Bonds Part 5: Reinsurance Bonds

Reinsurance bonds also called Catastrophe bonds are a unique asset class, one whose performance has little relationship to the bond and stock market hence their unique value. Here we explain what reinsurance bonds are, how we can invest in them, and what value they add to a diversified portfolio.

History

Catastrophe bonds or “CAT’ bonds were first introduced in 1992 to help strengthen the insurance industry by increasing their capital in response to several large and costly natural disasters. The market for CAT bonds has quadrupled since 2010 in response to insurance companies strengthening their balance sheets and the need to meet regulatory requirements for liquidity. Investor demand for investments that are not “correlated’ to other investments including traditional bond categories and the stock market has led to significant interest among institutional investors who fund most of this category of investments. Due to the nature of the markets, it is very difficult for an individual investor to get exposure to this asset class. We invest in them on your behalf through a mutual fund that is only available to institutional investors.

How Do They Work?

Catastrophe bonds are typically floating rate bonds with the principle at risk, they may be issued in blocks of $50 to $100M and they typically mature in 1-5 years.

The complex nature of these bonds is shown in the chart above. The collateral trust shown in the center of the chart above holds the cash received from the investor and therefore that protects investors from counterparty risk, therefore the only risk to the investor is the insurance risk from the predefined catastrophe which is typically weather or another type of event. The principle could be forfeited if the event occurs, and because of that risk, most catastrophe bonds are rated BB or below.

Why Invest in Them

Cat bonds which represent the reinsurance asset class provide high potential yield in a decidedly low yield environment. Over the years most advisors have believed strongly in the so-called 60/40 model – 60% in growth investments and 40% in bonds, that model worked well when interest rates were higher, and bonds were in a secular bull market for years due to the gradual decline in interest rates from when they peaked in the early 1980s.[1]

Note: The performance of the S&P 500 Total Return Index and the 10-Year Constant Maturity Treasury are used to estimate the nominal returns of the 60 / 40 portfolio. Excess returns are over the 3-month Treasury yield.

Source: Bloomberg, FRED.

When bond yields fall so dramatically it also increases the risk of being in the typical bond. Changes in interest rates have a dramatically greater effect on the value of a bond or a bond fund when rates are this low. A measure of that is effect is through something called Duration, that metric is calculated through a complex mathematical formula[2]. The simplest explanation of it is the relationship of the duration of a bond to how much it is value changes with interest rates, for example, a bond with a duration of 1 will lose roughly 1% of its value if interest rates rise by 1%. A bond with a duration of 5 will lose 5% of its value if interest rates increase by 1%. Because of this enormous drop in yields over the last 40 years the duration of a key bond index, the Bar Cap Aggregate has increased to 6.6, making it very sensitive to interest rate changes.

Over the last 40 years or so the 60/40 portfolio has returned on average 8-9% per year, with bond yields so low and probably in the range of 2% per year for the next 10 years. it is doubtful that the 60/40 portfolio that includes traditional bond categories will provide a return that high, a return of 5-6% is much more likely.

We find that many advisors and investment firms still rely on this simple model despite its probable low return over the next 10 years.

Non-traditional fixed income categories can provide much more yield, in fact, their yield is in the 6% range. To achieve that return on bonds now one must go into the junk bond market, an asset class with a poor risk vs. return profile. It is true that CAT bonds have low ratings (because of event risk not due to the typical type of default risk junk bonds have) but they can improve overall diversification in a portfolio and improve diversification even in times when financial markets are stressed.

Here is a table comparing some investment categories[3]:

 Cat BondsU.S. TreasuriesHigh Yield BondsU.S. Equities
Annual Return7.00%1.30%8.00%8.70%
Standard Deviation[4]3.20%0.40%9.40%14.80%
Sharpe Ratio[5]1.800.70.5
Highest Monthly Return3.10%0.50%12.10%12.80%
Lowest Monthly Return-6.50%0.00%-15.90%-16.80%
% Positive Months89%86%71%67%

Improving Diversification

We choose asset classes based on the relationship to other assets we hold in the client portfolio. We have a strict definition of what is and is not an asset class and we only use asset classes that improve the “efficiency” of our portfolios (risk vs return ratio). Improving efficiency can happen in either of two ways, it can improve return, or it can reduce risk, some asset classes can do both. The reinsurance asset class improves both as opposed to traditional fixed income since its return is higher than many traditional types of bonds, and its lack of “correlation” with many other asset classes reduces risk in your portfolio. One very important characteristic of reinsurance or CAT bonds is that they do not become “correlated” to stock during risk on events like we experienced in 2020 at the start of the Covid pandemic. Corporate bonds and especially high yield or junk bonds become highly correlated to stock during risk on events dramatically, diminishing their contribution to portfolio efficiency. Here is a summary of our rationale for using them:

  • They have a yield in the 4-6% range even in this low yield environment
  • CAT bonds improve portfolio “efficiency;” in other words they improve the risk vs. return profile of our portfolios. Their high yield and lack of correlation with other investments are how they do that.
  • They do not become correlated with the stock market during significant market declines, unlike other investments some use to try to improve yield, things we avoid like junk bonds, floating-rate bonds, and preferred stock, all categories commonly used by many advisors.
  • They improve “tail risk” performance of portfolios, the average decline during bear markets is reduced.

What is the Risk?

We mentioned that CAT bonds have low ratings usually BB or below and they are considered “junk.” The reason is the possibility that the principal invested in the bond may be lost to the insurance company if the event that is tied to the bond occurs (principal impairment event). For example, a CAT bond may be redeemed at face value if a specific hurricane event does not occur but the occurrence of a hurricane and the actual losses facing the insurer may result in the loss of all the principal or a portion of it. There are different types of triggers and different formulas used that determine how much of the principle is “impaired.” This risk can be reduced by having many types of CAT bonds with different triggering events, for example, hurricanes, earthquakes, and floods.

Gaining Access

We gain access to this asset class through a mutual fund that is only available to institutional investors. It is very difficult if not impossible for the average investor to gain access, huge amounts of principle must be committed and you need to have a relationship with the third parties that issue the bonds.

The Video of Laura and Steve discussing Reinsurance Bonds may be found here;

This is on our YouTube Channel “Its Your Smarter Money, Hosted by Atlas Fiduciary; https://www.youtube.com/channel/UCWSB3UQN3y4IXAUh7dEBMzA


[1] Source; Oliver Wyman

[2] https://en.wikipedia.org/wiki/Bond_duration

[3] Source: Bloomberg, Factset, Neuberger Berman for February 2002 to December31 2020.

[4] Standard Deviation is a measure of volatility, monthly returns were within the average plus or minus this amount 68% of the time.

[5] The Sharpe ratio is a ratio of the return of an investment to the risk, this is the formula SR = (Investment Return -Treasury Return)/Standard Deviation

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