As hedge funds achieve unprecedented gains in the high-risk domain of the debt market, there is a growing attraction from mainstream investors towards the products responsible for these remarkable returns.
Catastrophe bonds, the cornerstone of the best-performing hedge fund strategy last year, have outperformed other high-risk fixed-income products, delivering a 20% increase in 2023. This surge eclipsed the 13% rise in high-yield US corporate bonds and the approximately 4% increase in US Treasuries.
Niklaus Hilti, head of insurance-linked strategies at the investment arm of Credit Suisse (now part of UBS Group AG), notes that the extraordinary returns have expanded interest in catastrophe bonds beyond hedge funds. Institutional investors are increasingly drawn to the asset class, seeing it as a means to diversify their investment portfolios.
Catastrophe bonds serve as a risk shield for the insurance industry against overwhelming losses, transferring this risk to investors willing to accept the potential loss of their capital in the event of a disaster. In return, investors stand to gain substantial profits if the predefined catastrophe does not occur.
The cat bond market, existing for decades, has experienced a revival due to climate change-induced weather events and heightened inflation, driving record levels of issuer and investor activity. Some cat bonds now feature tighter trigger clauses, favoring investors and cat bond funds by reducing the likelihood of payouts.
While niche hedge fund investors dominate the cat bond market, mainstream institutional investors like Schroders Plc, GAM Holding AG, and Credit Agricole SA are increasing their presence. Insurers have increased issuance by 50% in the past year.
Daniel Ineichen, Schroders’ head of portfolio management, observes that high returns and the appeal of cat bonds as portfolio diversifiers are driving business for the asset manager. Swiss Re, traditionally involved in proprietary trading of cat bonds, has set up an investment manager overseeing third-party capital, currently managing around $1.5 billion in assets.
Investors entering the cat bond market acknowledge the complexity and high risk associated with these instruments, which don’t move in tandem with the broader market. The global market for insurance-linked securities reached about $100 billion by the end of Q3 2023, with cat bond issuance alone hitting an all-time high of over $16 billion.
Despite the challenges, experts believe that the cat bond market’s favorable state and higher interest rates will continue to attract investors, even if the exceptional gains of 2023 are not replicated. Niklaus Hilti emphasizes that while cat bonds remain niche investments, the momentum and higher risk premia have made them an increasingly attractive option for those willing to take on the associated risks.
