There’s a new(ish) bond that has traders on Wall Street a bit off kilt: The Catastrophe bond.
Catastrophe bonds, or CAT bonds, are high-yielding debt instruments that are typically insurance-linked and meant to raise funds when catastrophes, like hurricanes or tornadoes, strike. The conditions on CAT bonds are that if the issuer suffers a loss from a predefined catastrophe, their obligation to pay interest or repay the principle are either deferred to later periods or completely forgiven.
Investment banks and insurers are issuing billions of dollars of these bonds a year, reports the Wall Street Journal. Warren Buffet was the first to eschew these bonds, completely steering his firm, Berkshire Hathaway, from the market for CAT bonds in 2014, reports the Financial Times.
Catastrophe bonds have thrown a monkey wrench in the typical way of conducting business in the insurance market. Typically, insurance companies raise capital (by having individuals purchase insurance accounts) and then fund insurance payouts from this pool funds. To mitigate some of the risk, insurance companies will “pay premiums to companies known as reinsurers, a low-profile corner of the industry that serves as insurance for insurers,” the WSJ reports.
With CAT bonds, things work slightly different. The bonds are sold directly to the company or entity, like a local government or municipality. A risk assessment tool is then used to calculate the odds of a particular catastrophic event occurring, and then investors receive high-yields on these bonds but with the caveat that if disaster strikes they lose their principle entirely.
There were $20 billion in the market for CAT bonds in 2014, and today there are a reported $72 billion — more than three times the amount in just two years. These bonds have become so popular because they are considered uncorrelated with other assets, an attractive feature following the 2008 meltdown that saw the market drop drastically in tandem with all asset classes.
Experts predict that the market for CAT bonds will double in the next few years, reports the Journal. This is mostly due to the fact that the yield on catastrophe bonds have outperformed other bonds and high-rated securities over the past decade.
Wall Street has concerns that quickly escalating market for CAT bonds has hindered interest rate returns, and furthermore the threat of hurricanes and other catastrophic events could undermine the newly rising interest rates and cause a run on the market for CAT bonds.
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