Finance And Law: Sizing Up New Bond Options For Hedge Funds

Michael McDonald, PhD 
Posted with permission from Above The Law

As the hedge fund market continues to evolve, new investment opportunities are evolving with it. Attorneys need to understand these products and how they work in order to help with providing legal advice, compliance aid, and fund start-up document creation services. In past columns I have discussed litigation finance, an area that I believe is poised to become a hot arena in the next decade. Litigation finance is still a niche area, though. An equally complex area that has already become in vogue with funds is cat bonds.

Cat bonds, despite their name, are not related to felines. Instead, cat bonds or catastrophe bonds, as they are formally called, are a crucial link in the reinsurance markets. Cat bonds were invented in 1993 by executives at Hanover Re, but were slow to gain traction for more than a decade. All of that changed around the financial crisis. In 2008, when virtually every other financial asset melted down, cat bonds gained an average of 2.85%.

The reason for that effective performance during the recession is that the bonds’ values are based on natural disasters and other insured phenomena that are uncorrelated to traditional financial markets. In particular, cat bonds pay investors a traditional bond-like coupon every year. However if a particular event occurs that is pre-specified in the bond language, investors are on the hook for the losses. Thus, for instance, if a severe hurricane occurs, a cat bond investor may lose some or all of the initial funds invested in the bonds. The bonds are not merely limited to hurricanes and storms, though – there are cat bonds related to too many people dying from pandemics, and bonds related to people not dying soon enough from natural causes. There are cat bonds related to railroad accidents, plane crashes, and typhoons. In some sense, litigation finance is merely a special form of cat bond with a reversed payout structure.

In addition to the uncorrelated nature of the bonds, cat bonds have traditionally been a very lucrative business. Traditional reinsurance providers have typically aimed to earn returns of around 16%. Cat bond yields vary, but even in today’s market, with numerous institutional investors chasing yield, the bonds are still yielding 6% or more. By comparison, another staple group among pensions, municipal bonds, are yielding less on average than at any time in the last 20 years. Some riskier cat bonds yield far more, though – bonds I have reviewed for valuation on behalf of clients in recent months have sometimes yielded 10-12% or more.

Cat bonds have many positive qualities, including effective diversification benefits in most portfolios. Yet there are important features that investors and attorneys advising investors need to be aware of. For instance, due to the high yields these bonds carry, investors are often seduced into believing they can earn significant alpha (i.e., excess returns versus traditional financial markets that are not justified by the risks being taken). That assumption is dangerously naïve. Cat bonds are especially complex to value, which compounds the issue.

The problem with valuation of cat bonds is that the risk of an adverse event can be very difficult to calculate. While traditional bonds are fairly straightforward to value, valuing cat bonds requires an understanding of not only statistics and actuarial concepts, but also correlations between events, relationships between cat bonds and financial markets, and financial assumptions on loss-given-defaults. Needless to say, most hedge funds and institutional investors wisely employ outside consulting firms to help them determine these values, and most reputable cat bonds these days are sold with an additional independent valuation report included in the documentation.

On the whole, the important point for investors and their advisors to remember with instruments like cat bonds is simply this: in financial markets, it often pays to think differently than others do, but careful thinking about the details behind such investments is a necessity.