A catastrophe bond, or CAT bond, is a kind of bond that is involved with the chances of extreme catastrophes such as storms and other natural events. CAT bonds are generally high yield bonds with some significant and unique risks. They are complicated debt products that are often related to the way that insurance is applied to a property, region, or asset.
A specific feature of many CAT bonds is that in the case of a certain catastrophe, the debt is actually written off, and the borrower is allowed to default. The way that this works varies from one bond to another, but it is this aspect of a CAT bond that poses the most risks to the lender, or those holding the high yield bond. In exchange for higher yields, the bond holder takes on that risk is part of a diversified portfolio.
Some finance professionals today are touting CAT bonds as a way to diversify risk. One of the aspects that some find positive about CAT bonds is the fact that they are not tied to stock sectors or other market events. Rather, they are tied to real world events and natural situations. That means that realistically, an investor who diversifies well can stand to lose out from either negative market events or negative real world events, and still make gains even in troubled times. Whether or not this is true for any single investor is something that has to be judged on a case to case basis, but with a highly complicated statistical modeling that some traders use, CAT bonds end up looking good as diversification tools.
One of the foremost dangers of a CAT bond is that investors are not always fully informed about what they are buying into with their money. For someone who is readily willing to take the risk of a high yield CAT bond and its higher chance of default, investing in these instruments may be seen as “fair play,” but because so much of the average investment capital is filtered through trading desks and brokers, there is a lot of chance for someone to hold risky CAT bond funds, or other similar holdings, without really knowing what the risks are.
Some of the most prominent financial journalists of recent times have held forth on the pros and cons of the CAT bond. Finance author Michael Lewis has explored much of the nature of these bonds in a New York Times piece called, “In Nature’s Casino.” Traders and others who look more closely at the CAT bond as a market traded derivative product get insight on how sophisticated financiers are essentially betting on natural catastrophes, with all of the risks and benefits that this entails.