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?

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