John DeCaro overviews the risk-linked securities market.

Risk-linked securities (RLS) continued to deliver consistent returns to investors, as the broad RLS market generated a 2.97% total return during the first half of 2003. By comparison, the corporate high yield market had its strongest performance since the first half of 1991 on the heels of a significant decline in yields and commensurate contraction of credit spreads. It would appear that the decoupling of the RLS market from high yield that began in earnest in early 2002 is essentially complete.

By the middle of last year, the par amount of outstanding RLSs stood at $2.875bn, a net increase of $108m from the end of 2002. Though modest in scale, this growth rate belies the amount of activity in the market.

Five transactions worth $586.5m matured, while four new offerings raised $694.5m. The net issuance of $330m during the second quarter of 2003 was the largest net amount since the fourth quarter of 2000 and contained the largest single securities issuance ($470m; Phoenix) since the first Residential Re deal in 1997.

Performance

RLSs returned 2.97% during the first half of last year, compared with a 17.88% return on the Merrill Lynch High Yield Master II Index. Returns were hampered by significantly low LIBOR yields (average annualised rate of 1.28%) and a -0.28% price return driven by seasonal widening of discount margins on Atlantic and European windstorm securities. Credit spreads contributed 2.61% (annualised spread to LIBOR of 522 bps) of the total return.

Despite the recent strong performance of high yield securities, RLSs have outperformed the Merrill Lynch High Yield Master II Index by a cumulative 22.3% since the end of 1999 (9.4% versus 4.0% annualised). Volatility of monthly returns on RLSs has continued to decrease (1.62% in 2001 versus 0.37% in 1H03), leading to strong risk-adjusted returns and Sharpe ratios (3.56 in 2003 versus 0.84 in 2001). This decline is largely the result of more stable prices in the secondary market - annualised volatility of monthly price returns has declined from 2.2% in 2001 to 0.9% in 2003.

Market environment

Though net issuance totalled only $108m, raising the size of the market to $2.875bn, the composition dramatically changed as a result of Swiss Re's Pioneer and Phoenix transactions and the maturity of five issues.

Significantly, two of the maturities (NeHi and Pacific Re) were sponsored by primary insurers who are unlikely to reissue in the future.

By the end of last June, the number of outstanding issues had declined from 20 to 19 at year-end, while the number of individual issuers had dropped from 14 to 11 (although the Phoenix transactions were issued by Swiss Re, they provided risk transfer to an unaffiliated third-party).

Swiss Re's market share jumped from 29.1% to 43.5%; however, if the $470m of Phoenix securities are excluded from the total then only 27.2% of the issues are sponsored by Swiss Re.

The addition of three new transactions helped increase the average par amount of each outstanding issue from $81.4m at 30 June 2002 to $98.5m.

Inclusive of the aggregate value of each of the individual Pioneer 2002 tranches, there are now 12 securities with greater than $100m outstanding versus ten a year ago.

Pioneer 2003-I and II

Swiss Re issued $74.49m of securities under the Pioneer 2002 program during March and June, bringing the total amount of outstanding Pioneer notes to $460.99m. Quarterly issuance declined from the $104.25m raised in December 2002 to $42.6m and $31.9m in March and June, possibly reflecting current investors in the program's saturation with the individual risks represented in this structure. It also worth noting that the June offering coincided with the marketing period for the Phoenix transactions and that Swiss Re elected not to offer any of the Japan earthquake (Class E) and multi-peril (Class F) notes at that time.

Excluding the investment grade and multi-peril tranches (Classes D and F), Swiss Re has been able to obtain a total of $349.5m of fully collateralised, first event risk transfer protection in four peak zones for a three-year term at an average risk premium of 5.44% for a 1.30% expected loss. The laddering strategy of holding quarterly offerings at a fixed spread enabled Swiss Re to lower premium costs even further - $159.5m was issued at an average spread of 536 bps versus the initial $190m offering at 551 bps.

In early July, Swiss Re launched the Arbor program, which basically replicates the Pioneer program under a new series of special purpose vehicles (SPVs) but with a couple of tweaks. Palm, Oak, Sequoia and Sakura are the SPVs that mirror the risk profile of the Pioneer A, B, C and E tranches (neither the New Madrid D tranche or the multi-peril F tranche were represented).

Arbor I and Arbor II provide coverage for the first and third losses to occur in the loss layers represented by the four new single peril SPVs.

This first event, multi-peril exposure has greater value for Swiss Re than the Pioneer Fs in that the individual events covered have the same probability of attachment as the single peril tranches. Even though Pioneer F provides multi-peril protection, there is a gap in coverage between the exhaustion probability of the Pioneer A, B, C and E notes and the attachment probabilities of the individual risks within Pioneer F.

Across the six SPVs, $203.9m of securities were issued, raising the total size of the RLS market in mid-July above $3bn for the first time.

Residential Re 2003

The $150m Residential Re 2003 offering which closed in late May was significant for several reasons. Notably, it was the first transaction significantly exposed to aggregate losses (as opposed to most catastrophe bonds, which tend to assume risk arising from a single loss occurrence) since the Mosaic Re II notes issued by F&G Re in 1999.

The coverage protected USAA from the aggregation of losses (net of reinsurance) it may incur from both hurricane and earthquake events occurring anywhere in the US. As such, investors are exposed to somewhat esoteric risks such as Hawaii hurricanes and earthquakes in South Carolina, Alaska and the Pacific Northwest in addition to the familiar perils (e.g., California and New Madrid earthquakes, East and Gulf Coast hurricanes). In addition to being a multi-peril security, this edition of the Residential Re notes exposes investors to more frequent/higher probability loss events than previous offerings. As a result, pricing on the notes came at a spread of 4.95% for a 0.48% expected loss, compared with indicative bid risk-adjusted spread levels in late April of 470 bps for the Residential Re 2001 and 2002 notes (0.68% and 0.67% expected losses).

Phoenix Quake/Quake Wind/Quake Wind II

The largest series of RLSs since Residential Re in 1997, and largest risk transfer amount, was issued by Swiss Re in June in the form of $470m of securities providing second event coverage against a combination of Japanese earthquakes and/or typhoons (depending on the specific bond).

Phoenix Quake and Phoenix Quake Wind both raised $192.5m at a spread of 245 bps, while $85m of Phoenix Quake Wind II notes were issued at a spread of 350 bps.

The first Residential Re transaction provided USAA with $400m of risk transfer protection through the issuance of $313m of first event bonds and $164m of principal-protected notes. All $470m of principal is at risk in the Phoenix securities.

The Phoenix Quake and Quake Wind offerings are notable in that they almost doubled the size of the investment grade RLS market. As at the end of June 2003, there were six investment grade securities with a par amount of $745m outstanding, versus six issues and $425m at the previous year-end. Additionally, this offering is significant in that it illustrates the ability of the RLS market to absorb larger transaction sizes at reasonable pricing levels. As transaction sizes increase, bringing improved liquidity, larger institutional investors whichhave historically not been active in this market should begin to participate.

- John DeCaro is Vice President of Cochran, Caronia & Co, where he is responsible for the sales, trading and research of risk-linked securities.