How is a portfolio affected by the inclusion of cat bonds?

A traditional investment portfolio complemented with cat bonds would be expected to deliver more stable returns. Looking at the past ten years, a traditional portfolio, allocated to Swedish and foreign equity and bonds, would have delivered higher returns and a lower volatility with a cat bond allocation.

As cat bonds are fundamentally uncorrelated, as our Underwriter Meryem Savas has addressed previously on the blog, it would be expected that a traditional portfolio complemented with cat bond positions would achieve diversification benefits, resulting in a more stable return profile.

We have carried out a comparison of three different methods to diversify a reference portfolio with cat bonds. The reference portfolio chosen can be described as a “traditional portfolio” (according to statistics by the Swedish Investment Fund Association), consisting of 60% equity (Swedish and global) and 40% bonds.

Using this portfolio, we have studied three different ways to reallocate to cat bonds, where cat bonds:

1. Replace some equity
2. Replace some bonds
3. Replace both equity and bonds, maintaining the relation between the two

Obviously, there are other possibilities to reallocate a portfolio to a certain level of cat bond exposure, such as replacing other alternative investments in an existing portfolio. For the sake of clarity, we have chosen to limit the analysis in this blog post to the portfolio described above.

Data selection

The analysis is based on ten years’ of weekly data, from Jan 1, 2007 to Dec 31, 2016. During the period selected, cat bonds have had higher returns and lower volatility than equity and bonds.

For cat bonds, we have chosen the Swiss Re Global Total Return index (SRGLTRR). It is a capital weighted index, where the returns are reinvested. The index is not investable, so a cat bond portfolio would be expected to deviate somewhat from the index.

The reference portfolio consists of 30% SIX RX (the Stockholm Stock Exchange, reinvested dividends), 30% MSCI World (world index reinvested dividends) and 40% OMRX Treasury Bill Index.

As the cat bond index has had higher returns and lower volatility than the equity and bond indices during the selected period, it is natural that a portfolio holding a share of cat bonds would have delivered higher returns and lower volatility.

As an example, cat bonds have yielded comparable returns with global equity post-2008. However, during the ten-year period studied, the annual volatility for cat bonds has been 2.30%, which can be compared to the 18.89% volatility of the global equity index.

Effects on the reference portfolio by reallocating to cat bonds

1. Cat bonds replace equity

As the equity share of the reference portfolio has been decreased and replaced by cat bonds, we see the largest decrease of the volatility. However, it also results in a lower increase of the return than the other two cases. If the reference portfolio is reallocated to hold 15% cat bonds, replacing equity, the volatility decreases by 2.85 percentage points (from 9.85% to 6.68%). The mean annual return increases by 0.56 percentage points (5.38%, compared to 4.83%) during the period.

An investor may wish to replace equity with cat bonds as they offer “equity like returns”, while the correlation with stock markets is very low. For institutional investors, cat bond investments also entail, unlike equity, a considerably lower solvency capital requirement.

2. Cat bonds replace bonds

If cat bonds, instead, replace bonds in the reference portfolio, we see a larger impact on returns, while the impact on volatility is virtually non-existent (we see a very small increase of the volatility of 0.01 percentage points with a 15% share of cat bonds). The return, with 15% allocation to cat bonds, increases by 0.64 percentage points to 5.47%.

The rationale for replacing bonds with cat bonds could, for example be that cat bonds essentially are bonds. Cat bonds have, in the selected period, demonstrated better risk adjusted returns and increased the diversification of the bond position, due to the low correlation.

3. Cat bonds replace bonds and equity, maintaining their proportions

If cat bonds proportionally replace bonds and equity, maintaining their relative sizes, the volatility decreases strongly, though somewhat less than if only equity is replaced. The impact on the return is less than by only replacing bonds, but larger than in the case where equity is replaced. In the reference portfolio, we see a 1.76 percentage points decrease of volatility to 7.77% and a 0.59 percentage point increase of the annual return, to 5.42%.

Impact on the risk adjusted return

As cat bonds, during the selected period, have demonstrated both higher returns and lower volatility than any comparison index, the risk adjusted return, measured as Sharpe ratio, increases.

There are methodological problems using the Sharpe ratio for cat bonds, as the risk involved is related to what is commonly described as “tail risk”, where large low probability events make up a large share of the risk. As the ten-year period includes several events affecting cat bonds (the Lehman crash of 2008 affected the collateral of four cat bonds, in 2011, three cat bonds were triggered by Kansas tornadoes and the Tohoku earthquake, and in 2015, MultiCat Mexico was triggered following hurricane Patricia), it is acceptable to use the Sharpe ratio, though it should be interpreted cautiously.

Hence, the figures below, should only be seen as an indication of how the risk adjusted return can be affected. In this example, we have only selected the cases where the portfolio holds 15% of cat bonds.

¹⁾ Risk free rate – USGG3M 30/12/2016

The largest impact on the Sharpe ratio occurs when cat bonds replace equity, as the volatility decreases substantially, though the impact on return is less than if bonds are replaced. If bonds are replaced, the Sharpe ratio increases to a smaller degree.

Summary

For the selected reference portfolio, a share of cat bonds would, in the past ten years, have contributed to higher returns as well as lower or unchanged volatility. Replacing bonds with cat bonds has the largest contribution to return, but with a virtually unchanged volatility. Replacing equity decreases volatility, but gives less contribution to return.

This means that the risk adjusted return, measured as Sharpe ratio, would have improved over this period regardless of whether equity or bonds are replaced, or if they are replaced proportionally. The largest impact on the Sharpe ratio is seen in the portfolio where cat bonds replace equity.

In summary, we see that the reference portfolio, complemented with cat bonds, would have performed better than the reference portfolio without cat bonds over the past ten years.