2016-10-31 - By Robert Lindblom

Cat bonds and interest rate risk

For fixed income instruments, such as cat bonds, the sensitivity to interest rate variation is very important to investors. Any investment in fixed-income instruments, such as traditional government or corporate bonds, or cat bonds, carries an interest rate risk. Cat bonds are, however, structured in a manner that minimises this risk.

Cat bonds carry a low interest rate risk

The interest rate risk reflects that market prices of fixed-income instruments tend to decrease, when interest rates increase and vice versa. With increasing interest rates, investors expect a higher return for a given investment. As the coupon of a traditional fixed-income instrument is predefined, this is accomplished by an adjustment of the market price. An interest rate change of 1% can entail substantial market price variation. The longer the remaining residual maturity of a bond is, the more sensitive it is to changes in interest rates.

Cat bonds are so called floating rate notes (FRN). The bondholder of an FRN generally receives a coupon with a fixed risk premium plus the interest rate of short-term money market instruments. Instruments that are constructed as an FRN, for example cat bonds, are less sensitive to changes in interest rates, as the coupon is partially linked to changes in the interest rate. If there is a change in interest rates, the coupon is expected to follow while the market priceremains unchanged. However, the residual maturities of the underlying money market instruments generally causes some minor interest rate risk.

Evaluation of the interest rate risk

Investors in fixed-income instruments utilize a variety of methods to assess the interest rate risk. A common way to measure this interest rate risk is to calculate the modified duration, which reflects the price sensitivity of a fixed-income instrument to a 1% change in interest rate.

Many fixed-income instrument evaluation methods cannot be directly applied to FRN, but offer a simplified measurement of the interest rate risk. The modified duration for SEF Entropics Cat Bond Fund calculated in Bloomberg was on 30 September, 0.09.

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Robert Lindblom

Robert Lindblom

CEO

Robert has close to 30 years' experience from the insurance- and asset management industry. Prior to starting up Entropics Asset Management AB, Robert worked for 10 years with the European Asset Manager Brummer & Partners, where he started, and become the first CEO of Brummer Life Insurance Company. Prior to that Robert was one of the founders of one of Sweden’s first insurance broker firms where had the position of CEO for 10 years. Robert holds an MBA in Finance from Cass City University, London.

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