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How Catastrophe Bonds Work

There are posts on this blog about bond basics, corporate bonds, and real return bonds. There is another lesser known type called as catastrophe bonds. As the name indicates, these instruments are linked to natural disaster events. This post will look at these bonds in some detail.

The Basics

Natural events such as tornadoes and earthquakes that have a low frequency of occurrence but high impact may not seem to affect the overall day-to-day movements of the stock market. However, it is possible that an individual company’s stock price could fall if a weather event destroys its property/assets in a particular region. Even so, the company is likely to recoup the majority of its losses through insurance claims.

Catastrophe bonds provide the means for reinsurance companies to minimize their risk at times of a major claim arising from natural events. A reinsurance company is one that offers insurance to another insurance company. These reinsurance companies are willing to pay a high rate of interest to bondholders to spread the risk (i.e., claim at times) of natural disasters.

To simplify the fundamentals, a reinsurance company will pay a high interest rate to bond owners to get access to their (bond) capital, which may be used by the company to pay out claims that might arise due to catastrophes. For the investor (bond owner), the high risk of a natural disaster happening (that could lead to loss of capital) is offset by the high rate of return offered by the reinsurance company.

Evaluating Catastrophe Bonds

As evident, these bonds are high risk and hence, they are rated below investment grade (BB or B). Catastrophe bonds are rated based on their probability of default, i.e., a natural calamity driving the reinsurance company to default. If a region has an earthquake every 5 years, then buying a catastrophe bond that insures a period spanning 30 years may not be a prudent investment. Also, comparison with government and/or corporate bonds will put their true investment worth into perspective by showing if the extra risk is being offset by better reward.

Investing in Catastrophe Bonds

It looks like most investments in catastrophe bonds come from institutions (the Ontario Teachers’ Pension Plan is an example). Fermat Capital Management is a company that deals exclusively in catastrophe bonds for institutional investors. Retail investors may have to turn to mutual funds such as Pioneer Multi-Asset Ultrashort Income Fund that holds catastrophe bonds to get their share.

One of the advantages of catastrophe bonds is their low or lack of correlation with the other asset classes; they are simply tied to the natural event they are protecting against. Investors seeking a high return while having the ability to stomach big losses may be interested in researching this type of bond. With climate change being a significant topic of discussion in recent years, it would not be surprising if more funds, and even ETFs, are introduced.

Do you have any more insight into catastrophe bonds? Would you be willing to buy some units if more funds were introduced? Would you use this bond as a portfolio diversification tool or consider it as a gamble?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.

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About the author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.

{ 1 comment… add one }
  • Dominique Brown September 12, 2012, 5:11 am

    It would be great to invest in catastrophe bonds if you have extra bucks to spend to make sure that your properties are protected. Though I would not consider it to be on my top priority. In my opinion, I think that institutions are the ones who will most likely benefit on catastrophe bonds should a natural tragedy occur.

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