August 9, 2017

Breakingviews: Need and Yield Make Cat Bonds Roar

by Breakingviews

Need and yield are making cat bonds roar. Low interest rates and a hunger for uncorrelated returns are fueling investor demand for bonds insuring against hurricanes, pandemics and other catastrophes, pleasing insurers eager to lay off risk. Yields on these instruments have fallen even as issuance has soared. Disaster, if it strikes, may only increase their popularity.In a typical cat bond, an issuing insurer or government agency pays a healthy interest-rate premium to investors over about three years. If a pre-specified event happens, the buyer forfeits some or all of the principle. So if, say, an earthquake above a certain strength rocks Tokyo, a Japanese insurer already has cash on hand to help pay claims quickly.

Increasing comfort with the risks – payouts have been sparse recently – and a dearth of good yield alternatives has encouraged investors to buy these vehicles. It also helps that the various risks covered, ranging from Ebola to hurricanes, have low correlations with each other and other asset prices.

The results are dramatic. Including the World Bank’s latest offering insuring Mexico against hurricane or earthquake damage, over $10 billion of these bonds have been issued in 2017, more than in any previous calendar year. Yet the average rate premium over comparable government benchmarks that investors receive, after adjusting for projected catastrophe losses, has fallen below 2 percentage points from about 3.5 points four years ago, according to Risk Management Solutions.

Yields have risen lately ahead of the North American hurricane season, as they typically do each year, but investors may still be too complacent. The forecast is for more frequent and bigger storms in the Atlantic this year than average. A tropical storm that hit Mexico’s Yucatan peninsula Monday night was expected to become the season’s first hurricane before making a second landfall on the country’s Gulf Coast on Thursday. Bigger storms may be brewing. A repeat of Hurricane Katrina, which devastated New Orleans in 2005, could knock investors hard.

Such an event is unlikely to dent the market, though. Increased coastal development and rising sea levels have made insurers wary of potential losses, and left municipalities covering more of the risk. Both will want to let bondholders take on a greater share of the burden. Buyers probably won’t shy away either. Diversification and high yields provide insurance of their own, and institutions typically invest less than 1 percent of their holdings in the asset class. These instruments look set to remain the cat’s meow.

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