Chin Liu, Managing Director of Amundi, joined Julie Cooling, Founder and CEO of RIA Channel, to discuss investing in bonds with return drivers uncorrelated to interest rates.
Catastrophe bonds (Cat bonds) transfer insurable risks into a financial security. The frequency and severity of natural disasters determine the performance of cat bonds. The returns to cat bonds are relatively uncorrelated to financial markets, as financial market returns don’t predict or influence the occurrence or severity of hurricanes or earthquakes.
Insurance companies wish to limit their financial exposure to a particular category of losses over a specific time frame. Traditionally, the insurance companies would purchase coverage for specific risks from a reinsurance company. Alternatively, insurance companies may wish to sell catastrophe bonds to investors. If there are no substantial losses from pre-defined events, investors will receive interest on the bond and a return of their principal at maturity. If the insurance company experiences substantial losses from pre-defined catastrophes during the life of the bond, investors may forfeit some or all of their principal, similar to the role of a reinsurance company.
The bonds insure low-frequency, high-severity events such as earthquakes, hurricanes, European windstorms, floods, hail, and wildfires. Cat bond investors can use forward-looking, science-driven models to accurately assess the price of this risk, especially at a time when the risks may be increasing due to climate change. If the probability and severity of risks are assumed to be rising, the compensation paid to reinsurers and cat bond investors should also rise. Ideally, the price charged for insurance should be able to pay the rising claims costs while leaving an adequate return to investors as compensation for their risks.
Cat bonds have historically offered attractive returns. Liu terms this as a “self-healing asset class,” where reinsurance premiums typically substantially increase in the wake of large claims from a recent catastrophe.
Many advisors will include cat bonds as part of their asset allocation to high-yield bonds, bank loans, or alternative investments. Typical allocations are 1% to 3% of assets for high-net-worth investors.
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