An introduction to catastrophe bonds

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September 19, 2024

Introduction

Catastrophe bonds (cat bonds for short) have received significant interest in recent years, with 2023 breaking the record for total issuance at US$16.45 billion (previously set in 2021).1 We believe this trend is likely to continue as the first half of 2024 surpassed the prior year’s first-half record. As of the time of this writing, the size of the market (capital outstanding) has grown about 32% since the end of 2021,2 while yields are at attractive levels last witnessed in 2012.

Cat bonds cover specific perils, such as natural disasters. Therefore, it is not surprising that the growth in this market is often attributed to two factors:

  1. Concerns about climate change—storms of greater magnitude and intensity could cause greater property damage.
  2. Recent inflation—reconstruction from storm damage is now more costly.

Investors are compensated if the disaster does not occur or, if it does, monetary losses remain below a predefined threshold. The returns to investors have not gone unnoticed. Investments in cat bonds have underpinned some of the most successful hedge fund sub-strategies of 2023.3

Cat bonds provide investors with the possibility for returns largely independent of market and economic risks that affect traditional equity, fixed income and even most alternative asset classes, potentially making them an appealing diversifier.

Investing in the asset class comes with risks, which we describe in this paper. Nevertheless, we seek to use risk-management techniques to hedge the unpredictability of nature, even while reaping the rewards of the asset class.

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CONTRIBUTORS

Jordan Strah
Senior Analyst
Franklin Templeton Investment Solutions

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Endnotes

  1. Source: Artemis. Deal Directory. August 20, 2024.
  2. Ibid.
  3. Source: S. Lee, G. Naik, “Hedge Funds Rake in Huge Profits Betting on Catastrophe Risk.” Bloomberg. January 21, 2024. Original data from Preqin. Annualized as of September 30, 2023. Past performance is not an indicator or a guarantee of future results.

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal.

Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.

Equity securities are subject to price fluctuation and possible loss of principal.

International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. These risks are magnified in emerging markets.

Diversification does not guarantee profit or protect against a loss.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

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