Cat bonds compelling, but often overlooked by fixed income managers: King Ridge

According to a new report from King Ridge Capital Advisors (KRCA), catastrophe bonds are offering more opportunities for bond and multi-asset fund managers to diversify their portfolios, reduce correlations and improve risk-adjusted returns.

“Fixed income securities have long been a foundational building block of conservative investment strategies, providing stability and predictability. In recent years, consistently low bond yields, combined with escalating inflation and interest rates, along with increasing correlations with equities, have sparked concerns about bonds’ capacity to effectively diversify portfolios and reduce risk,” KRCA said.

“In light of these market dynamics, portfolio managers and asset allocators are actively seeking alternative sources of yield and diversification. CAT Bonds (Catastrophe Bonds), a subset of Insurance-Linked Securities (ILS), may be a compelling yet overlooked asset class.”

Since the cat bond market’s inception over two decades ago, catastrophe bonds have provided a bridge between insurers and the capital markets, however despite their potential, KRCA notes that cat bonds have not been broadly utilised by bond managers and multi-sector asset managers.

According to the investment advisor, a number of obstacles have hindered the wider adoption of catastrophe bonds, including infrastructure support costs, liquidity constraints, and complexity.

“There may be more subtle explanations for the lack of integration within traditional portfolios. A principal obstacle to the wider utilization of CAT Bonds may be the fact that their risk characteristics and the methodologies utilized to evaluate those risks do not align with traditional bonds,” the firm added.

Moreover, the firm also highlights how traditional bonds are driven by credit and duration risk, while cat bonds tend to rely on insurance risks from natural disasters, which ultimately makes them harder to integrate into fixed-income portfolios.

King Ridge Capital Advisors (KRCA) also explained that many portfolio managers see cat bonds as being unconventional due to their lack of alignment with traditional benchmarks, such as the Swiss Re Cat Bond Index, which remains relatively unknown in mainstream performance analytics.

Historically used by hedge funds and alternative managers, catastrophe bonds remain unfamiliar to many traditional bond fund managers, which contributes to skepticism regarding their role in multi-sector portfolios.

On the other hand, KRCA notes that the challenge of concentration risk persists, particularly in the face of potential drawdowns caused by correlated natural disasters, such as experiencing multiple hurricanes within a single season.

“While diversifying across different perils and regions can reduce risk, concerns about tail risk may have continued to hinder broader acceptance among fund managers,” the firm explained.

It’s also worth highlighting, that throughout recent years, fixed-income markets have faced challenges that have compromised their traditional role as diversifiers against equity market volatility.

Furthermore, the rising correlations between equities and bonds, especially during times of synchronised global growth and high inflation, have reportedly diminished traditional bonds’ effectiveness as a diversification tool, KRCA noted.

KRCA also affirmed that cat bonds generate returns from natural disaster risks, which have historically shown little correlation with financial markets.

Referring to data sourced by Bloomberg, KRCA explained that cat bonds maintain low correlation with traditional fixed-income assets, which ultimately provides a distinct diversification advantage, increasing their appeal for portfolios aiming to minimize exposure to the escalating risks linked to traditional bond holdings.

“Catastrophe Bonds present a distinctive opportunity for bond and multi-asset fund managers to diversify their portfolios, lower correlations, and achieve improved risk-adjusted returns. With barriers to the incorporation of Cat Bonds into traditional portfolios, such as research, infrastructure costs, and limited in-house expertise, gradually being overcome, the rapid evolution of the market suggests that Cat Bonds should be a key component of a resilient, diversified fixed-income portfolio,” KRCA added.

Concluding: “As fixed-income markets evolve with changing economic conditions, bond managers should reevaluate their strategies and embrace innovative asset classes like Cat Bonds.”

The imminent launch of the Brookmont Catastrophic Bond ETF, which will be managed by Brookmont Capital Management, LLC, while ILS manager King Ridge Capital Advisors LLC will be the sub-adviser to the cat bond ETF, effectively managing the portfolio, shows one way that the accessibility of the catastrophe bond asset class is expanding.

Read our recent interview with Brookmont and King Ridge: Cat Bond ETF liquidity Q&A: Brookmont Capital Management and King Ridge Capital Advisors.