As bond markets everywhere get battered by a cocktail of higher interest rates, deficit angst and hawkish central bankers, one class of debt instrument is handing creditors double-digit returns: catastrophe bonds.
Investors in the $40 billion market for so-called cat bonds have literally been sitting out the storm to reap returns as high as 16% this year. Because of the way the bonds are structured, their coupons keep going up as Treasury yields rise, and investors get a sizable risk premium on their capital, as long as catastrophe doesn’t hit.
It’s a dynamic that’s caught the attention of a growing number of asset managers and issuers. Andy Palmer, who’s in charge of structuring cat bond deals for Swiss Re in Europe and Asia, says this year’s issuance through September climbed 27% to $10.2 billion from the same year-earlier period. He describes the mood in the market as “buoyant.”
Big reinsurers like Swiss Re and Munich Re, as well as some real-economy companies, have increasingly looked to cat bonds as they try to protect themselves from once-in-a-lifetime disasters. In July, Blackstone Inc. turned to cat bonds to shield property assets from natural-disaster losses. And Google parent Alphabet Inc. has issued them in case its California operations get hit by an earthquake.
Asset managers, meanwhile, are lining up to get access to outsize returns. They also like the portfolio diversification that cat bonds offer, because the instruments don’t correlate with equities or other fixed-income markets. Schroders AG and GAM Investments of Switzerland run the biggest cat bond funds, according to Morningstar Inc. Credit Suisse, Amundi Asset Management and Axa Investment Managers are also active in the market.
But investors need to have the stomach for a very particular variety of risk that’s growing more pronounced in a world where weather patterns are being upended by climate change.
Cat bond investors make money so long as the specific catastrophe described in the bond’s terms — such as a hurricane, extreme flooding or an earthquake — doesn’t take place. If it does, bondholders can lose some or all of their money, which is then used to cover the cost of damages inflicted by the natural disaster.
Returns have increased because rising Treasury rates automatically pass through to the coupons on cat bonds, which are floating-rate instruments. Investors also are seeing bigger premiums for taking on the growing risk of severe weather events. And the terms that define a trigger event have tightened.
“There’s been a repricing of catastrophe risk around the globe, especially in places like California, Florida and Australia,” said Steve Evans, owner of Artemis, a firm that tracks the cat bond and insurance-linked securities market. “The return potential has roughly doubled in the last decade.”
Here’s How Cat Bonds Work:
A reinsurer or company issues a bond when it wants to spread the risk of a particular disaster to capital market participants. Investors are paid out in full provided the event — which is carefully defined in terms of severity or impact to the sponsor, or to metrics such as exact wind speeds — fails to materialize. Some of the biggest bets focus on high-speed wind storms, especially in Florida. If the defined catastrophe does occur, investors can lose some or all their money. The insurance company then uses the forfeited funds to help pay claims.
Investors get paid a floating coupon — often based on US Treasury rates — plus a premium for taking on the catastrophe risk. On that basis, the total return of the Swiss Re index rose to 7.55% in mid-May from 5% at the end of the first quarter, marking the highest annual return in a decade. Now average returns are exceeding 16%, according to Swiss Re.
Just a year ago, the investment case was less sound. Returns had ranged between 2.8% and 5.8% over the 2018 to 2021 period, according to the Swiss Re cat bond index. The mood shifted in 2022 when Hurricane Ian struck Florida, causing more than $50 billion in insurance losses.
Several investors lost money and the deal size shrank.
“It was a pretty big event,” said Paul Schultz, chief executive of Aon Securities, an investment bank that organizes cat bond deals.
Property damage following Hurricane Ian in Venice, on Sept. 29.
Overall, rising inflation, higher currency-related costs and the impact of Ian “caused a significant repricing of risk,” Schultz said.
And that repricing has galvanized the market.
This year, cat bond investors have mostly been spared major trigger events. Analysts at Citigroup Inc. estimate total insured losses in the third quarter reached about $17 billion, which is less than normal “for this active period,” according to a recent client note.
For now, many of the models underpinning the terms of catastrophe bonds focus on big hurricanes and earthquakes. But investors and issuers are going to need to figure out how to come up with equivalent models for wildfires and flash floods.
“There are concerns the modeling isn’t keeping up with those risks,” said Peter DiFiore, a managing director of Neuberger Berman, which oversees about $1.2 billion in cat bond investments on behalf of clients.
Mara Dobrescu, director of fixed-income strategies at Morningstar Inc., said investors are “simply betting those mathematical models are well calibrated and correct.”
Meanwhile, the market is continuing to grow. The World Economic Forum has estimated the cat bond market will jump to $50 billion by the end of 2025.
“We’re very bullish” on cat bonds, said Palmer of Swiss Re. “It’s a very technical, complex financial product that’s not suitable for every investor, but we believe it’s a fundamental part of the reinsurance market today.”