As hurricane season approaches, financial advisers continue to look warily upon catastrophe bonds.
Known as cat bonds, the securities are issued by special-purpose entities set up by insurers. The bonds offer investors high, variable-rate interest payments.
In the event of a catastrophe, however, the insurance company can take the collateral backing the bonds, which means investors may lose some or all of their principal and interest.
In recent years, hedge funds, pension funds and other money managers have poured billions of dollars into cat bonds. Last year, for example, insurers issued $7 billion worth of such bonds, up significantly from $4.7 billion in 2006, according to Guy Carpenter & Co. LLC of New York.
Many advisers, however, shun cat bonds — in large part because they consider them too risky.
"Cat bonds are a way for insurance companies to lay off risks on the individual investor the same way mortgage-backed securities were used by banks," said Hildy Richelson, president of Scarsdale Investment Group Ltd. of Blue Bell, Pa. "The attitude of the individual investor very often is that they buy what's yielding the most, but the average investor doesn't know what they're buying."
The 2008 hurricane season is expected to have more than the normal number of storms, according to Joe Bastardi, chief long-range forecaster with AccuWeather Inc. of State College, Pa.
In 2005, the year Hurricane Katrina struck, some $57 billion in insured losses were generated, exclusive of those covered by the federal flood insurance program, ac-cording to a report from Rand Corp. of Santa Monica, Calif.
Two weeks ago, the Financial Industry Regulatory Authority Inc. of New York and Washington issued an investor alert to explain how cat bonds work.
In that alert, Finra warned that most cat bonds are rated BB, which places them in the category of non-investment-grade securities.
That alone is reason enough to avoid investing in them, said Howard A. Trauger, president of Schuylkill Capital Management Ltd., a Philadelphia firm that manages $50 million in assets.
"A-rated or better, if you can believe any of the ratings today," Mr. Trauger said. "This is the only thing we'd buy for our clients, and we'd be unlikely to participate in the [cat bond] market."
But the BB rating isn't necessarily a bad thing, said Michael Temple, director of credit research at Pioneer Investments of Boston. The company runs the Pioneer High Income Trust, a high-yield closed-end fund with more than $520 million in assets.
"Ironically enough, we're talking about a rating that is the highest-quality rating in the portfolio if you're a high-yield investor," Mr. Temple said.
Bank loans and high-yield bonds tend to average in the low-BB to high-single-B range, he said. Ratings agencies are looking at the possibility of the bonds' defaulting when grading securities, but in the last 10 years, the incidence of defaults in the high-yield market has been low, Mr. Temple said.
The attractiveness of the cat bond may wane, he said, because such bonds float on the London interbank offered rate, the interest rate at which banks can borrow from other banks.
Since the Libor is low, the overall yields for cat bonds has also fallen. As a result, junk bonds and bank loans are now yielding more, Mr. Temple said.
"We're evaluating a mix of high-yield bonds and bank loans, but we haven't made any decisions," he said. "We're comfortable where we are now."
DIVERSIFYING RISKS
Although advisers are concerned about diversification of asset types, within the Pioneer High Income Trust, risk types must also be diverse, Mr. Temple noted. No more than a quarter of its assets are exposed to wind risks in the United States, and even in that category, the fund differentiates between southeast winds — which breed hurricanes — and northeast winds, which tend to spawn snowstorms.
"The real risk [in the cat bond] is the structure being pierced by a multistandard-deviation event," Mr. Temple said, describing a disaster of such magnitude that the insurance company would need the proceeds.
For many advisers, catastrophe bonds simply represent too much risk.
"It's fat-tail risk — the risk of something unexpected happening," Ms. Richelson said. "And it's the decision by the insurance company to draw back from funding these types of risks."
Mr. Trauger is just as wary.
"We're not out buying lucky-stake Friday gold mine stuff that's a speculative investment," he said.
Mr. Trauger's clients, particularly those who have trusts, would prefer a tamer investment, as their priority is to protect their assets.
"Speculators get the bulk of the great returns, but clients of speculators get the bulk of the great risk, he said.
Most advisers say they will eschew the world of high-yield debt.
"In-vestors will endure losses as long as they come in the context of gains," Ms. Richelson said.
"That's why they don't abandon the stock market after a crash," he said. "What exactly do you think the odds are of losing all of your money?"
E-mail Darla Mercado at [email protected].
