Investors Are Counting on This Hedge. They Might Be Disappointed.
Catastrophe bonds are supposedly uncorrelated with financial markets, but recent research found they won’t offer investors shelter when it’s most needed.
Investors seeking safe haven in catastrophe bonds may want to think twice.
“Institutional investors have embraced CAT bonds as a new asset class,” viewing them as “zero-beta” investments that shield them from market-related risk, according to recent research from professors Wolfgang Drobetz and Henning Schröder at the University of Hamburg and professor Lars Tegtmeier at the University of Applied Sciences Merseburg. But “CAT bonds cannot act as a safe haven in phases of extreme market declines,” the professors wrote in a paper evaluating the role of these insurance-linked securities in a global multi-asset portfolio.
CAT bonds are the most prominent of securities that insurers have been developing since the early 1990s to protect against peak losses from natural disasters such as earthquakes and hurricanes, according to the paper. Their growing popularity over the past decade means insurers are succeeding in transferring the risk of damage tied to these catastrophic events to institutional investors.
The global CAT bond market has swelled to $23 billion in June 2017, from $2.2 billion in 2002, according to the paper. The authors examined whether these securities can serve as a diversifier, hedge, or safe haven against big price swings in stocks, bonds, real estate, commodities, private equity, and infrastructure.
“Our results indicate that CAT bonds are a poor hedge,” Drobetz, Schröder and Tegtmeier said in the paper. “CAT bonds can serve as a strong safe haven against extreme down price movements of stocks only during the post-crisis period.”
Catastrophe bonds are collateralized, floating-rate fixed-income securities tied to a special purpose vehicle that holds principal paid by investors. “Investors are compensated for taking over the risk through regular coupons,” the authors said.
Many investors see CAT bonds as isolated from global financial markets because the occurrence of natural disasters is uncorrelated with equity volatility, according to the paper. This so-called “zero-beta characteristic of CAT bonds is an attractive feature to investors during bear market periods,” the authors said, adding that their “comparably high interest rates” make them particularly appealing in a low-rate environment.
While these insurance-linked securities may fail to perform as “zero-beta assets” during times of crisis, they can still provide diversification benefits in a market downturn, according to the paper. “The effect of the financial crisis on CAT bonds returns, compared to stocks and bonds, is relatively small.”
But if investors have been snapping up these bonds based on the belief they will offer shelter during times of stress, they may be disappointed. The authors found “no evidence that CAT bonds are qualified as a safe haven investment against extreme price movements in other asset classes.”