۱- Introduction

۲- CAT bonds and Asia Pacific markets

۳- Liquidity hypotheses

۴- Data

۵- Empirical analysis and discussion

۶- Conclusion

References

Abstract

This study measures liquidity in the catastrophe (CAT) bond market and the liquidity premium embedded in CAT bond spreads. The empirical results show that time to maturity, yield volatility, and yield dispersion from the primary market are the three most effective liquidity proxies. Given these three proxies, the average estimated liquidity premium in the CAT bond market is 67.57bps, accounting for only 9.42% of the average CAT bond spread (717.37bps) in the secondary market during the period 2002-2016. The average CAT bond liquidity premium is higher than the corporate bond liquidity premium of a similar risk class by about 35bps during the pre-crisis period. The more significant part of the high-yield spreads, 90.58%, is attributed to other risk natures of CAT bonds. Lastly, the liquidity premium increases dramatically after occurrences of severe natural catastrophes as well as during the 2008 financial crisis.

Introduction

Catastrophe (CAT) bonds, which are a type of insurance-linked securities (ILS), can resolve inefficiency in the reinsurance market and have been by far one of the most successful securitization structures to date (Cummins and Trainar, 2009).1 CAT bonds are a high-yield financial instrument, presenting an average spread of 717.37 basis points (bps) over LIBOR (London Interbank Offered Rate) and an excess spread of 322.74bps compared to similarly rated corporate bonds during the period 2002: Q2 to 2016: Q1. One theory is that their high-yield spreads are due to their liquidity premium, because CAT bonds are not publicly traded and their transactions are in the over-the-counter market (OTC). Various studies indicate that liquidity is factored into corporate bond yield spreads (Houweling et al., 2005; Chen et al., 2007; Bao et al., 2011; Dick-Nielsen et al., 2012; Schestag et al., 2016; Lo et al., 2019; etc.), but there is no evidence on how liquidity is related to CAT bond spreads. While we do not find any literature investigating the liquidity effect on CAT bond spreads, some relevant studies (Braun, 2016; Gürtler et al., 2016) do consider issue volume, maturity, and time to maturity in order to measure CAT bond liquidity in the primary market or secondary market for such bonds.2 To our surprise, these studies find no empirical evidence to support the liquidity hypothesis, implying that investors do not demand a liquidity premium for CAT bonds. Based on the above background, this study looks to examine whether the liquidity premium is present and, if so, to measure how much it is embedded in CAT bond spreads. Previous studies of CAT bonds focus on finding price determinants of their yield spreads.