2018-05-31 - By Oskar Schyberg

How do cat bonds compare to corporate bonds?

Both cat bonds and corporate bonds are fixed income instruments so it is relevant to compare the risk premium of cat bonds with similarly rated traditional corporate bonds. Currently, cat bonds pay a higher risk premium compared to similarly rated corporate bonds.

Both cat bonds and corporate bonds are fixed income instruments so it is relevant to compare the risk premium of cat bonds with similarly rated traditional corporate bonds. Currently, cat bonds pay a higher risk premium compared to similarly rated corporate bonds.

Essentially, cat bonds (and the wider asset class Insurance-linked securities, ILS) are corporate bonds where the credit risk is exchanged with reinsurance risk. Instead of bankruptcy, the risk is the occurrence of a specified large natural catastrophe, such as an earthquake or a hurricane. In addition, the principal investment paid by cat bond investors is invested in AAA-rated government bonds, thereby protecting investors against increasing interest rates (see our blog post on cat bonds and interest rate risk).

Cat bonds currently outperform similarly rated corporate bonds

Most rated cat bonds are considered “speculative” by rating agencies (Moody’s: Ba, B; Standard & Poor’s: BB, B), entailing that there is a “substantial” to “high” credit risk. They should thus be compared to “high-yield” or “speculative” corporate bonds.

Looking at the risk spread of similarly rated cat bonds and corporate bonds, we find that cat bonds currently carry a higher spread than corporate bonds.

corporate bond and cat bond spreads 2015-2018

In the graph, we see that for B-rated cat bonds, in the beginning of 2018, the risk spread was 5.3% (1.8% higher compared to B-rated corporate bonds), and that for BB-rated cat bonds the risk spread was 3.2% (1.1% higher compared to BB-rated corporate bonds). In the past three years, the corporate bond risk spread peaked in 2016, which is commonly ascribed to uncertainty about economic slowdown in China and oil price volatility. In addition to stabilization of these factors, the start of Fed rate increases in 2016 have also contributed to declining risk spreads.

Cat bond and corporate bond risk structures

A common fear among investors new to cat bonds is the “tail risk” – low probability events that can cause substantial losses due to a single or a series of connected events. While it is true that there is a tail risk to cat bonds, the same is actually true for corporate bonds. Repeated severe corporate bond default events worse than those during the Great Depression occurred in the end of 19th century (Corporate bond default risk: A 150-year perspective, Journal of Financial Economics, 2011).

Both corporate bond and cat bond losses tend to cumulate during extreme events, when several bonds can trigger. However differently from cat bonds corporate bond losses cluster in sequences of several years which can depend on prevailing market conditions and contagion among companies. For example, 1873-1875 during railroad boom and crash period a three-year total corporate bond value-weighted default rate was 35,9% with the worst year of 16,25%. Those numbers cannot be directly compared to historical event loss simulation results on cat bond portfolios but it shows the similarity of risk magnitude.

The 1906 San Francisco earthquake and the 1926 Great Miami hurricane would have resulted in losses close to 30% and 20% on Entropics’ cat bond portfolio if the catastrophes would happen today.

The outlook on the closer time horizon 1997 – 2017 exemplifies losses of moderate severity. During the period B-rated corporate bonds had an average annual credit loss of 1.7%, and a maximum credit loss of 7.3%.

Annual credit losses for corporate bonds (b-rated) and cat bonds

Cat bonds had corresponding 0.8% and 4.6% during the same period. Losses in 2008 were a result of a faulty construction of cat bonds, where the collateral was invested in instruments issued by Lehman Brothers, causing losses when the bank crashed. 2017 cat bond losses in the chart reflect an estimated maximum loss, some of which will be incurred in 2018, following the hurricane and wildfire season of 2017.

Conclusion

Cat bonds and corporate bonds, both are event-driven, with similar tail risk. In addition, cat bonds are constructed in a way that virtually eliminates credit risk (post-Lehman) and interest rate risk. They contribute to diversification of a credit risk portfolio, in addition to providing higher risk premium compared to similarly rated corporate bonds.

Print Friendly, PDF & Email

Share post:      
Oskar Schyberg

Oskar Schyberg

Underwriter

Licentiate of Engineering degree in applied/financial mathematics. At Entropics since December 2013.

View all posts from Oskar.