Catastrophe Bonds: An Alternative Approach for Portfolio Diversification

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1 Alternatives Catastrophe Bonds: An Alternative Approach for Portfolio Diversification Investors continue to look for new ways to improve returns in the current low yield fixed income environment. They are also seeking new sources of diversification as global markets become more correlated. Caleb Wong Senior Portfolio Manager Catastrophe bonds (or cat bonds) offer a potential solution to both challenges. Insurers use cat bonds to replace traditional reinsurance by paying investors to assume a portion of the risks associated with major natural events, such as a hurricanes or earthquakes. To attract these investors, insurers offer them the opportunity to earn higher yields. Cat bonds also offer the potential for diversification benefits because they are not typically influenced by the economic and geopolitical factors that drive the performance of traditional assets, such as stocks and bonds. Today, cat bonds make up almost $25 billion of the approximately $600 billion reinsurance market. 1 How Cat Bonds Work Cat bonds are typically issued by insurers to help transfer a set of remote, but potentially severe, event-specific risks on their books to capital market investors. The most common events are natural and extreme catastrophes such as hurricanes, earthquakes, windstorms and typhoons. When a catastrophe occurs, the issuer of the cat bond typically accepts a certain amount of loss, while a cat bond investor is typically responsible for the remainder of the potential risk of loss. Exhibit 1 In a typical structure, the insurance company sponsor creates a Special Purpose Vehicle (SPV) Exhibit 1 Cat Bond Investors Help Protect a Portion of an Insurer s Potential Risks Hypothetical insured risk of insurance company 1. Insurer accepts the first $200 million of losses 2. Cat Bond principal pays for the next $100 million of losses $300M+ Excess Retained by Insurer $100M Transferred to Capital Market $200M Retained by Insured 3. After the principal assets in the Cat Bond are exhausted, insurer absorbs the remaining losses Source: OppenheimerFunds. Not FDIC Insured May Lose Value Not Bank Guaranteed 1. Source: Aon Benfield, 7/1/15.

2 OppenheimerFunds that issues the cat bond and invests the bond proceeds in highly rated cash or money-market-type investments. The SPV engages in an agreement with the sponsor to reinsure specific risks of the sponsor. Reinsurance premiums paid by the insurance company sponsor and interest payments from the collateral are passed through the SPV to the cat bond investors, who typically receive the combined payments in the form of a floating rate coupon. Cat bonds identify a defined threshold of physical or economic loss that will trigger an event. Some cat bonds are triggered when payments are made by a specific insurance company or when certain measurement levels are met relative to the characteristics of the event. Other cat bonds employ a combination of thresholds, or an aggregation of event losses. If a catastrophic event doesn t occur during the term of the bond, investors get back their principal. But if an event does occur, the SPV sells the principal collateral and transfers the proceeds to the insurer. As a result, cat bonds can partially or completely default, depending on the level of losses. Exhibit 2 Exhibit 2 Typical Cat Bond Structure Insurance Company Sponsor Insurance Premiums Reinsurance Contract Special Purpose Vehicle Principal Interest Capital Market Investors Interest Principal Collateral Account (typical Money Market funds) Source: OppenheimerFunds. 2

3 The Right Way to Invest The Cat Bond Market Cat bonds emerged in the 1990s, following Hurricane Andrew and the Northridge earthquake, which cost the insurance industry more than $25 billion. Those losses severely depleted capital in the reinsurance industry, a development that prompted industry participants to look to the capital markets to help meet the unexpectedly sharp demand for reinsurance protection. Exhibit 3 Cat Bond Issuance Cat Bond Issuance by Quarter USD billions $ Q1 Q2 Q3 Q4 Source: Aon Benfield Securities, Inc. Q Cat bond issuance in the capital markets benefited from the introduction of more sophisticated catastrophe models developed in the mid- to-late 1980s. These disciplined and independent tools gave insurers and investors the rigorous analytics necessary to evaluate and price the catastrophe risks embedded in the bonds. Today, cat bonds make up almost $25 billion of the approximately $600 billion reinsurance market. Issuance of cat bonds and other alternative reinsurance securities continues to grow steadily. Total outstanding cat bond issuance grew more than 70% between 2011 and Exhibit 3 Reinsurer capital had grown to $580 billion as of March 31, 2015, up 15% since Overall, alternative capital (a category that includes cat bonds and other insurance-related securities issuance) increased to $66 billion, up 3% since year-end The greatest demand comes from insurance markets in regions of the world with high property values. Miami and New York City create the biggest demand for hurricane insurance while the San Francisco, Los Angeles and Tokyo metropolitan areas are the biggest markets for earthquake insurance. In Europe, certain economically productive regions of France and Germany are big buyers of protection against winter windstorms. Finally, insurers are also seeking to transfer mortality-related catastrophe risks such as pandemics and wars that would lead to large losses of life. Exhibit 4 Exhibit 4 Examples of Covered Perils and Regions U.S. Midwest U.S. West Coast U.S. Extreme Mortality Canadian European U.S. Hurricane UK Flood European Windstorm & Extreme Mortality Japanese Japanese Typhoon Mexican Caribbean Hurricane Central American Australian & Windstorm Hurricane/Typhoon Windstorm Extreme Mortality Source: AXA Investment Managers, Source: Aon Benfield, 7/1/15. 3

4 OppenheimerFunds Low Correlation with Traditional Investments Because the performance of cat bonds is governed by specific acts of nature, they are not typically impacted directly by economic factors such as market movements, interest rates or inflation, and thereby offer one of the lowest correlations 1 with traditional capital market investments. Exhibit 5 These low correlations were demonstrated during three important recent crises in the capital markets. Exhibit 6 In the summer of 2011, a U.S. credit downgrade caused the S&P Total Return Index to drop 12.8%. In 2013, the Barclays U.S. Aggregate Index fell 2.03% on fears of the Federal Reserve curtailing its bond buying program (the so-called taper tantrum ). In August 2015, the S&P Total Return Index dropped 6.0% the biggest monthly drop in three years in the aftermath of a Chinese currency devaluation and amid growing fears of a global economic slowdown. Exhibit 5 Cat Bonds Have Historically Low Correlations With Many Asset Classes Correlation of Swiss Re Catastrophe Bond Index with other asset classes June 2005 to June 2015 Index S&P GSCI 0.02 S&P Dow Jones REIT 0.11 Barclays U.S. Aggregate 0.13 CSFB High Yield 0.15 Sources: Bloomberg, Credit Suisse. As of 6/30/15. Please see definitions page for index definitions. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict performance of any investment. Past performance does not guarantee future results. In all three of these periods, the Swiss Re Cat bond Index returned between 1.2% and 2.3%. Exhibit 6 Cat Bonds Have Performed Well During Recent Financial Crises 4.0% European Debt Crisis 7/31/11 9/30/11 Taper Tantrum 5/30/13 8/31/13 China Currency Devaluation 8/1/15 8/31/15 Total Return (%) Barclays U.S. Aggregate S&P Total Return (SPXT) Swiss Re Global Total Return Index (hedged) (SRGLTRR) Source: Morningstar A measure of how securities move versus each other. A perfect positive correlation (+1) implies that as one security moves, either up or down, the other security will move equally in the same direction. Alternatively, a perfect negative correlation ( 1) means that if one security moves in either direction the security that is perfectly negatively correlated will move by an equal amount in the opposite direction. If the correlation is 0, the securities are not correlated.

5 The Right Way to Invest Strong Performance vs. Other Asset Classes with Less Volatility Cat bonds have meaningfully outperformed a traditional 60/40 stock/bond portfolio and many other asset classes over the past 10 years. They have delivered this performance in spite of return shocks from a number of catastrophic trigger events. Exhibit 7 Cat bond yields have historically averaged between 5% and 7%. The quarterly coupon investors receive combines insurance payments as well as proceeds from the principal, which is invested in highly rated securities such as treasuries and money market instruments. The performance of cat bonds is also impressive on a risk-adjusted basis. Cat bonds have historically exhibited very low volatility and have very high Sharpe ratios, a measure that calculates the returns investors receive for each unit of risk they take on. While cat bond performance over the past 10 years was comparable with that of the S&P 500 Index, cat bonds were 80% less volatile. Exhibit 8 Exhibit 7 Cat Bonds Have Outperformed Despite Recent Trigger Events $25,000 20,000 60/40 S&P and Barclays Agg Swiss Re Cat Bond Index Total Return Barclays U.S. Aggregate S&P 500 Total Return Two Lehman-issued cat bonds underperform because collateral included mortgages Japan s Tohuku earthquake causes $30B of insured losses Hurricane Sandy causes $35B of insured losses Swiss RE Cat Bond Index 15,000 Hurricane Katrina causes $40B of insured losses 10,000 5, Sources: Swiss Re, FactSet, JPMorgan, Barclays, Citigroup, Standard & Poor s, 3/31/15. Please see last page for index definitions. Past performance does not guarantee future results. Exhibit 8 Cat Bonds Have Historically Higher Risk-Adjusted Returns than Other Assets Risk-adjusted returns of Swiss Re Catastrophe Bond Index 10-year Sharpe Ratio as of 6/30/ Sharpe Ratio GSCI WGBI-xUS Hedged MSCI EAFE Russel 2000 DJ REIT MSCI EM CSFB LL S&P500 CSFB HY JPM EMBI BarCap Agg Swiss Re Cat Bond Total Return 1.7% 3.7% 7.1% 8.2% 9.0% 10.8% 4.9% 8.2% 7.5% 7.7% 4.4% 8.0% Volatility Sources: Bloomberg, Credit Suisse, 6/30/15. Sharpe Ratio time frame June 2005 to June Please see last page for index definitions. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any strategy. Past performance does not guarantee future results. 5

6 OppenheimerFunds Investing in Cat Bonds Adding an allocation of catastrophe bonds to a traditional 60/40 stock portfolio may offer several benefits: Increase the portfolio s return potential through the additional income the cat bonds may offer. Increase the overall diversification of the portfolios. Lower the volatility of the portfolio and thereby enable investors to earn higher risk-adjusted returns. The hypothetical returns depicted in Exhibit 9 demonstrate how the performance of a traditional 60/40 portfolio would have been affected by adding varying levels of a cat bond allocation over the past decade. A 2.5% allocation to cat bonds would have increased average annual returns by 0.04% while decreasing volatility by 0.20% per annum. A 5% allocation would increase returns an additional 0.04% and reduce volatility by an extra 0.20% per annum. The high yields and low correlations of cat bonds may help make the sector an attractive addition to investor portfolios. Disciplined portfolio construction and risk management techniques can be used to address the special risks associated with cat bonds, a strategy that could mitigate losses and improve returns over time. Exhibit 9 Adding Cat Bonds to a Traditional 60/40 Portfolio May Help Increase Total Returns Hypothetical 10-year returns as of 6/30/ Cat Bonds: 10% S&P 500: 54% Barclays Agg: 36% Annualized Total Return (%) Cat Bonds: 7% S&P 500: 55.8% Barclays Agg: 37.2% Cat Bonds: 5% S&P 500: 57% Barclays Agg: 38% Cat Bonds: 3% S&P 500: 58.2% Barclays Agg: 38.8% Cat Bonds: 1% S&P 500: 59.4% Barclays Agg: 39.6% S&P 500: 60% Barclays Agg: 40% Annualized Volatility (%) Source: Morningstar, as of 6/30/15. Past performance does not guarantee future results. Returns are hypothetical and based on hypothetical portfolios. 6

7 The Right Way to Invest Risks Investors in cat bonds assume a set of risks that differ considerably from those traditionally assumed by investors in the capital markets. Cataclysmic Events Because the asset class is relatively young, index performance and Sharpe ratios have not yet been affected by a truly large-scale cataclysmic event. Most cat bond investors hold a diversified portfolio of risks and are not exposed to any single form of risk. But a cataclysmic hurricane in Miami, a massive earthquake in either Los Angeles or San Francisco, or a catastrophic windstorm affecting Europe, could lead to losses of greater than $100 billion. Losses of that magnitude could lead to significant losses in the cat bond index. Catastrophe Modeling Risk Investors are paid a premium to cover the uncertainty associated with assessing the risks of catastrophes. Models are based on historical records and are improving constantly, but an element of risk remains because the data in the models are limited by the low number of observed events. Liquidity Risk Investors must recognize that although cat bonds are traded daily, and are typically backed by money market collateral, they are not as liquid as other investments and may become more difficult to buy and sell during periods of market stress. Recovery Risk While traditional bonds often allow investors to recover some portion of principal if the issuer s debt obligations are restructured, cat bonds have binary risk profiles. They offer significant rewards if losses do not exceed a certain threshold, but may lose some or all principal when a catastrophic event occurs. Credit Risk Investors have modest exposure to credit risk. Because the bond proceeds are invested in highly rated collateral, such as U.S. Treasury Bills or European Bank for Reconstruction and Development Notes, there still is a modest element of credit risk. Additionally, the issuer could suspend premium payment for reasons associated with its creditworthiness or changes in the tax and regulatory environment. Under this last scenario, investors would be subject to reinvestment risk as the principal is returned before the bonds mature. 7

8 The Right Way to Invest We recognize that markets constantly change, but we believe The Right Way to Invest remains constant and encompasses four key principles: Make global connections Look to the long term Take intelligent risks Invest with proven teams Visit oppenheimerfunds.com or call to learn more. Visit Us oppenheimerfunds.com Call Us Follow Us Sharpe Ratio is the measurement of an investment s excess returns per each unit of additional risk (measured by standard deviation). Index Definitions The S&P Total Return Index is calculated intraday by S&P based on the price changes and reinvested dividends of the SPX Index with a starting date of January 4, The S&P 500 Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy. The Swiss Re Global Cat Bond Index tracks the aggregate performance of all U.S. dollar and euro-denominated cat bonds, capturing all ratings, perils and triggers. The index seeks to hedge out the euro risk at the inception of each bond. The index is based on Swiss Re pricing indications only. The S&P Goldman Sachs Commodity Index (S&P GSCI ) is a composite index of commodity sector returns, representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The MSCI Emerging Markets Index (Net) is a trademark/service mark of Morgan Stanley Capital International. The MSCI Emerging Markets Index (Net) is designed to measure global emerging market equity performance. The MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The JPMorgan Emerging Market Bond Index (EMBI) measures the total return performance of international government bonds issued by emerging market countries that are considered sovereign and that meet specific liquidity and structural requirements. The Citigroup WGBI Index is a market capitalization weighted bond index consisting of the government bond markets of multiple countries. The Citigroup WGBI Non-U.S. Index (WGBI ex-u.s.) is a market capitalization weighted bond index consisting of the government bond markets of multiple countries excluding the U.S. Credit Suisse High Yield Index tracks the performance of domestic non-investment-grade corporate bonds. The Credit Suisse Leveraged Loan Index is a composite index of U.S. dollar denominated senior loan returns representing an unleveraged investment in senior loans that is broadly based across the spectrum of senior floating rate loans and includes reinvestment of income (to represent real assets). The JPMorgan Domestic High Yield Index tracks the investable universe of domestic below-investment-grade bonds in the United States. The Barclays U.S. Aggregate Bond Index (Barclays Agg) is an index of U.S. dollar denominated, investment-grade U.S. corporate government and mortgage-backed securities. The Dow Jones Equity REIT Index is a stock market index composed of property company constituents that are designed to represent general trends in eligible listed real estate stocks worldwide. The FTSE NAREIT Equity REITs Index is designed to measure the performance of domestically based U.S. Real Estate Investment Trusts. The Barclays High Yield Bond Index covers the universe of fixed rate, non-investment-grade debt. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results. Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall, and a fund s share price can fall. Event-linked securities, otherwise known as Cat Bonds, are fixed income securities for which the return of principal and interest payment is contingent on the non-occurrence of a trigger event that leads to physical or economic loss. If the trigger event occurs prior to maturity, event-linked securities may lose all or a portion of their principal and additional interest. Investments in below-investment-grade ( high yield or junk ) bonds are more at risk of default and are subject to liquidity risk. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and geopolitical risks. Emerging and developing market investments may be especially volatile. Diversification does not guarantee profit or protect against loss. These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of 9/30/15 and are subject to change based on subsequent developments. Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by asking your financial advisor, visiting oppenheimerfunds.com or calling CALL OPP ( ). Read prospectuses and summary prospectuses carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. 225 Liberty Street, New York, NY OppenheimerFunds Distributor, Inc. All rights reserved. DS November 16, 2015