Elevated inflation and rising interest rates: what's the solution?

2022 has been a traumatic year for financial markets, with global equity indices down double digits year to date. Markets have had to grapple with a continual flow of negative news, most notably the war in Ukraine. Around the world, inflation is hitting multi-decade highs while interest rates are rising. In September, both the US Federal Reserve and the European Central Bank raised rates by 75 basis points, with further hikes expected in the coming months. Against this challenging backdrop, investors are increasingly seeking ways to protect returns and to diversify their portfolios. Below we outline two alternative asset classes – catastrophe (cat) bonds and mortgage-backed securities (MBS) – which we believe are well positioned for the current environment.

Cat bonds

What are cat bonds?

Cat bonds, a type of insurance-linked security (ILS), are fixed income instruments issued primarily by insurers and reinsurers to transfer to investors exposures from potentially large insured losses associated with natural catastrophes. For issuers, ILS represents an alternative to the traditional reinsurance market: instead of passing catastrophe risk on to reinsurers by buying reinsurance, a cat bond issuer aims to transfer it directly to the capital markets, where capacity for such risks is greater. 

What can they offer investors in the current environment?

Cat bonds and ILS, by their very nature and construct, are adjustable-rate instruments that index well with interest rate rises and inflation. The coupons on cat bonds and ILS are all floating rate, so every basis point rise in interest rates on the short end of the curve flows directly into the coupon. The inflation element is a little more complex, but easiest to understand at a fundamental level. Insurance companies themselves meticulously reset their premiums on an annual basis with every policyholder according to prior and expected inflation. This means that the very nature of the business itself is indexed to inflation.

Less obvious is the fact that an environment filled with fear, uncertainty and doubt drives insurance and reinsurance policies. More specifically, market turmoil tends to affect the psychology of insurance buyers, compelling them to buy more insurance, for which they are willing to pay a premium. This is positive for the asset class, but crucially investors do not necessarily pay with a higher risk because a market crash cannot cause a hurricane or an earthquake to occur. Further, given the uncorrelated nature of the asset class, no hedging is required to insulate cat bonds or ILS from traditional market factors.

In addition to their low correlation with traditional asset classes, cat bonds and ILS are well aligned with environmental, social and governance (ESG) principles. With regard to environmental factors, ILS are at the forefront of monitoring the cost of extreme weather and, to our knowledge, is the only market that provides a direct climate-priced signal. Making the analogy to inflation-linked bonds, ILS are themselves climate linkers in our view. 

Moving to the ‘S’ in ESG, insurance in general is a social form of finance, applied to essentially neutralise risk across a broader pool to reduce its impact and severity on society. Were it not for ILS, following the hurricane losses in the US in 2004-05 there would have been a significant global increase in the cost of insurance. Reinsurance is a global scheme and as such, if it comes under stress, it affects the pricing of insurance globally. 

In relation to governance, the ILS market brings an unprecedented level of market transparency around pay outs for catastrophes. This allows governments to plan and budget for their response to such catastrophes; The World Bank estimated that having funding in response to a catastrophe from ILS has a multiplier effect of at least one hundred times. This means that every USD 1 of response to a catastrophe coming from ILS is worth at least USD 100 of aid that comes through the traditional response system. 

Mortgage-backed securities

What is an MBS?

An MBS is an instrument which is backed by a pool of mortgages whereby the investor is entitled to the cash flows associated with those underlying mortgages; each pool can include individual mortgages on either residential or commercial properties.

There are two main groups of MBS: ‘agency’ and ‘non-agency’. The former are generally guaranteed or insured by a government agency, and are therefore more secure but offer lower rates of return. The latter are issued by private institutions, are privately insured or not insured at all, and are therefore subject to credit risk, but may potentially deliver greater benefits.  

What can they offer investors in the current environment?

It may surprise you to learn that MBS is the second largest segment of the US bond market after treasuries, accounting for almost a quarter of the US fixed income market. The combination of high credit quality, large size and a diverse range of investors also mean the US MBS market is generally highly liquid.

The MBS market played a central role in the global financial crisis (GFC), but the asset class has evolved considerably in the years since. Almost inevitably, the subprime crisis served as the harshest form of quality control. Since then, only individuals with higher credit profiles have been able to obtain mortgages.

We have seen the US mortgage market undergo dramatic change in 2022. Higher mortgage rates are contributing to declining home sales, which have now fallen to levels consistent with those pre-Covid. Despite this, the price of houses in the US is continuing to increase. In June, house prices increased by +0.6% from May, and 18% year-on-year, according to Case-Shiller. While we are not expecting these large increases to continue, we believe the lack of inventory and strong household formation should continue to provide support for house prices for the foreseeable future, mitigating the impact of rising mortgage rates.

As most mortgages in the US are fixed rate, rising interest rates do not have a material impact on the credit quality of most of the outstanding mortgage market. The increase in house prices has in fact improved the loan-to-value ratios on existing mortgages, which in turn has improved the credit profile of seasoned mortgage securities. Loss severities on seasoned mortgages have steadily decreased as house prices have risen, and the number of mortgage liquidations that have resulted in no-loss has steadily increased over time.

Regulations and tighter lending standards have improved mortgage credit quality in the wake of the GFC. Consequently, the underwriting criteria for US agency residential mortgages remain fairly tight, although they have been loosened to some extent to help first-time buyers. Non-agency underwriting criteria are also tight, and the amount of capital required by banks to hold them is significantly more than for agency. 

Despite concerns about strong inflation and the prospect of a recession, we believe MBS can weather the storm. We expect the US consumer to remain resilient due to the tight labour market and the high savings rate during the pandemic; the US unemployment rate in August was 3.7%, which we believe should allow the Federal Reserve to act aggressively without crushing the labour market and leaving consumer credit relatively unscathed. Further, the MBS market continues to be supported by strong house prices which, in our view, are unlikely to fall significantly while there is a shortage of homes.

Clearly then, both ILS and catastrophe bonds and MBS hold a special position in the market. Given today’s challenging and volatile markets, the diversification and low correlation benefits they can offer have never been more important.

Related publications

By browsing this website, you agree to our privacy policy.
I Agree