Hurricane Milton Threw A Spotlight Onto Catastrophe Bonds

Catastrophe bonds (cat bonds) are financial instruments that transfer the risk of natural disasters from insurance companies to investors, who receive higher yields in return but risk losing their principal if a specified catastrophe occurs.

With their low correlation to traditional asset classes and their potential for consistent, attractive returns, cat bonds could help improve the risk/return profile of a typical investment portfolio.

There are no ETFs or index funds that specifically track cat bonds right now, but you can gain exposure to those assets through specialist mutual funds, which allow for diversification without the need to access the institutional market or manage individual bond positions.

If you’ve been keeping up with market news lately, you’ve probably heard something about catastrophe bonds and Hurricane Milton. The storm was predicted to be Florida’s worst in a century, with experts bracing for major damage – and investors bracing for losses on a type of investment that’s been gaining popularity in recent years. Luckily, the storm wasn’t as bad as expected. So now that the skies over Florida have cleared, let’s dive into what those bonds are all about…

What are these bonds?

Catastrophe bonds (or “cat bonds” for short) are a way for insurance companies to protect their bottom lines in the event of a major disaster, like a hurricane or an earthquake, by transferring some or all of the financial risk to investors. When an insurance company issues a cat bond, investors fork over money in exchange for interest payments (called coupons, just like with any bond). More specifically, they get paid a floating coupon – that is, one that moves in line with the overall level of interest rates in the economy – and a premium for taking on the catastrophe risk to boot.

Each security will detail a specific potential disaster – right down to its severity – in the terms of its contract. If it happens and causes losses that exceed a certain amount, the insurance company can use the money investors paid to help cover the cost of the claims. In that case, investors might lose some or all of the money they paid for the cat bond, but they’ll still keep all the interest payments they received until the catastrophe hit. If the specified disaster doesn’t happen during the bond’s term, the insurer has to return the principal (i.e. the borrowed amount) to the investors.

In essence, cat bond investors are betting that a major natural disaster won’t happen. If it does, they stand to lose some or all of their money. If it doesn’t, they earn an interest rate that’s typically higher than most other types of debt. Some of the biggest bets focus on high-speed wind storms (especially in Florida) and earthquakes, but there’s growing demand for cat bonds that cover wildfires and flash floods, which have been happening more frequently because of climate change.

And, yeah, they’re popular: in recent years, as bond markets around the world got hammered by rising interest rates, these debt instruments kept on shining. The Swiss Re Global Cat Bond Index is up 46% since the start of 2020, outperforming the SPDR Bloomberg Global Aggregate (made up of investment-grade government and corporate bonds) by more than 50 percentage points.

What’s the appeal of catastrophe bonds?

They improve portfolio diversification.

Cat bonds offer diversification benefits since their performance is generally not correlated with traditional assets, like stocks or regular bonds. They’re driven, after all, by hurricanes and earthquakes and the like, not by market rallies and crashes. Cat bonds benefitted from this lack of market correlation in recent years, delivering strong returns even as stocks and government bonds fell in tandem.

Because of that low correlation to traditional asset classes, a cat bonds allocation could generally improve the risk/return profile of a typical investment portfolio. In fact, incrementally adding 5% allocations to the traditional 60/40 (stocks/bonds) portfolio has been shown to decrease risk and increase return – so long as you don’t go overboard with it.

They offer attractive risk-adjusted returns.

Cat bonds’ primary return comes from their high yields, which tend to be bigger than those found on traditional bonds to compensate for their unique risk (namely, disaster risk).

As of the third quarter of 2024, the average coupon on these bonds stood at 9.2%, according to data provider Artemis, while expected loss stood at 1.6%. The latter is an estimate of the potential losses on the cat bonds due to qualifying catastrophic events. It represents the average annual loss anticipated over the life of the bonds, based on historical data and modeling of potential future events. Subtracting one from the other gives you 7.6% as cat bonds’ net yield – almost four percentage points higher than you’d get on 10-year Treasuries today.

The Swiss Re Global Cat Bond Index has had just one negative year in its 23-year history – and that was in 2022 when Hurricane Ian caused about $60 billion in insurance losses in Florida. The silver lining to that event was a significant repricing of disaster risk, which meant that cat bonds introduced afterward offered higher yields. That partly explains why the Swiss Re Global Cat Bond Index had its best year on record in 2023.

They can hedge against periods of market turmoil and/or rising interest rates.

With a cat bond, you get paid a floating coupon – the kind that moves in line with the overall level of interest rates in the economy. So when interest rates are heading higher, these bonds should fare relatively well because the coupons they pay investors will also go up. That makes them a good potential hedge against rising interest rates, which, as we’ve seen over the past few years, can lead to heavy losses in both the stock and bond markets.

Higher interest rates might not be a worry now, with many of the world’s central banks looking to lower rates rather than hike them. But volatility may be a concern. Cat bonds aren’t driven by economic or corporate news, but instead move independently of mainstream assets – which makes them an attractive buy for investors who want to shield against the market’s ups and downs.

What are the risks?

Your biggest worry with cat bonds is event risk. If the specified catastrophic event occurs and meets the predefined criteria in the bond’s terms, you could lose some or all of the money you’ve invested in it. That risk is not something to sneeze at these days. Climate change means weather disasters are more common. Plus, insurance losses have been creeping up as more events hit densely populated areas and as inflation drives up the cost of repairs.

Take Hurricane Milton, as an example. The storm is estimated to have caused up to $60 billion in damages, according to early figures. That would make it one of the costliest storms in US history, with a portion of those losses expected to be covered by cat bonds.

You should also be aware of two other big risks. First is liquidity risk: the cat bond market is less frequently traded than traditional securities markets, which might make it harder for you to sell your positions. Second is counterparty risk: there’s a chance that the counterparty (the insurance or reinsurance company) might default on its obligations – especially following a major catastrophic event that leads to heavy insured losses.

You can reduce some of your risk, just like you would with other asset classes, with proper diversification. That means investing in multiple cat bonds, encompassing different disaster categories, regions, and issuers. Over its 23-year history, the Swiss Re Global Cat Bond Index’s maximum drawdown was just 10%. Compare that to the S&P 500 which saw a max drawdown of 57% during that time, or global bonds, which saw a 26% drop.

How do you invest in catastrophe bonds?

The easiest way for a retail investor to gain exposure to these assets is through investment funds. While there are no ETFs or index funds that track the Swiss Re Global Cat Bond Index yet, several specialist mutual funds focus purely on cat bonds. By investing in those funds, you can achieve diversification across various cat bonds without the need to access the institutional market or manage individual bond positions. Schroders and GAM Investments run the biggest cat bond funds, according to Morningstar.

As always, do your own research before investing.