What Are Catastrophe Bonds, and Should You Invest in Them?
Catastrophe Bonds Definition and Investing
Catastrophe bonds are insurance-linked investment securities that can be used to manage risks that are associated with catastrophic events, such as hurricanes or earthquakes. Cat bonds are unlike conventional bonds and investors are wise to understand them completely before investing. Here's what to know about these unique bonds.
What Are Catastrophe Bonds?
Catastrophe bonds, also known as cat bonds, are investment securities that work like insurance products for the purpose of reducing the greatest risks associated with insuring catastrophic events, such as major hurricanes and earthquakes. For investors thinking of buying cat bonds, it's smart to understand fully how they work.
Learn How Bonds Work
A smart place to begin your understanding of catastrophe bonds is to learn how conventional bonds work. Bonds are debt obligations issued by entities, such as corporations or governments. When you buy an individual bond, you are essentially lending your money to the entity for a stated period.
In exchange for your loan, the entity will pay you interest until the end of the period (the maturity date) when you will receive the original investment or loan amount (the principal). Types of bonds are classified by the entity issuing them. Such entities include corporations, publicly-owned utilities, and state, local, and federal governments.
How Catastrophe Bonds Work
In the case of catastrophe bonds, the issuing entity is an insurance company. Cat bond investors will allow the issuing company to hold their principal in return for interest paid by the issuing company. In the event of a catastrophe, the issuing company may stop interest payments, or they may not be responsible for paying back the principal at all (the principal is forgiven).
Like conventional bonds, catastrophe bonds are typically held until maturity. From the purchase of the bond up to the maturity date, the investor receives interest (fixed income) for a specified period, such as three months, one year, five years, 10 years, 20 years or more. Most catastrophe bonds have relatively short maturities, such as three- to five-year terms.
There is no "loss" of principal as long as the investor holds the bond until maturity and there is no catastrophe, which would enable the issuing company to defer interest payments or repayment of principal. Again, in some cases, the principal amount may be completely forgiven.
An example of a catastrophe bond would work something like this: The issuing entity, XYZ Insurance Company, issues three-year catastrophe bonds at $1,000 face amount and pays 8 percent interest. The cat bond investor buys 10 bonds and sends the $10,000 to XYZ Insurance Company (or the entity that makes the market for the bond) and gets a bond certificate in return. The bond investor gets 8 percent per year ($800) for three years. That is unless there is a catastrophe!
Risks of Investing in Cat Bonds
The most obvious risk of investing in catastrophe bonds is that a catastrophe would occur and the investor may not receive their interest or principal. However, like other investment securities, the investor is rewarded with higher yields in exchange for taking the risk.
The relatively short maturity periods mitigate the risk some, but catastrophic events are more difficult to forecast than capital markets. Therefore, buying catastrophe bonds is not unlike making a bet that a major catastrophic event will not take place in the next few years. That's like betting against a stock market crash—it's not a matter of IF but a matter of WHEN.
Buying Catastrophe Bonds
Most catastrophe bond investors are hedge funds, pension funds, and other institutional investors. Individual investors are not commonly purchasers of cat bonds. Some mutual fund companies, such as Oppenheimer, invest in cat bonds and often track an index of cat bond securities, the Swiss Re Global Cat Bond Total Return Index.
Individual investors looking for exposure to cat bonds may consider buying bond funds that hold them. This way, the investor can hold a basket of cat bonds, rather than buying one or a few, which would entail greater market risk. If looking for high yields, an investor may alternatively seek to buy high-yield bonds or high-yield bond mutual funds.
Above all, investors are wise to maintain a properly diversified portfolio of investments that are suitable for the individual investor's objectives and tolerance for risk. As a general rule, investors should not invest in securities that they do not understand. For this reason, it's important to learn about catastrophe bonds before buying them. Then, the investor may make an informed decision about buying these fixed income securities or not.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.