Catastrophe Bonds. Safe or Sorry?

As hurricane season is upon us, catastrophe bonds are in the news again. Caleb Wong and I were partners in "cat bond" investing for many years in our multi-sector bond portfolios.  These are incredibly great assets for "go anywhere" bond portfolios built by sophisticated investors.  Today, Blackrock, Neuberger and others have bond funds that utilize this sector to great effect.  Their super high yields and "AA" ratings might tempt individual investors, but the rating is deceiving.

What are they? Consider a home owner.  Most of us don't have the cash to completely rebuild after a natural disaster, like an earthquake or hurricane, so we buy homeowners insurance.  Home insurance companies, in turn, might be overexposed to many losses from a single event so they go out to reinsurers to mitigate their risk.  A really, really big event can be a big financial hit on even the biggest reinsurers.  That's where cat bonds come in.  The reinsurers issue a bond that pays an attractive interest rate.  They are strong companies so they can get a high rating on their debt, typically double-A, but there's a twist.  The bonds have a provision that if their losses due to, say, "Florida Wind" are large enough, the bondholder loses their principal investment.  Since the insurance company doesn't have to pay back the bond, the cash is freed up to cover losses.  There are a lot of nuances and different flavors of cat bonds but that's basically it.

As you can see, these bonds are potentially risky.  Why would anyone buy them?  While hurricanes happen every season, the chance that a monster storm hits a major city is less than certain.  If it happens there will be large insurance losses but, even then, the chance that that storm causes enough damage to trigger a loss event for the bonds is still small.  Even with headline-making storms a hurricane-linked cat bond probably is still okay.....probably.... Only death and taxes are certain. Losses do occur.

I am loathe to use gambling analogies when speaking of investments but there is a similarity to roulette. In this "game" red or black is a small winner but 0/00 is a huge loser. As analysts, we judge whether the odds are fair or better. California quake, Mexican quake and European wind are common perils in the cat bond space. We don't forecast weather or earthquakes. The market price of hurricane bonds goes down when a big storm is headed for Florida but they are not liquid so the indicated price might not reflect any actual trading.  What we do know is that AFTER a big disaster reinsurance premiums go up.  That is a good time to buy.  The chance of an another earthquake tomorrow is not greater but the yields will be higher.

There are some secular trends that affect how we think about cat bond prices.  Climate change might be increasing wildfire risk and hurricane risk.  You have heard that. What you may not have heard is urban development has vastly increased the value of property in at-risk areas like coasts and forests.  This has increased insurance risk more than any other factor in recent decades.

The yield these bonds offer reflect an assessment of the risk but risk management takes special skill that most bond investors don't have.  Cat bond investors have to be insurance actuaries, but not credit analysts.  Most risk managers are used to thinking in terms of normal distributions, the classic bell curve.  Cat bonds don't work that way. They have very skewed distributions, the fattest of the fat tails. There is a very high likelihood that an investor will get all of their money back and a tiny likelihood they will get nothing, but there is very little in between.  This means that common statistical measures like standard deviation and volatility are not valid for cat bonds.  Even pros make this mistake.  An investor must think carefully of how these bonds fit into the broader portfolio.

If these bonds are risky why do they merit a "AA"rating?  The rating reflects the ability of the issuer to pay according to the terms of the indenture but not the likelihood of a trigger event.  The terms specify how principal will be impaired so losing the entire principal due to an "impairment event" is not a default.  Losing principal due to the bankruptcy of the insurance company would be a default, something made less likely due the protection cat bonds give the company.

What makes cat bonds so great in multi-sector portfolios?  Diversification.  They have high yields but essentially zero correlation to other other assets, or at least the insured risks don't.  If the Fed raises rates, we don't care.  If the stock market corrects, we don't care.  When a rare impairment occurs, we treat it like the default of a corporate bond, something unfortunate but hopefully not disastrous for a well-diversified portfolio.  Sizing is key.  Florida wind risk is the risk insurers are stuffed with but we don't want our entire cat bond portfolio in only that "peril." 

Cat bonds are one of the best arrows in a multi-sector bond manager's quiver and are well worth the investment in understanding them.