For most investors, the word "bond" conjures up images of traditional corporate, convertible or government bonds. However, there is another type of debt instrument in the marketplace that's growing in popularity. It's known as the "event-linked bond". In this article, we'll take a look at event-linked bonds, and show how and why they are used. (To get some background on bonds, see our Bond Basics Tutorial.)

TUTORIAL: The Basics Of Bonds

The Evolution of Event-Linked Bonds
Event-linked bonds are a way for reinsurance companies to obtain funding, and at the same time mitigate their risk against a major claim or catastrophe. In fact, that's why investors often refer to these bonds as catastrophe bonds (CAT). These bonds came on the scene in the mid-1990s, as insurance and reinsurance companies found themselves looking for ways to offset risks associated with major events, such as the damage caused by a natural disaster.

The use and popularity of these bonds is expected to increase, as insurers are faced with large monetary claims thanks to rising property (and other asset) values. In addition, some believe that due to global warming the frequency and/or strength of hurricanes and other storms may continue to increase - creating a growing need for companies to protect themselves. (Keep reading about the evolution of bonds in The Bond Market: A Look Back.)

How They Work
Reinsurance companies pay high rates of return (some bonds can carry double-digit yields) to spread the risk of a major hurricane, earthquake or other catastrophic event among many investors. Because of this, event-linked bonds are generally a high-risk, high-reward proposition. And while individual investors can participate, they usually do so through managed products such as mutual funds. However, there is a little catch that makes event-linked bonds somewhat unique when compared to other bonds.

The catch is, should a major event occur, the insurance company may use the investor's principal to pay off claims. So in essence, the investor in wagering that such an event will not occur. This risk can offset the attractive yields these bonds typically pay.

Risk Premiums
Evaluating whether a particular bond is worth the risk is not always easy. That's because there may be some subjectivity and assumptions involved in the evaluation process. Let's delve in a bit further.

  • An investor should consider what rate of return he or she could reasonably fetch (the prevailing market rate) on a government bond or highly rated corporate bond.
  • Next, one should consider the yield on the event-linked bond. There may not be too much of a difference, but in some cases it might be five points or higher. However, don't forget that in exchange for such a lofty return, the investor runs the risk of possibly losing his or her principal based on something that's pretty difficult to forecast, like a storm.
  • Because of this, it makes sense for the would-be investor to next review the ratings given to the bond by any rating agencies. Potential investors should note that most event-linked bonds are rated below investment grade, due to the fact that they are generally considered riskier than higher-grade corporate debt.
  • Finally, if any data or models are available either from the issuer or the credit agency, make sure to read those as well. Check to see if the assumptions being made about event probabilities are reasonable. This is not always easy because predicting when and where an act of nature might occur is not an exact science. However, the point is that by doing this investors may be able to get (first hand) a better sense or feel of what the probability of such an event occurring might be.

To help you understand, let's take a look at an example. If historical data shows that a Category 2 hurricane strikes the coast of Louisiana every 30 years, then the investor might not feel comfortable in taking the chance on a 100-year bond. (Find out another way to hedge against acts of nature in our article, Introduction To Weather Derivatives.)

Why Invest in Event-Linked Bonds?
Beyond the potential yield, another feature that investors find attractive is the bond's general correlation, or lack thereof, with other asset classes. Event-linked bonds are generally tied to a certain event and are not 100% correlated to swings in the Dow Jones Industrial Average or S&P 500. This generally low correlation can be very attractive for investors looking to spread risk within their portfolios. (Diversifying across different asset classes is important for building a portfolio of assets with low correlation. Read Diversification Beyond Equities for more information.)

Who Should Invest?
Event-linked bonds are not for everyone, particularly those that are risk averse. However, those seeking potentially large returns in the form of an income stream and who are willing to accept risk may find these bonds to be an attractive investment that fits into their overall portfolio strategy. (To find out where you stand on risk, see Risk and Diversification: What Is Risk? and Do You Understand Investment Risk?)

One way that the individual investor can invest in event-linked bonds without the hassle of having to search through mounds of ongoing research is to purchase shares in a mutual fund that maintains a position in event-linked or CAT bonds (such as the Pioneer Diversified High Income Trust).

Again, keep in mind that mutual funds can be a terrific way to invest because they often have managers and analysts that dedicate large amounts of time toward analyzing such bonds, and because they usually have access to large databases of information.

TUTORIAL: Advanced Bond Concepts

The Bottom Line
Event-linked bonds, or catastrophe bonds, have become increasingly popular among reinsurance companies since their inception in the '90s, and with fears of global warming continuing to grow, they look to be a handy staple in the reinsurance market. Investors may find these bonds' high yields attractive, as well as their lack of correlation with other popular asset classes, which helps create the right diversification plan for investment portfolios.

For further reading, see our article High Yield, Or Just High Risk?

Related Articles
  1. Bonds & Fixed Income

    Calculating Yield to Worst

    Yield to worst is the lowest possible yield on a bond that may be called in the future.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares Cali AMT-Free Muni Bond

    Learn more about the iShares California AMT-Free Municipal Bond exchange-traded fund, a popular tax-advantaged ETF that dominates its category.
  3. Mutual Funds & ETFs

    ETF Analysis: iShares Floating Rate Bond

    Explore detailed analysis and information of the iShares Floating Rate Bond ETF, and learn how to use this ETF as a defense against rising interest rates.
  4. Term

    Understanding Total Returns

    Total return measures the rate of return earned from an investment over a period of time.
  5. Mutual Funds & ETFs

    ETF Analysis: Vanguard Intermediate-Term Corp Bd

    Learn about the Vanguard Intermediate-Term Corporate Bond ETF, and explore detailed analysis of the fund's characteristics, risks and historical statistics.
  6. Technical Indicators

    Use Market Volume Data to Determine a Bottom

    Market bottoms often carve out classic volume patterns that let observant traders make fast and accurate calls.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares National AMT-Free Muni Bond

    Take an in-depth look at the iShares National AMT-Free Municipal Bond ETF, a highly diverse and very popular muni bond fund.
  8. Investing News

    Fund Firm Jolts: Pimco's Isn't The First Or Worst

    When you business is built on prudence and trust, a lot can go wrong to cost you tons of clients and assets. Here are a few examples.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares JPMorgan USD Emerg Markets Bond

    Learn about the iShares JPMorgan USD Emerging Markets Bond fund, which invests in bonds of sovereign and quasi-sovereign entities from emerging markets.
  10. Investing Basics

    What is a Settlement Date?

    A settlement date is the day a security trade must be settled.
RELATED TERMS
  1. Yield To Maturity (YTM)

    The total return anticipated on a bond if the bond is held until ...
  2. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  3. Credit Rating

    An assessment of the credit worthiness of a borrower in general ...
  4. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
  5. Coastal Barrier Improvement (CBI) ...

    A federal law that makes federal disaster relief and federal ...
  6. Accelerated Return Note (ARN)

    A short- to medium-term debt instrument that offers a potentially ...
RELATED FAQS
  1. Do mutual funds invest only in stocks?

    Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the ... Read Full Answer >>
  2. What is the relationship between the current yield and risk?

    The general relationship between current yield and risk is that they increase in correlation to one another. A higher current ... Read Full Answer >>
  3. How does the bond market react to changes in the Federal Funds Rate?

    The bond market is highly sensitive to changes in the federal funds rate. When the Federal Reserve increases the federal ... Read Full Answer >>
  4. How do I use the holding period return yield to evaluate my bond portfolio?

    The holding period return yield formula can be used to compare the yields of different bonds in your portfolio over a given ... Read Full Answer >>
  5. What is the relationship between current yield and yield to maturity (YTM)?

    Both the current yield and yield to maturity (YTM) formulas are methods of calculating the yield of a bond. However, these ... Read Full Answer >>
  6. What is a 'busted' convertible bond?

    In finance, a convertible bond represents a hybrid security that offers debt and equity features and risks. While a convertible ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!