I wrote an introduction to alternative investments here. Actually, it is more about the risks of alternatives, since the whole blog is about the pros ;).
“Catastrophe bonds (or “CAT” bonds) were first introduced to help strengthen reinsurance companies’ balance sheets in the aftermath of Hurricane Andrew in 1992. Hurricane Andrew caused over $15.5 billion in insured property loss (close to $29 billion in today’s dollars) and ultimately led to the insolvency of at least 16 insurance companies. This brought to light significant shortfalls in the industry’s resilience to infrequent, but severe, natural catastrophe events. Since then, catastrophe bonds have played an integral role in a maturing and increasingly dynamic insurance-linked securities (“ILS”) market, which has attracted the attention of institutional investors given its potential to deliver returns that are fundamentally uncorrelated to traditional financial markets”. (from here)
(Re)Insurance companies issue CAT bonds to free up capital, optimise balance sheets and write additional policies. If you are thinking about MBS…BINGO! That’s the risk, we will see it later. A less intuitive but prolific issuer since 2017 has been the World Bank, which has used CAT bonds to provide the financial capacity to respond to damages caused by certain extreme events in developing economies. A minority of bonds cover risks like mortgage insurance risk, aviation, marine, extreme mortality, life, health care and terrorist attacks.
CAT bonds are a form of risk transfer that packages different types and levels of catastrophes: bad ones like hurricanes and tornadoes and lesser ones like hail storms or certain kinds of floods.
SwissRE, the issuer of the index that tracks CAT bonds, is building its new HQ exactly in front of my gym. No sorry, exactly in front of the window in front of the treadmill I used every Sunday of the past year. I can basically tell you every engineering detail about that building because…any excuse is good to stop thinking about the pain of running.
Anyway, the tables above show you why CAT bonds are interesting. They offer high returns with low volatility (maybe not as low as stated there) and, crucially, low correlation with stocks and bonds. This should be obvious considering that CAT bond performance is driven by insurance events whereas credit and equity performance is more tightly linked to broader economic and financial cycles.
Why CAT bonds now?
Some US-based mutual funds offer this type of exposure for retail investors but recently it was announced the first ETF in this category: $ROAR, the Brookmont Catastrophic Bond ETF.
In straightforward terms, CAT bonds pay high coupons (spread at issuance are typically between 5% and 15%) and if a particular event, in a particular location, happens then the bond is cancelled, i.e. the issuer doesn’t have to repay it (not all bonds are binary though). They are floating bonds with a typical duration of 3 to 4 years. They generally do not have a credit rating due to the skewed nature of the loss distribution. Market spreads are strongly influenced by recent insurance losses: a year of high losses tends to mean higher demand for coverage and higher risk aversion from investors in the following year, leading to spreads being set wider. Seasonality is another factor, with prices normally falling in anticipation of an active hurricane season and rising when bonds come off risk at the end of the season.
The best instruments leave the issuer (the entity that is unloading the risk) with some skin in the game: the issuer should not dump 100% of a particular risk into a bond because this will lead to adverse selection (the issuer will keep for itself the risks that he likes and sell the others; in a market when information asymmetry is large, you want to avoid that). While for the untrained eye, CAT bonds might look like a straightforward instrument, the legal piece sitting behind it is extremely complex and it might therefore take some time after the trigger-event to determine the loss on the bond (in these cases, this is technically covered by the “extension period” clause included in the bond).
NatCat risk is really hard for insurers to diversify internally. That’s why CAT bonds are great instruments: they transfer risks to investors who can diversify them. Due to global warming, these risks are also going up dramatically and the U.S. hurricane and earthquake exposure is believed to be the biggest risk on the insurance industry’s balance sheet. CAT bond funds try to enhance diversification by taking small positions in many different bonds, linked to different events; as the market continues to grow, it offers more scope for diversification and portfolio customization via different regional, event and trigger-mechanism exposures.
Can an instrument designed to repay flood damages be destroyed by lack of liquidity?
CAT bonds are not liquid instruments. There are plenty of ETFs where the underlying is less liquid than the ETF wrapper but in this case we might have a real issue. Bonds, outside Govies, tend to have liquidity problems because the typical investor is the buy-and-hold type: once a bond is bought on the primary market, the buyer puts it under their mattress until maturity. 90% of the time, the lack of liquidity is a problem for buyers, who cannot find willing sellers, and the remaining 10%, the problem is the other way around. There is a piece of positive news though: with the growth of the CAT bond market, liquidity seems available but sometimes at the cost of very wide bid-ask spreads.
The prospectus indicates that the ETF will allocate at least 80% of its investments to CAT bonds…which is a common stipulation found in many prospectuses (the >= 80% allocation). It also mentions “event-linked swaps” and a few other bespoke products that might come with lower spreads but offer greater liquidity. Maybe even a 10% in T-bills could help with liquidity or, with the use of derivatives, the fund would be able to have the risk exposure and some cash for liquidity needs.
The ETF will for sure display some correlation when credit and equity markets tank because flows matter: even if the underlying asset class is behaving well, investors might need to sell to meet margin calls in other corners of their portfolios. Supply-and-demand balance normalised fast in the past, driven by opportunistic buyers, while keeping correlations low over the medium and longer term. Compared to other diversifiers like long-vol and tail risk, this is not ideal because it means investors are not 100% free in choosing the timing for rebalancing the portfolio.
If the ETF makes it to the market, it would be a very interesting instrument to study.
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