Understanding Cat Bonds

Abstract

Cat bonds are short-term, floating rate instruments that act like reinsurance contracts in that they provide issuers protection against prespecified catastrophic property losses such as major U.S. hurricanes or earthquakes or similar events in Europe or Japan. In this article, the authors review the diversification and other performance characteristics of cat bonds and study their value in the context of portfolio allocation. They find that cat bonds’ low correlation to equities, fixed income, and hedge fund indexes can make them compelling from a diversification standpoint. Moreover, cat bond performance over the past 14 years has been a steady 8.3% annual average return with volatility of 2.8%, for a realized Sharpe ratio of 2.4. However, this performance has in part been the result of lower-than-expected principal writedowns during this period. Furthermore, cat bonds may have become a victim of their own success, as a combination of investor appetite and limited supply has pushed their yields to unprecedented low levels—2.5% as of this writing, which equates to an expected Sharpe ratio of 0.5. Though still compelling from a diversification standpoint, these yields might not justify their relative illiquidity and the risk of investing in a relatively unknown security.