as a starting point,” said Bennett. “Also, most CAT bonds issued in the world are concentrated in very few risks, with the majority exposed in whole or in part to hurricanes in Florida. California earthquakes are also heavily insured in the catastrophe bond market.
“Those are called peak perils and because there’s such a high concentration in them, dedicated cat bond investors look for other types of risk referred to as diversifiers, which tend to be priced more attractively.”
The World Bank bond for Mexico this week provides a good example of peak peril versus diversifier, given the different classes in the bond.
“In Mexico’s case, the earthquake and Pacific hurricane classes are complete diversifiers because there’s no correlation with peak perils,” said Bennett.
“But for the Atlantic hurricane class there’s some, because it’s possible a storm that could impact Florida could also go into the Gulf of Mexico and impact Mexico. So we have two complete diversifiers and a partial diversifier. There is also a secondary market in these bonds, so investors will look at other securities covering similar perils as pricing benchmarks.”
Specialist market
Dedicated insurance-linked securities funds took most of this week’s bonds, between 60% and 78% on each tranche, with asset managers taking 19%-24% and reinsurers and life insurers the remainder.
“It takes a certain level of knowledge of the insurance market and pricing to invest directly in catastrophe bonds,” said Bennett. “There are specialist insurance-linked securities funds that only purchase these types of securities.
“There are also some alternative asset managers that can look at any types of assets and opportunistically choose to buy. There are some larger asset managers that maybe have a small allocation to catastrophe bonds and a few pension funds. There are also some insurance companies that are in this market anyway through insurance contracts but also buy as part of their bond portfolios.”
But some many other investors can play, albeit indirectly.
“There is also a much larger group of investors, including pension funds, that don’t buy these bonds directly but invest mainly through the specialist funds,” said Bennett.
Pay-outs from World Bank to FONDEN are intermediated by Munich Re and Agroasemex, a Mexican state-owned insurance company. GC Securities is sole bookrunner for the deal, and was joint structuring agent along with Munich Re. GC Securities and Munich Re Capital Markets were joint managers.