Potential for tremors in cat bond market
Despite being dismissed by Warren Buffett as a ‘fashionable asset class’ with a worsening outlook, we expect interest in catastrophe bonds to continue in 2016. Although issuances have been at roughly the same level for the past two years, at around $7 billion, the size of the market currently stands at $25 billion with steady growth expected in the forthcoming years.
Catastrophe bonds are a type of insurance-linked security (ILS) that enables re/insurers to reinsure catastrophe risk they have underwritten. Like a plain vanilla bond, they offer investors a specified coupon rate and at maturity, repayment of the principal. Where they differ is that, if a catastrophe occurs (as specified in the bond covenants) before maturity, investors will forfeit the principal and it will be used by insurers to pay outstanding claims that arise from the catastrophe.
The majority (approximately 86 percent) of perils covered by catastrophe bonds are located in the US, which is also home to 59 percent of catastrophe bond investors.
Why catastrophe bonds are attractive to investors
Although investors are liable to lose the entirety of their principal if a qualifying catastrophe occurs, the yields on these bonds tend to be higher than those of most sovereign and investment grade bonds. As these bonds are triggered by the occurrence of natural catastrophes, the credit risk of these bonds is uncorrelated with the health of the economy or financial markets. This makes them an attractive proposition for investors because it helps them to diversify the business cycle risk inherent in many of their fixed income portfolios.
The data available seems to validate these much-vaunted diversification benefits. According to Schroder’s, catastrophe bonds were one of the only asset classes that provided positive returns in 2008.
The loose monetary policy in developed economies has made it difficult for investors to generate the rates of return they were used to making before the financial crisis. Quantitative easing has led to a flow of money into sovereign debt markets and pushed yields down. This has then fed through to the corporate bond market, further reducing fixed income yields. Until recently, emerging market debt would have been a viable alternative for yield-hungry investors. However, the stronger dollar and major falls in prices of commodities over the past 18 months, combined with increasing levels of debt relative to GDP, have cast doubt on the ability of these economies to service their debts. This combination of economic trends has increased investor interest in the catastrophe bond market.
A period of change
