As the hedge fund market continues to evolve, new investment opportunities are evolving with it.
Cat bonds, despite their name, are not related to felines. Instead, cat bonds or catastrophe bonds as they are formally called, are a crucial link in the reinsurance markets. Cat bonds were invented in 1993 by executives at Hanover Re, but were slow to gain traction for more than a decade. All of that changed around 2008, when virtually every other financial asset melted down, cat bonds gained an average of 2.85%.
The reason for that effective performance during the recession is that the bonds’ value are based on natural disasters and other insured phenomena that are uncorrelated to traditional financial markets. In particular, cat bonds pay investors a traditional coupon every year. However if a particular event occurs which is pre-specified in the bond language, investors are on the hook for the losses.
For instance, if a severe hurricane occurs, a cat bond investor may lose some or all of the initial funds invested in the bonds. The bonds are not merely limited to hurricanes and storms though – there are cat bonds related to too many people dying from pandemics, and bonds related to people not dying soon enough from natural causes. There are cat bonds related to railroad accidents, plane crashes, and typhoons. In some sense, litigation finance is merely a special form of cat bond with a reversed payout structure.
In addition to the uncorrelated nature of the bonds, cat bonds have traditionally been a very lucrative business. Traditional reinsurance providers have typically aimed to earn returns of around 16%. Cat bond yields vary, but even in today’s market with numerous institutional investors chasing yield, the bonds are still yielding 6% or more. By comparison, another staple group among pensions, municipal bonds, are yielding less on average than at any time in the last 20 years. Some riskier cat bonds yield far more though – bonds I have reviewed for valuation on behalf of clients in recent months have sometimes yielded 10-12% or more.
Cat bonds have many positive qualities including effective diversification benefits in most portfolios. Yet there are important features that investors and those advising investors need to be aware of. For instance, due to the high yields they carry investors are often seduced into believing they can earn significant alpha (i.e. excess returns versus traditional financial markets which are not justified by the risks being taken). That assumption is dangerously naïve. Cat bonds are especially complex to value which compounds the issue.
The problem with valuation of cat bonds is that the risk of an adverse event can be very difficult to calculate. While traditional bonds are fairly straightforward to value, valuing cat bonds requires an understanding of not only statistics and actuarial concepts, but also correlations between events, relationships between cat bonds and financial markets, and financial assumptions on loss-given-defaults.
Needless to say, most hedge funds and institutional investors wisely employ outside consulting firms to help them determine these values, and most reputable cat bonds these days are sold with an additional independent valuation report included in the documentation.
On the whole, the important point for investors and their advisors to remember with instruments like cat bonds is simply this; in financial markets it often pays to think differently than others do, but careful thinking about the details behind such thinking is a necessity.
Mike McDonald is a PhD in finance and a university professor in the subject at Fairfield University in Connecticut. He also runs a consulting company doing work on quantitative investing, big data, and machine learning for a variety of financial firms, asset managers, institutional investors, and government regulators. Prior to getting his PhD, Mike worked for a major Wall Street bank and one of the top hedge funds. Comments, questions, and concerns are always welcome – email Mike at M.McDonald@MorningInvestmentsCT.com or visit his firm’s website at www.MorningInvestmentsCT.com