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.
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.