Hi, do you know what the world's most profitable fund in 2023 invests in? It doesn't buy stocks, nor does it buy cryptocurrencies. It's a very mysterious financial product called a catastrophe bond.
Catastrophe Bond: What is it?
You might be wondering, "What kind of bond?" A catastrophe bond is a bond tied to major disasters. It's also known as a "Cat Bond" for short. In 2023, its return reached 20%.
Some people might think, "20% is okay, but Bitcoin can go up 20% in a day." In the financial world, if you only look at returns without considering risks, it's like talking nonsense. Otherwise, why bother with banks? Just buy Bitcoin!
Take a look at this chart showing the general performance of US bonds in 2023, and then compare it to the performance of catastrophe bonds. You'll see that catastrophe bonds not only have high returns, but they are also stable.
Why are Cat Bonds so Stable?
Are you curious about what can deliver such a stable 20% return? Is it just another scam product created by those cunning capitalists?
Let's take a look at what a catastrophe bond is. The concept is actually very easy to understand. It's quite similar to buying ordinary bonds. You receive interest payments periodically and get your principal back at maturity.
The only difference is that you're betting against nature. If a major disaster, like a hurricane, flood, fire, earthquake, etc., occurs, then sorry, depending on the severity of the disaster, part or even all of your investment principal could be lost.
Of course, this so-called "act of God" is not a vague concept. Each bond has very strict limits on the time, geographic location, and type of disaster covered.
For example, let's say there's a bond with a five-year maturity. If no disaster occurs during that time, you can receive a risk-free interest rate plus 10% annually as your total return.
However, if a hurricane hits Florida within those five years, and if the wind speed reaches a certain level, or a named hurricane makes landfall in Florida, then it's considered a disaster. You'll have to compensate based on a pre-agreed clause. There's a high probability you could lose all your principal.
You can simply think of it as depositing money in a bank and earning an extra 10% interest annually. However, if a severe hurricane hits Florida, your money is gone. What I just described is a Florida hurricane catastrophe bond. This is not a random example I made up; it's actually a very popular type of catastrophe bond recently.
Why are Florida Hurricane Bonds Popular?
Why? Because after the pandemic, many people started working remotely and moved away from crowded places like New York to places with pleasant climates like Florida, where it feels like a vacation every day.
This led to a surge in housing prices and supply in Florida, prompting more people to buy insurance. The biggest concern they want to protect against is hurricanes.
This, in turn, is linked to Florida hurricane bonds. We'll talk about the specific link later.
Similarly, there might be California wildfire bonds, Japan earthquake bonds, New York flood bonds, etc.
In November of last year, a new type of bond emerged called a cyber catastrophe bond, or Cyber Cat Bond. This means that if a company gets hacked, it's considered a disaster. It's quite imaginative! I just don't know how they define being "hacked".
Why Buy a Catastrophe Bond?
Let's get back to our topic. Why would anyone buy such bonds? Well, it's simple: they're very profitable when there are no disasters. The numbers I mentioned earlier about the Florida hurricane bond weren't made up. Its risk premium has indeed reached 10%.
I checked, and generally, the risk premium for this type of bond ranges from 3% to 15%. In recent years, it's generally been above 8%. Pretty tempting, isn't it?
What's the Risk?
How high is the corresponding risk? In other words, what's the probability of such a disaster happening? Generally, it's between 0.5% to 2% per year. This means you only need to bear the risk of losing money 0.5% to 2% of the time each year to get an 8% to 10% excess return.
Sounds great, right? But intuitively, for its profit to remain stable at this level of return, it's definitely not something ordinary people can play with.
In fact, that's indeed the case. Even though it sounds so profitable, only a handful of highly specialized hedge funds are active players in the catastrophe bond market.
However, when we say these hedge funds are "highly specialized," their specialty isn't mathematical modeling or quantitative hedging. It's weather forecasting and earthquake prediction. Think about it, you need to accurately calculate the probability of a disaster happening to determine whether a bond is worth buying or not.
Otherwise, even if you're lucky once or twice, it might not be more profitable than a bank deposit in the long run. It's quite ironic that these catastrophe bond buyers, the hedge funds, have researchers who spend all day studying things like weather forecasts and geology.
Didn't Nvidia boast that their AI chips are very good at calculating turbulent phenomena like hurricanes? Let me tell you, these hedge funds bought a lot of those graphics cards!
These hedge funds aren't just calculating the probability of disasters happening when they buy the bonds. They don't just predict once and hold the bond until maturity.
What really requires their expertise is that, as the bond price fluctuates, they need to predict the future probability of a disaster in real time to decide whether to trade the bond.
For example, let's say there's a hurricane in the ocean that's slowly moving towards Florida. The price of the Florida hurricane bond will definitely plummet. The higher the probability of landfall, the steeper the bond's decline.
As a hedge fund or bondholder, if you can predict this hurricane's arrival before others, selling it early could avoid huge losses.
Conversely, let's say the market estimates the hurricane's probability of landfall to be 60%. But you're a professional, and after careful analysis, you feel it's not that serious. You can then swoop in and buy a lot of these bonds at a bargain.
If the hurricane doesn't cause actual damage, as you predicted, and just grazes past Florida, the bond price will immediately rebound, and you'll make a fortune.
Another example: let's say there's a fire in California. These fund managers might use all their resources, like satellite imagery, to assess the fire's scale and determine whether it'll cause actual damage and trigger the bond's compensation.
That's basically how it works. By now, I believe you should realize that this is not money ordinary people can earn, and this 10% excess return is not something ordinary people can achieve.
Why a 20% Return in 2023?
Speaking of this, some quick-witted friends might ask: Even without a disaster, the excess return is only 10%. Why did the bond yield reach 20% in 2023?
Let me reveal the secret. In September 2022, the United States was hit by Hurricane Ian, which became the most destructive hurricane on record in Florida, causing over $100 billion in cumulative losses and triggering compensation mechanisms for several catastrophe bonds.
Therefore, investors were a bit spooked afterward. They felt that recent global warming might be increasing the probability of such extreme disasters and intensifying their severity. They became a bit hesitant to trust their original models and didn't dare to buy these bonds.
As a result, the price of the bonds began to fall. So, the entire catastrophe bond market actually had a negative return in 2022.
Later, in 2023, nothing major happened. Not only were there no major payouts triggered, but investors also received their coupon payments, and the bond prices gradually recovered. This is how the annual return reached approximately 20% in 2023.
So, the 20% we mentioned at the beginning was a bit of a gimmick. It was also the year with the highest historical return for catastrophe bonds. If you look at the historical returns of catastrophe bonds, it's generally less than 10%. It's definitely higher than government bonds, but it's definitely not as exaggerated as 20%.
Who Issues Catastrophe Bonds?
Let's look at the people who buy these bonds. Look at their earnings. If nothing happens, they can get a steady income. But if a disaster happens, they will lose a lot.
What does this equate to? Isn't it a bit like providing insurance, like major disaster insurance?
Let's think about it. Who would buy this insurance? In other words, who would issue this bond? Who would be compensated if a disaster occurred?
The most important issuers here are insurance companies. Because once a disaster occurs, the insurance company will have to pay a lot of money.
So they issue catastrophe bonds, which is equivalent to hedging some of the risk.
Another type of issuer is government agencies, such as state governments in the United States. For example, the New York State government. Once there's a flood and Manhattan is flooded, they'll suffer heavy losses. They may issue New York Manhattan Flood Bonds to hedge against this risk.
There are also governments of countries with less developed financial markets, such as Mexico, Chile, and Jamaica. They'll have the World Bank help them issue these catastrophe bonds.
So if you buy this catastrophe bond, you are equivalent to providing insurance for the insurance company, or for the governments and the World Bank. You are amazing!
The Structure of the Catastrophe Bond Market
Let's take a look at the entire chain of catastrophe bonds. Like ordinary people or companies, we need to avoid certain risks, so we'll find insurance companies to buy insurance.
For insurance companies, a large part of individual risks can be smoothed out through a sufficiently large number of policies. For example, the risk of a car accident or health problems. This is actually the basic logic of insurance companies' existence: to share each person's risk through large volumes.
However, it's different for catastrophe insurance. Imagine if a hurricane hits Florida, and possibly half of the homeowners come to you for compensation. Who can handle that?
For this type of systemic risk, insurance companies actually can't reduce their risk through large volumes. Even if the insurance company or the government has money and can withstand the losses caused by such disasters, they may have to reserve a large amount of emergency funds to deal with such low-probability events, which is not economical for them.
It's like saying that if you're worried that your house has a 1% chance of facing a hurricane disaster, you'll put half of your assets in the bank in a demand deposit account just in case. That's not realistic at all. A more ideal solution is to buy insurance.
The same goes for insurance companies. They also need to issue some catastrophe bonds to hedge their own risks or transfer risks to the market.
Investors in the market love these bonds. Why? First of all, the yield is high enough.
More importantly, this catastrophe bond has almost zero correlation with other financial assets.
Think about it, the price fluctuation of this catastrophe bond is basically calculated based on the probability of a disaster, like the probability of a typhoon or earthquake. This has almost nothing to do with stock market fluctuations, if not completely irrelevant.
This lack of correlation is great for asset allocation. By allocating part of your assets to such catastrophe bonds, you can greatly reduce the volatility of the entire portfolio, which is equivalent to reducing the investment risk for investors.
Therefore, consumers transfer part of their risks to insurance companies by purchasing insurance. Insurance companies transfer part of their risks to a wide range of investors by issuing catastrophe bonds. These investors reduce the risk of their portfolios by buying these catastrophe bonds. See? With the help of securitization, consumers, insurance companies, governments, and investors all reduce their risks.
Note that the costs associated with these disasters don't disappear. If your house is blown down, it's still blown down. The losses are still there. It's just that the catastrophe bond allows the entire market to share the burden and help you with compensation.
The ingenuity of this mechanism lies in the fact that those who invest in these catastrophe bonds are not doing it out of some noble moral obligation. They're just here for profit. You don't have to rely on their moral standards.
Moreover, they're not profiting from disasters. On the contrary, they're the ones in the entire market who fear and least want disasters to happen.
See, the high yields of these bonds attract a group of very professional people who spend all day studying the probability of disasters and whether something might happen. And once something does happen, they are the ones who have to pay with their own margin.
Isn't this division of labor quite reasonable?
When you first hear about catastrophe bonds, you might think it's another fancy product packaged by Wall Street.
Indeed, it was promoted by Goldman Sachs in the early 2000s. But after our analysis, don't you feel that it's not some overly complex financial product that no one can understand? It genuinely uses the securitization of the financial market and is driven purely by profit to automatically allocate risks and returns, helping society achieve a reasonable division of labor.
Isn't it amazing? This might be the charm of finance!