What kind of returns can I expect from cat bonds?
Cat bonds have in the past 20 years had a total return on par with the equity markets. The total cat bond sphere, as measured by the commonly used index Swiss Re Cat Bond Total Return, has historically returned 8.7% per annum on average in the past decade This gives a total return of 130.7% in ten years, slightly above the total return on the stock markets in the same period. The return is highly due to the uncorrelated nature of cat bonds, which have left them largely unaffected by a number of drawdowns, most notably the financial crisis in 2007-2009, affecting most traditional asset classes.
While the index has performed well, it is not an investable index and would not fit all portfolios due to concentration risks and, for example, responsible investment aspects, but it gives an overview of the performance of cat bonds as an asset class.
Even though cat bond returns are uncorrelated with the broader capital markets, most cat bond investors aim at diversifying their portfolios in order to minimize concentration risks. Cat bonds offers strong diversification also within the asset class as a hurricane does not cause an earthquake. The cat bond market is still dominated by US Wind risk (about 65%) of the outstanding capital has this exposure) on the east coast. This gives a healthy supply and good risk adjusted returns. However, bonds covering others perils are fewer, usually referred to in the industry as “diversifiers”, and have therefore not as high risk spreads. Thus an investor willing to carry, for example, a single bond can outperform the index but will lose his investment if the bond is fully triggered. In a diversified you will expect to recover from a loss by earning coupons from the remaining portfolio.
Floating rate-notes counter risks of increasing interest rates
Cat bonds are constructed as floating rate notes. Investor return is not only risk premiums paid by the cat bond sponsor, but also comprises the returns of the money market instruments where the collateral is invested. As a result, the total return of a cat bond investment has a certain protection against inflation and increasing interest rates, which we will return to in another blog post. The modified duration (the value change of a security in response to a change in interest rates) of a cat bond portfolio is thus low. The current modified duration for Entropics’ portfolio is 0.09%.
Lower price on risks affect all asset classes
A common argument against cat bonds is that “returns have decreased”. While this is true, looking at the returns five and fifteen years back, the argument does not convey the full story. One reason for the very high returns in the early years of cat bonds is that the asset class was still not fully understood by the broader market. Thus, an extra “novelty premium” can probably be seen even in the early 2000’s. This phenomenon is likely to affect any financial instrument when it is first introduced to the market. The reinsurance company Swiss Re noted that this premium seemed to have faded by 2010 as the asset class matured.
In later years, the low interest rate climate has had profound impact on all asset classes, as interest bearing instrument returns are near, or even below, zero. The resulting “hunt for yield” have pressed risk premiums in all markets. In the case of the equity market, this has mostly lead to increasing equity prices. For fixed income instruments, this means spreads have tightened, meaning that the difference between yield and risk has decreased. Cat bonds are, of course, not unaffected in this respect; to have the same yield a somewhat higher risk is accepted today, but still pay good risk adjusted returns. In the past months, coupons on new issuances have increased somewhat, as sponsors have taken advantage of the demand to issue bonds with a higher expected loss frequency.
The SEF Entropics Cat Bond Fund
The SEF Entropics Cat Bond Fund has a return target of 4-6 % above the risk free rate over a reinsurance cycle. In 2015, the return was -3.29%, following the claims on MultiCat Mexico following Hurricane Patricia. In 2016, until the end of August, the return was 5.62%, including the partial recovery of MultiCat.