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There is an interesting article in Barron's this week regarding catastrophe bonds. Basically, catastrophe ("CAT") bonds are similar to normal bonds in that you invest a principal in return for periodic coupons. Once the bond matures, you receive your principal back - hopefully. The hopefully part is where these bonds are slightly different.

Yes, with all bonds you have the risk of losing your principal, but for CAT bonds it is less about credit risk, and more, obviously, about catastrophic risk. In most cases this is a binary proposition. If there is no event, you get all your money back. If there is an event, you do not get anything back. In return you get a nice coupon to compensate for the risk you are taking. After Hurricane Katrina, one CAT bond tranche was offered by Swiss Re with an annual coupon of near 40%. In fact, CAT bonds have returned over 33% from 2005 to this May, ahead of the 19.1% offered by the Lehman High Yield Corporate Bond Index over the same time frame. A additional benefit of CAT bonds, beyond the high yields, is that their returns are often uncorrelated with the returns of other equity or fixed income investments, providing another vehicle for diversification.

Cat bonds were designed as a way for insurance companies to remain solvent if an event they insured does occurs. Insurance companies could simply buy reinsurance, passing the risk on to another insurance company, but there is the worry of too much correlation to the event.

As an alternative, they could sponsor a CAT bond. In short, the company would create a special purpose entity (yes, I know what you are thinking) that would issue the CAT bonds with the help of an investment bank. Investors would then buy the bonds and receive a coupon with a defined spread over Libor. This spread can be as little as 0.5% to 20% or more depending on the event and the likelihood of its occurrence.

Recent catastrophic events also have an impact on defining the spread. You can get a little more background on CAT bonds here and here.

Since CAT bonds often involve the creation of a special purpose vehicle, some investors are a little worried that some reinsurance companies are moving beyond their specialties. They are also concerned that by moving the risk off balance sheet, companies are preventing investors and the market from knowing the real exposure each company is taking. Cat bonds do allow reinsurance companies to survive and be less exposed if a major event does occur.

Therefore, companies are less exposed by taking out insurance themselves, but off-balance sheet items are more difficult to value and risks are less transparent. The effects on market participants, such as Munich Re, Swiss Re, Liberty Mutual, Allianz, and Hannover Re, among others, is difficult to tell. On the other hand, the benefits to the investment banks underwriting the bonds, such as Barclays Capital, Deutsche Bank, Lehman Brothers, Goldman Sachs, and Swiss Re Capital Markets, among others, is a little easier to see and quantify, along with the potential returns for institutional investors, who at this point are the only ones currently receiving CAT bond distributions.

As mentioned in the Barron's article, to date only one CAT bond has been triggered, implying a low probability of catastrophic events occurring, or at least the ones that are being underwritten. Then again, the last two years have seen a lower level of terrorist events and major hurricanes. In fact, the last two hurricane seasons, which have been forecast to be strong, have fortunately been milder than expected. This year is once again forecast to have an active hurricane season. Hopefully the forecast will be wrong again, and CAT bond investors will get a return of principal, and the people on the coasts and around the globe will be spared from another major event.

Source: Catastrophe Bonds Generating High Yields