CAT bonds are high yield bonds that cancel debt in the event of a catastrophe, posing a risk to lenders. They are promoted as a way to diversify risk and are not tied to stock sectors. However, investors are not always fully informed about the risks, and some traders bet on natural catastrophes.
A catastrophe bond, or CAT bond, is a type of bond that is concerned with the possibilities of extreme catastrophes, such as storms and other natural events. CAT bonds are generally high yield bonds with some significant and unique risks. They are complicated debt products that often have to do with how insurance is applied to a property, region, or asset.
A specific feature of many CAT bonds is that, in the event of a given catastrophe, the debt is canceled and the borrower may default. How this works varies from bond to bond, but it is this aspect of a CAT bond that poses the greatest risk to the lender or to those who own the high-yield bond. In exchange for higher returns, the bondholder assumes that the risk is part of a diversified portfolio.
Some financial professionals today are promoting CAT bonds as a way to diversify risk. One of the things that some see as positive about CAT bonds is the fact that they are not tied to stock sectors or other market events. Rather, they are tied to real world events and natural situations. That means that realistically, an investor who diversifies well can miss out on negative market events or negative real-world events, and still turn a profit even in tough times. Whether or not this is true for any individual investor is something to be judged on a case-by-case basis, but with a highly complicated statistical model used by some traders, CAT bonds end up looking good as diversification tools.
One of the main dangers of a CAT bond is that investors are not always fully informed about what they are buying with their money. For someone willing to take the risk of a high-yield CAT bond and its higher probability of default, investing in these instruments can be seen as “fair play,” but because much of the average investment capital is filtered through trading desks and brokers, the chances are high that someone has risky CAT bond funds or other similar holdings, without really knowing what the risks are.
Some of the most prominent financial journalists of recent times have weighed in on the pros and cons of the CAT link. Finance author Michael Lewis has explored much of the nature of these bonds in a New York Times piece called “In Nature’s Casino.” Traders and others who take a closer look at the CAT bond as a market-traded derivative gain insight into how sophisticated financiers are essentially betting on natural catastrophes, with all the risks and rewards that this entails.
Smart Asset.
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