Buying bonds that insure against the extremely unlikely possibility of a specific catastrophic financial event can prove to be a very profitable investment and an ideal portfolio diversification move. I’m talking about cat bonds. Here is probably the first article you have ever read on the subject. Enjoy! Words: 821
Dr. John Seo, Co-Founder and Managing Principal of Fermat Capital Management, LLC (www.FMC.com), made a presentation on the subject of cat (catastrophe) bonds at IMN’s The 11th Annual Canada Cup of Investment Management held recently in Toronto which I had the pleasure of attending again this year as a representative of Seeking Alpha.
This article contains components of Seo’s presentation, my conversation with him, material from a newspaper article on the subject (see here) from a few years back and my understanding of this unique way to make money from potential catastrophes.
Cat Bonds: What are They?
Cat bonds (catastrophe bonds) are insurance-linked securities (ILS) that transfer insurance risk of natural catastrophes to the capital markets. In effect, capital market participants are paid by re/insurers to take insurance risk off their balance sheets. These ILS are offered to investors at attractive yields – typically 5 –15% over Libor – in exchange for bearing the risk of losses triggered by well defined events. Currently, the cat bond market is estimated at $12 –15 billion.
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Expressed another way, as Michael Lewis said in a 2007 The New York Times article entitled In Nature’s Casino, cat bonds are insurance “against potential losses from extremely unlikely financial events, or ‘tail risk’ as it is known to quantitative traders for where it falls in a probability curve. Tail risk, broadly speaking, is whatever financial cataclysm is believed by markets to have a 1%, or less, chance of happening.”
These abovementioned ‘extremely unlikely financial events’ cover such things as hurricanes, earthquakes, tornadoes, tsunamis, flash floods, widfires, extreme winter storms and as Lewis says “an unpleasant phenomenon delicately known as ‘extreme mortality’ which, more roughly speaking, is the possibility that huge numbers of insured human beings will be killed off by something like a global pandemic.”
The pricing of the possible cost of such an extreme event as mentioned above differs from peril to peril and is known as “pricing tail”. Pricing is not based on what has happened when and where in the past but on models that develop detailed probability analyses of what conceivably might happen in the future in tens of thousands of specific locations and what the financial implications (losses) would likely be for each location as a result.
“Catastrophe risk is fundamentally different from normal risk,” writes Lewis. “It deals with events so rare that experience doesn’t help you much to predict them. How do you use history to judge the liklihood of a pandemic killing off 1 in every 200 Americans? You can’t. It has happened only once (the Spanish flu epidemic in 1918). You lack information. You don’t know what you don’t know. The further out into the tail you go – the less probable the event – the greater the uncertainty. The greater the uncertainty, the more an investor should be paid to live with it” hence the sizable yields of cat bonds.
Cat Bonds: Why Invest in Them?*
- Alpha: Offer an attractive risk premium, which may allow for a better risk/return profile than other asset classes
- Uncorrelated asset class: Have no or very low correlation with other assets
- Tail independence: Diversification effect and downside protection persist in times of market stress
- Growing market: Approximately 20% p.a. growth over the last decade with expectations of strong growth to continue
- Liquidity: Sophisticated secondary markets
- No duration risk: Typically structured as floating rate notes
Cat Bonds: Characteristics and Benefits*
Minimal Interest Rate Risk: Significant coupons averaging 7-9%
Low Correlation: Uncorrelated to traditional asset classes (0.15 vs. S&P 500*; 0.13 vs. Citigroup World Government Bond Index*)
Highly Liquid: High degree of underlying liquidity, structured as 3-5yr floating rate bonds
- Minimal Credit Risk: Bonds collateralized with cash or treasuries.
Source: GAM *Swiss Re BB Rated Cat Bond Total Return Index in USD. January 4, 2002-March 31, 2012. Past performance is not indicative of future performance.
Cat Bonds: The Investment Opportunity*
- A specialist asset class offering genuine diversification
- Minimal exposure to credit risk
- Low exposure to interest rate risk
- Low exposure to financial market risk
- Relatively young and inefficient market
- Attractive risk-adjusted returns vs other asset classes
Asset Class Performance Comparisons: Returns (% p.a.)/Std. Dev. (% p.a.)
- High Yield Bonds: 8.79%/12.43% (Credit Suisse High Yield Index)
- Global Equities: 0.35%/19.49% (MSCI World Index )
- Gov’t Bonds: 7.91%/7.93% (Citigroup bWorld Government Bond Index)
- Cat Bonds: 8.50%/3.61% (Swiss Re BB Rated Cat Bond Total Return Index)
Source: Bloomberg, CS First Boston Corporation, MSCI, Thomson Reuters
Some investors may not see the appeal of an investment whose first name is catastrophe thinking of cat bond investing as just gambling. As Seo sees it, however, “That’s what investing is – but cat bond investing is gambling with the odds in your favor.” Interested?
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