The Journal of Alternative Investments
Cat bonds are short-term, floating rate instruments that act like reinsurance contracts in that they provide issuers protection against pre-specified catastrophic property losses such as major hurricanes, earthquakes, or similar such events. We review the diversification and other performance characteristics of cat bonds, and study their prospective value in the context of portfolio allocation. While cat bond performance over the past 14 years showed an 8.3% annual average return with a realized Sharpe ratio of 2.4; looking ahead the authors believe that investor appetite, limited supply and expected principal write downs combine to meaningfully lower expected returns in coming years. Though still compelling from a diversification standpoint, the authors believe these lower expected returns might not justify their relative illiquidity and the risk of investing in a relatively unknown security.