Catastrophe bonds provide diversification for portfolios

Catastrophe bonds help companies to reduce the risk of loss from extreme events and are a useful source of diversification for investors, according to van Eyk Research.

van Eyk said catastrophe bonds are designed to spread or reduce the risk of loss related to potential catastrophes and, in return for offsetting this risk, investors are offered a very attractive yield. 

According to van Eyk, if the catastrophe does occur on a grand scale, investors risk losing a substantial amount of the principal placed on the bond. The research house believes investors are overpaid for taking on this risk.

van Eyk refers to the Swiss Re Global Cat Bond Total Return Index as an example of the benefits of catastrophe bonds. Swiss Re research revealed that the index has declined just 0.46 per cent in the first half of 2011, and has generated steady returns from January 2002 to March 2011, despite periods of significant natural disasters worldwide.

An Aon Benfield Securities report showed 45 per cent of catastrophe bonds on issue are exposed to hurricanes in the United States. van Eyk has warned investors against concentrating their portfolio exposure to these geographical events because they risk experiencing significant drawdown if a major natural disaster like a hurricane makes landfall.

van Eyk stated that the catastrophe bond market is approximately US$25 billion, and the research house expects it to grow over the next decade, driven by increased population density, building cost inflation and concentration risk, and the growing popularity of such bonds with investors.