Cat bonds – is Mother Nature a better bet than Bernanke or Abe?

Amid the uncertainty about when the Fed will start to taper and whether the BOJ will further widen its tap, surely some of you must have been approached by your bankers to look at cat bonds – short for catastrophe bonds. Well at least, some of these literature flew my way recently, so allow me to share the little I’ve gathered.

Cat bonds are akin to bonds with embedded American call options where the coupons are stripped from insurance premiums and the triggers are marked by catastrophic events which can of course strike at random. They are generally issued by insurance companies who may have reasons at times find the capital market a better place to reinsure their exposures than going to reinsurers. There is no stopping anyone from issuing a cat bond of course. Hence, automotive companies and even a sovereign – Mexico – have issued cat bonds before. The first cat bond was issued back in 1996. It was however only in the past decade that they have become more popular, especially among long-term institutional investors. Hence, the lead players like Swiss Re have come up with indices to track cat bonds’ performance.

So those who have come across cat bond brochures would have seen charts like those below, showing how cat bonds have outperformed other asset classes, ranging from equities, hedge funds to private equity.

These charts make cat  bonds look great, especially accompanied by recent news article like this one from the FT a few days ago: Catastrophe bonds prove anything but a disaster.

Then come today, a splash by Berkshire Hathaway‘s Gen Re CEO that warned investors about the perils of investing in cat bonds: Drooling cat-bond investors overlook risk.   As can be seen, the cat bond market is somewhat in competition with the reinsurance market. So you may question if the comment above is spoken from a biased perspective.

So who is right? Well, it depends. Cat bonds have clearly the “lottery” element to them – i.e. risks which might not be calculable. As a matter of fact, I can see at least one cat bond which was issued against “lottery winnings”. See the Artemis‘ directory of cat bonds . So how did these cat bond indices such as the one by Swiss Re show such stellar high return/ low risk performance?

There are two reasons. Firstly, catastrophes most times are uncorrelated – a nuclear reactor disaster in Fukusima is not going trigger a similar event elsewhere. Hence, the cat bond indices are capturing very nicely uncorrelated events which help to reduce the volatility of the portfolio. Secondly, a cat bond coupon is extracted from insurance premiums which are put into a special purpose vehicle (SPV) to invest in some super safe assets such as money market funds or supranational bonds to generate the high yields for the cat bond investors. Typically, a cat bond is issued “after” an event which would have jacked up premiums but somehow, the insurer fearing a recurrence of this 1-in-1oo event may choose to issue a cat bond to reduce its exposure. If this cat bond has a 10-year maturity, investors are thus made to believe that their risk is just 1/10th of the 1-in-100 chance of the event occurring, i.e. 0.1%. However, should it happen, the investors could face early redemption with a partial or no repayment of principals. This is not to mention that it often takes time for the insurer to assess the scale of the damage, which is why some cat bonds have “extendable” option.

Hence, on a standalone, cat bonds are high risk. In fact, they should be seen like junk bonds which is why they are usually rated as BB. Bundled together, they become a well diversified portfolio offering high return/ low risk and better still, with performance totally uncorrelated to the mainstream financial markets such as S&P or treasuries.

Take a cat nap on this first before you chew.