Catastrophe bonds, a genuinely diversifying asset class

David Garcia, CFA

Associate Consultant

LCP clarity:

Catastrophe bonds offer genuine diversification benefits through low correlated returns to mainstream asset classes.

LCP insight:

Investors considering an allocation to catastrophe bonds must assess carefully the underlying risks as under certain scenarios losses can be potentially high, requiring a long-term horizon is necessary to avoid particularly unfortunate return periods.

“Don’t put all your eggs in one basket”.

How many times have we heard this saying in the world of investments? Diversification is one of the key pillars of investing, and in this article, I am going to describe how catastrophe bonds or “cat” bonds, might benefit investors through low correlation to traditional asset classes such as equities and corporate bonds.

What are cat bonds and how do they work?

Cat bonds are tradeable fixed income instruments whose performance depends upon the occurrence of pre-determined natural disasters, such as winter storms, major hurricanes, earthquakes, severe thunderstorms, wildfires, floods, etc.

The fact that cat bond prices are tied to unpredictable catastrophic events means that performance is not correlated to mainstream assets like equities or corporate bonds, where returns are more closely linked to macroeconomic factors, geopolitical issues or a company’s performance.

Investors receive periodic payments (the coupon) paid by the re/insurance company to transfer the risk during the term of the bond as long as a qualifying event has not been triggered. If the qualifying event does not occur during the tenor of the agreement, the investor will also receive the principal repayment at the end of the investment term plus any income generated by the money-market instrument. Cat bond investors take on the role of a re/insurance company, receiving premiums in exchange for accepting the risk of a loss.

Why is there a market for cat bonds?

Insurance-linked securities were firstly introduced in the early 90s following Hurricane Andrew (a Category 5 and destructive hurricane which struck Florida, the Bahamas and Louisiana) which caused large economic losses and the insolvency of a number of insurance companies. Re/insurance companies then started to transfer their risks to the broader capital market. Currently the market is around

The chart below shows indexed total returns over the last 20 years to end December 2021 for cat bonds, global equities, corporate bonds and UK property. All returns are to a hedged sterling investor.

Performance and market outlook

During the three largest market downturns (the crash of 2002, the subprime mortgage crisis of 2008 and the Covid-19 pandemic outbreak grey areas on the chart), cat bonds managed to preserve their value while showing diversification benefits in a risk-off environment. Returns have generally been significantly less volatile than equity markets. Since inception, the index has registered an annualised return and volatility of 7.4% and 3% respectively. Returns are shown to a hedged sterling investor.

Cat bond investors receive small premiums over time; however, a key risk is that a number of natural catastrophes occur at the same time (eg 2017 or 2021) which would have a material negative impact on returns. Long-term investment horizon is therefore required to accumulate small gains and outweigh losses. Our preference is investing in highly diversified portfolios across geographies, perils, triggers and structures to minimise the risk of a number of qualifying events being triggered at the same time. Investors interested in the asset class should allocate for the long term so as to avoid a particularly unfavourable time.

Over the last five years we have had a period with a number of natural catastrophe events driving available expected returns higher. A question cat bond investors should ask is whether they expect higher frequency and severity of qualifying events going forwards. Recently, the new IPCC Climate Risk Report warned that climate change risks are greater than previously thought. All in all, cat bonds investors should consider the difficulties that fund managers face when modelling such risks. More frequent and severe catastrophe events could drive expected losses higher but conversely also create an investment opportunity from risks being mis-priced.

A key ESG attribute that cat bonds present is that they have positive social benefits. Certain type of cat bonds have a pay-out mechanism that is based on fully objective and transparent measures, allowing capital to be quickly deployed after a catastrophe event hits a community or region. It is paramount that capital is quickly available so that communities can rebuild their homes and get their previous standard of living back. The World Bank issued a number of cat bonds that helped the Philippines and Mexico with financial protection against natural disaster related losses.

During 2021, cat bond demand was strong, reaching an issuance level of around $13 billion, exceeding the 2020 level.

LCP viewpoint

Our preference is investing in highly diversified portfolios of cat bonds across geographies, perils, triggers and structures to minimise the risk of a number of qualifying events being triggered at the same time.

David Garcia, CFA, Associate Consultant, LCP

Indices used:

Cat bond index: Swiss Re Global Cat Bond Index Total Return – Adjusted by 1M USD LIBOR and 1M GBP LIBOR.
Global equities: FTSE All World Total Return Index (GBP)
Global corporate bonds: Barclays Global Agg Corporate TR Index GBP Hedged
UK property: IPD Index (GBP)