Catastrophe bonds, also known as cat bonds, are experiencing a remarkable year due to a combination of favorable conditions. The Swiss Re Cat Bond Price Return Index shows that year-to-date returns have reached an impressive 16.5%.
The bond market has faced numerous challenges in recent months, including persistent inflation, a growing federal deficit, and a debt downgrade that has adversely affected Treasurys.
Despite these difficulties, cat bonds have thrived thanks to a perfect storm of circumstances. Emmanuel Modu, managing director at insurance credit rating agency AM Best, believes that this could lead to a record return for cat bonds this year.
So, why are cat bonds so lucrative at the moment? One reason is that they promise high returns if a particular natural catastrophe does not occur. However, if such a disaster does happen, the issuer utilizes investors’ funds to cover claims.
Although the US has already seen 24 climate disaster events this year, each causing losses exceeding $1 billion, many have not been severe enough to trigger payouts. Consequently, the year-to-date total returns, as measured by the Swiss Re Cat Bond Price Return Index, are on track to set a new record of 16.5%, unless a catastrophe occurs in the coming months.
Moreover, cat bonds are relatively insulated from other market forces such as virus outbreaks, bank failures, or wars, and their price fluctuations do not always correspond to yield fluctuations.
Another contributing factor to cat bonds’ success is that the money invested in them is directed to Treasurys. As US yields increase, so do cat bond returns. Additionally, investors demanded higher risk premiums for cat bonds due to the rising frequency of severe storms and wildfires in recent years.
Insurers and reinsurers often issue cat bonds to reduce their exposure to risk. Moody’s reports that cat bond issuance reached $10.3 billion by mid-August, surpassing the $10 billion issued in all of 2022. The market is set to surpass the record high of $13.9 billion in 2021.
Furthermore, investors find cat bonds appealing due to their attractive loss multiple. This metric compares the potential gains to potential losses. According to Modu, loss multiples have more than doubled since 2021, making them an important consideration for investors.
Hedge funds, pension funds, and other institutional investors are among the major buyers of cat bonds. They seek assets that are not strongly correlated with the broader market. Changes in interest rates, for example, do not cause hurricanes, making cat bonds an attractive diversifying investment.
Despite their appeal, it’s worth noting that cat bonds are typically classified as junk bonds because their probability of default is greater compared to investment-grade bonds, according to Jeff Mohrenweiser, senior director at Fitch rating agency.
However, Modu believes that investors are becoming more concerned about the impact of climate change on returns in the broader insurance-linked securities market. As a result, some investors are flocking to cat bonds as a way to avoid potential losses and preserve quality in their portfolios.
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