CAT Bonds Analyzed From The Investor's Perspective

by: Stefano De Caterina

Summary

1. What are they ?

2. How and when did they emerge ?

3. What are the major advantages for investors ?

4. Conclusion.

1. What are they?

Catastrophe bonds also known by their abbreviation as CAT bonds fall into the broader category of Insurance Linked Securities (Pending:ILS). ILS are financial instruments that transfer certain types of insurance risk, mainly property related, from the insurance market to the capital markets where the insured risk is spread among investors.

There are three main types of ILS: Catastrophe Bonds (CAT bonds), industry loss warranties (ILW) and collateralized reinsurance. Among them, CAT Bonds are the only financial instruments that are securitized and traded on a secondary market, whilst ILW and collateralized reinsurance are private transactions which cannot be traded in any secondary market and therefore they are by far less liquid.

They also differ in terms of minimum investment size with CAT bonds usually requiring a minimum investment size of 250,000 USD whilst ILS and collateralized reinsurance requiring a much bigger initial investment amount which may range from 2 to 5 million USD.

Cat bonds return on investment is tied to the occurrence of predefined catastrophic events, such as earthquakes, hurricanes, or floods. In case nothing happens, the investor receives a floating coupon plus the principal at the bond maturity. Conversely, if the event specified in the contract occurs, the investor incurs a partial or total loss of principal depending on the size of damages caused by the catastrophic event.

Cat bonds offer investors a high-yielding fixed income asset class whose returns are independent from macroeconomic risks and cycles.

Table 1. ILS classification.

How and when did they emerge?

The market opportunity for CAT bonds emerged in the mid-1990s, in the aftermath of hurricane Andrew (1992) and the Northridge earthquake (1994). These two natural catastrophes caused together property damages of 41 billion USD with a severe impact on the finances of the insurance industry which realized the need to resort to financial markets in order to reinforce its capital base. Since then CAT bonds market has grown exponentially.

What are the major advantages for investors?

Diversification

CAT bonds returns are related to factors such as meteorology, geology or engineering and, as such, they are unrelated to the economic cycle. As a result of that, CAT Bonds as shown in the table 2 below sport a very low correlation to other traditional asset classes (i.e. equities, bonds and commodities) thereby bring to the investor's portfolio a high degree of diversification.

Additionally, CAT bonds are characterized by a high level of intra-class diversification given by their correlation to different and independent risk factors arising in different parts of the world (i.e. earthquakes, tsunami, tornados, floods, etc).

Table 2 CAT Bonds market correlation

As shown in the table 3 below CAT bonds improve a portfolio's risk statistics such as volatility, value at risk and worst month return by increasing at the same time its average return. For this reason, CAT bonds should be present in any portfolio where a diversification from traditional market risk is desired.

Table 3 - Risk statistics

Immunity to potential rate hikes

In the current environment of record low interest rates, CAT Bonds pay a floating coupon and therefore they are largely immune to potential rate hikes which in the US, based on the current analysts' consensus, could happen most likely already next December.

In case of a rate hike, the money market component of the coupon will be adjusted upward thereby offering the investor a powerful shield against possible increasing rates scenarios and inflation. As showed in the table 1 above, the average yield of most CAT bond issuances falls in the range of 5% - 10% which is very appealing considering the current low yields of fixed income.

Over the past decade CAT bonds yields have beaten junk-rated debt by roughly half a percentage point and high-quality securities by some 3 percentage points.

Performance

Over the last 15 years, CAT Bonds have yielded very steady returns, only suffering mild volatility, also during difficult market conditions such as the occurrence of hurricanes and earthquakes. As shown in the table 4 below, these steady returns have so far translated in a risk-adjusted performance (measured by the Sharpe ratio) that is superior to that of bonds, equities or commodities. The annualized return over the observed period is also higher than that offered by the other traditional asset classes whilst the annualized volatility is by far lower.

Table 4 - CAT bonds performance

Conclusion

Connecting capital markets with insurance industry, CAT bonds offer institutional investors a great portfolio diversification with a very appealing risk/return profile.

Notwithstanding small investors today don't have yet direct access to CAT bonds they should understand and know them anyway since their retirement money might have been already invested in them through pension funds which represent one of the biggest investors in CAT Bonds.

Having said that, it would be desirable that in the foreseeable future this asset class be also accessible to individual investors through mutual funds and ETFs.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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