The fund with a 6.5% yield that is trading on a 9% discount

6 mins. to read
The fund with a 6.5% yield that is trading on a 9% discount

A few weeks ago I wrote about a buying opportunity for CATCo Reinsurance Opportunities, which is a highly unusual fund that invests in catastrophe insurance bonds. A similar opening has now become available on the other investment trust that provides exposure to this area, the Blue Capital Alternative Income Fund (BCAI).

BCAI was launched in December 2012 and gives investors access to the global catastrophe reinsurance market, an alternative asset class whose returns have been largely uncorrelated to those of more mainstream areas including equities and bonds. At the end of May it changed its name from the Blue Capital Global Reinsurance Fund.

The analysts at QuotedData have recently initiated coverage and they say in their report that the fund offers an alternative source of income with a yield of 6.5% and quarterly dividends. Most investment trusts with high yields are trading on substantial premiums to net asset value (NAV), whereas BCAI is currently available on a discount of 9%.

Its managers have said that the discount is unwarranted, given the strength of the opportunity and its strong and stable performance, and they believe that it offers a good entry point for investors.

Attractive total return and yield

Blue Capital Alternative Income aims to generate an annualised portfolio target return of one month US dollar LIBOR plus 8%, net of fees and expenses, over the long term. It does this by investing in a master fund − an underlying special purpose vehicle – that holds a broad range of reinsurance risks diversified by risk, geography and catastrophe.

BCAI also has a target yield of LIBOR plus 6% per annum on the original issue price of $1 per share with quarterly dividends. It is currently yielding 6.5%.

The global catastrophe reinsurance market is mainly denominated in US dollars and the managers have chosen not to hedge the associated currency risk for sterling investors. Analysis by QuotedData shows that despite this, the fund has generated steady, stable returns for shareholders based in the UK.

According to their calculations, in the four years from 1 May 2013 to 30 April 2017 the annual share price total returns have been 11.7%, 0.1%, 7.2% and 9.7%. Over the same period the target annual US dollar denominated returns have been between 8.2% and 8.6%.

The underlying portfolio

BCAI invests in a portfolio of fully collateralised natural catastrophe reinsurance risks. These are diversified in terms of geography, catastrophe (a specific cause of loss, such as a fire or flood) and events such as Hurricane Matthew. It holds these contracts via a master fund that is managed by Blue Capital Management Limited.

The fund currently has a portfolio of around 1,500 different contracts from a range of clients, which means that there is significant diversification. The managers mainly concentrate on smaller insurers that buy material amounts of reinsurance to meet their regulatory requirements. These companies tend to be consistent buyers and are less price sensitive than their larger counterparts.

The fund currently has a portfolio of around 1,500 different contracts from a range of clients, which means that there is significant diversification.

Blue Capital Management Limited, the investment manager, is a wholly owned subsidiary of Sompo International, an insurance company that is now part of Sompo Holdings Inc. Sompo International provides around 35% of the fund’s invested assets (capped at 50%) with the rest sourced from a variety of different insurance brokers. It also has a strategic investment of 28% of the fund’s shares.

Sompo International is a well-funded company with shareholders’ capital of just over $5bn and was responsible for writing $4.2bn of premiums in 2016. It is a global specialty insurer and reinsurer with a strong historical financial performance, although you would need to feel comfortable with the counterparty risk before investing in the fund.

Reinsuring the insurers

BCAI’s average sized client has $250m of shareholder equity. These companies insure a geographically well spread book of risks that helps to minimise the potential loss from a large catastrophic event like a Florida hurricane.

One of the features of the managers’ approach is that they try to visit each of the insurers that they reinsure once or twice a year. This helps them to establish a strong ongoing relationship with their clients and enables them to build up a better understanding of the underlying risks.

The majority of the portfolio consists of first event property catastrophe cover. This covers the first wave of a catastrophe loss that an insurer is responsible for rather than multiple events that take place within the same area during the contract period.

There is no obvious benchmark for this sort of business, although the management targets returns of 6.4% to 10.4% per annum on the underlying underwriting activity. They have achieved this in each of the four calendar years since the fund was created and it has meant that they have been able to generate steady growth in the NAV.

Their approach differs to that of the CATCo Reinsurance Opportunities fund that uses catastrophe bonds. These tend to have binary outcomes, as if all goes well the investor receives the coupon payments and their capital back at maturity, but if the parameters of the bond are triggered there is risk that they could lose all of their capital and the remaining coupons.

The potential impact of a large catastrophic event

The managers of the fund have modelled the potential impact of a catastrophic event on the likely returns. They have done this by taking some of the largest losses in history, revaluing them and overlaying the results on the portfolio.

Their analysis suggests that if there are no losses affecting the portfolio in 2017 the fund would return 14.2%. Most large single-loss events modelled from the historic data would still result in a positive NAV total return for the year. The biggest exceptions would be a repeat of Hurricane Andrew from 1992 or the Miami Hurricane from 1926 that would result in likely losses of 15% and 22% respectively.

Analysis suggests that if there are no losses affecting the portfolio in 2017 the fund would return 14.2%.

They have also modelled the probable maximum loss that they would expect to face in the event of each of the natural catastrophic events that the fund is exposed to. These are extreme outcomes based on one-in-a-hundred-year events.

Most would result in a loss of less than 13.3%, with the worst outcome being a large Hurricane hitting Florida that could wipe out 31% of the fund’s net assets. This significant exposure reflects the fact that the managers think that Florida is the best priced risk area in the world and is a deliberate strategy rather than an inadvertent risk.

Solid performance record

Between the inception of the fund in December 2012 and the end of April 2017 the shares returned 46%. According to the latest factsheet, 94.2% of months have seen a positive return, with the best being a gain of 3.2% and the worst a loss of 1.8%. The annualised standard deviation of these returns has been a remarkably low 3.4%.

The steady gains have been achieved despite the occurrence of a number of catastrophic events over the period. In fact last year’s loss activity was the worst since 2012 with the fund suffering a reduction in returns of 3.4% as a result of events like Hurricane Matthew, the Canadian wildfires and Japanese earthquakes.

Up to and including 2016 the fund paid dividends twice a year, but at the start of 2017 it switched to quarterly distributions. The first of these was set at $0.0165 and if maintained for the full 12 months would result in the same annual dividend as was paid last year of $0.066. Based on the current share price of $1.01 this would give the shares a prospective yield of 6.5%.

The annual management fee is 1.5% of net assets per annum and there is also a performance fee of 15% of returns over LIBOR plus 8%, subject to a high-water mark. This equates to ongoing charges of around 1.75%. BCAI has net assets of $199m and publishes its NAV on a monthly basis. No leverage (gearing) is allowed for investment purposes.

Blue Capital Alternative Income is a complicated fund and you should only consider investing if you understand the risks and are comfortable with them. Sophisticated investors who fall into this category will not find many other uncorrelated sources of high yield that are available on a 9% discount.

Comments (4)

  • Andy says:

    Be very careful about investing in an investment trust like this – it’s not like most trusts. Yes, it’s fairly non-corrolated, but the track record does NOT predict the future.

    They mention modelling of loss scenarios – but modelling cat losses is by no means a perfect science. Especially in the USA where it’s worth knowing that the Insurance Commissioner is an elected post. So guess who’s side he’s likely to be on post loss? And he’s quite likely to know v little about insurance – I remember being approached by a US insurance commissioner asking if a (by then bankrupt) insurance company in the territory could retroactively buy more cover after the windstorm had wiped them out……

    And, do remember that it’s quite possible for there to be more than 1 cat in a year – Florida hurricane, Tokyo EQ, European windstorm etc.

    I’ve just looked at a list of the top 25 international reinsurers – no mention of Sampo (although some of their business is probably being counted as Lloyds).

    I’m not saying that this is a bad investment – but view it as pretty high risk and don’t bet the ranch…… The people who are doing very well out of this are the various managers etc. I’m not remotely tempted by a 6.5% return – and I’m not in the slightest bit risk averse……

    • Nick Sudbury says:

      I agree that no track record can predict the future, it is just an indication of the sort of returns that the fund is capable of producing. Also, no financial modelling is perfect, but it is the only way that the managers and investors can assess the possible risks. The only point that I would make is that there have been a number of major catastrophes that the fund has been exposed to and they haven’t derailed the performance.

      The high yield provides an indication of the risk and it is just a case of whether you feel that the likely return compensates for the risk of loss. The main reason that I highlighted the fund was that there are very few high yielders available on a discount and that many traditional sources of income have been pushed to such high valuations that they would be vulnerable in the event of a market correction. This one is a lot less correlated than most.

  • Peter Parker says:

    15% of total returns (including yield) or 15% of any increase in nav. I’m not quite clear.

    • Nick Sudbury says:

      The Manager is entitled to an annual performance fee equal to 15 per cent. of: (a) the aggregate appreciation in the NAV of the Master Fund shares held by the Company (excluding special memorandum account shares) over the previous high water mark; less (b) the performance hurdle of LIBOR plus 5 per cent. on
      the starting NAV of the Master Fund shares held by the Company, provided that the performance fee shall not be less than zero and provided further that no performance fee will be payable in a performance period unless the performance trigger of LIBOR plus 8 per cent. on the starting NAV of the Master Fund shares held by the Company during the performance period has been reached.

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