An extremely high-risk, high-reward corner of the bond market is seeing volume soar to record levels

Sales of so-called cat bonds are 38% higher this year through May than over the same five-month period in 2023, which was already a record, according to Artemis, a compiler of data on insurance-linked securities. What’s more, the $4 billion issued in May alone represents the greatest volume of catastrophe bonds ever sold in a single month, Artemis said.

The development looks set to reshape a market that last year supported the world’s best-performing hedge-fund strategy. Cat bonds, which allow insurers to transfer risk to the capital markets, can leave an investor with huge losses if catastrophe hits, and huge gains if it doesn’t. In 2023, cat bonds soared 20%, marking the best annual return in their almost three-decade history.

Now, some veteran catastrophe-bond investors are looking for ways to cut their exposure as forecasts point to a particularly active hurricane season.

Tenax Capital, an asset manager specialized in cat bonds, says greater scrutiny is needed when various forecasting agencies predict a more active hurricane season than usual, which is then reflected in daily portfolio decisions.

Bonds in the firing line are those that are the most junior in an extreme weather event, said Toby Pughe, an analyst at London-based Tenax. The fund manager is now “even more strict in what we buy,” and is limiting investments to cat bonds that are triggered by statistically rare, large events, he said.

Extreme weather events are among a number of parameters driving cat-bond issuance. Others include inflation and population density. All of these parameters have risen in recent years, leading insurers and reinsurers to rely more heavily on capital markets to cover potential losses. 

Issuance of the bonds, including non-property and private transactions, reached an all-time high of more than $16 billion in 2023. The current value of outstanding cat bonds stands at $49 billion, Artemis estimates. Crucially, last year saw relatively few weather events that ended up triggering cat-bond payment clauses, leaving investors uniquely well off. 

This year, the risks appear to be higher. 

Thanks to near-record ocean temperatures and a shift to La Niña conditions, the US is expected to witness an extremely active hurricane season. Scientists at Colorado State University predict 23 named storms, 11 hurricanes and five major hurricanes, which is significantly higher than the historical average. They also warn of a higher probability that at least one major hurricane will make landfall this year.

No one can accurately predict the size or path of a Caribbean tempest. But a series of accumulating risks — climate change, increased property exposure and inflation — has raised the financial impact of any storm season, and especially a more active one.

“The US avoided a truly catastrophic hurricane season last year, but if forecasters are correct, we may not be so lucky in 2024,” said Adam Kamins, an economist at Moody’s Analytics, a unit of Moody’s. “With few signs of a slowdown in building in high-risk coastal areas, a major storm would have significant consequences.” 

The outlook for Florida, where it’s become increasingly difficult to gain access to insurance, is now prompting cat-bond investors to treat some corners of the market with caution.

“It wouldn’t surprise me if some investors say they’re not going to do Florida wind-storm cat bonds this year,” said James Eck, senior credit officer at Moody’s.

Given the growing risk associated with holding the securities, investors are now demanding higher returns from issuers. Artemis notes that spreads on cat bonds soared 23% between March and the end of May.

Meanwhile, insurers and reinsurers are continuing to farm out large chunks of their natural-disaster tail risk to the capital markets. Notable issuers include Citizens Property Insurance Corp., Florida’s property insurer of last resort, which recently finalized a $1.1 billion cat bond ahead of the hurricane period. The Texas Windstorm Insurance Association recently sponsored a $1.4 billion cat bond, its largest ever.

Countries exposed to extreme weather risk also are tapping the cat-bond market. In April, the World Bank issued three cat bonds that provide $420 million of insurance coverage against storms and earthquakes for Mexico. A week later, the bank priced a catastrophe bond for $150 million for Jamaica against named storm events. The deals are part of the World Bank’s goal to increase the amount it has outstanding in cat bonds to $5 billion over the next few years.

To be sure, a more active hurricane season doesn’t always mean more cat-bond losses. 

“It all comes down to where a hurricane makes landfall,” said Charles Graham, insurance analyst at Bloomberg Intelligence. A storm in a sparsely populated rural area could cause little damage, “but if something goes right through Miami, it’s going to be a different story,” he said.

History shows “that larger losses don’t necessarily need to be precipitated by an active season,” according to a recent report by Man AHL, a unit of Man Group Plc, the world’s largest publicly traded hedge fund manager.

That said, climate change is increasingly becoming a wild card for cat bond investors. Moody’s notes that 17 of the 19 costliest US hurricanes occurred in the past 20 years, even after adjusting for inflation. Added to this is a sharp rise in the frequency of billion-dollar events. 

Costly storms threaten to “destabilize” the insurance market as some insurers flee high-risk areas like Florida and California, Moody’s said.