- Catastrophe bonds, or cat bonds, have enjoyed a perfect storm of conditions that are leading to a banner year.
- According to the Swiss Re Cat Bond Price Return Index, year-to-date returns are clocking in at 16.5%.
- “It appears that if things go the way we think they might go, you might very well be looking at a record return of cat bonds this year.”
It’s been a tough few months for the bond market as persistent inflation, a ballooning federal deficit, and a debt downgrade have slammed Treasurys.
But catastrophe bonds, or cat bonds, have enjoyed a perfect storm of conditions that are leading to a banner year.
“It appears that if things go the way we think they might go, you might very well be looking at a record return of cat bonds this year,” Emmanuel Modu, managing director at insurance credit rating agency AM Best, told Insider.
So why are cat bonds so lucrative now?
That’s in part because cat bonds promise a high return if a certain natural catastrophe doesn’t happen. If the said disaster does occur, however, then the issuer uses investors’ money to help pay out claims.
While there have been 24 climate disaster events in the US this year, with losses exceeding $1 billion each, many haven’t been severe enough to trigger payouts. According to the Swiss Re Cat Bond Price Return Index, year-to-date total returns are clocking in at 16.5%, on track for a new high unless a catastrophe occurs in the next few months.
In addition, cat bonds are largely insulated from other forces moving markets — like virus outbreaks, bank failures, or wars — and price fluctuations don’t always mean yield fluctuations.
Another reason is that money invested in cat bonds goes into Treasurys. And as US yields have been going up, returns on cat bonds have been too.
Cat bond yields have also been on the rise because investors demanded higher risk premiums to make up for the increased frequency of severe storms and wildfires over the past several years, according to a Moody’s note last month.
Why investors buy cat bonds
Insurers and reinsurers often issue cat bonds to de-risk themselves. And with the climate threat growing, cat bond issuance this year reached $10.3 billion by the middle of August, above the $10 billion for all of 2022, according to Moody’s. The market is on track to eclipse the record high of $13.9 billion in 2021.
Meanwhile, cat bonds’ loss multiple, or the amount of money you could make versus the amount of money you could lose, has become more attractive for investors.
“Loss multiples have more than doubled since 2021, which is a pretty big deal, actually,” Modu said.
Many investors are hedge funds, pension funds and other institutional investors. And they are looking for assets that won’t swing in line with the broader market.
“Interest rate movements don’t cause hurricanes,” Jeff Mohrenweiser, senior director at the Fitch rating agency, told Insider. “So they’re somewhat independent and that’s attractive to investors because now they can put some non-correlated or diversifying risk into their portfolio.”
To be sure, cat bonds are typically considered junk bonds, he added, explaining that they’re below investment grade because the probability of default is much higher compared to an investment-grade bond.
But Modu thinks investors are getting concerned about the effect of climate change on returns in the broader insurance-linked securities market.
“So therefore, to avoid it, some investors are kind of flying to quality effectively,” he said. “And quality is cat bonds.”
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