Be Aware of Catastrophe Bonds

Posted on March 30th, 2020 at 4:48 PM
Be Aware of Catastrophe Bonds

From the Desk of Jim Eccleston at Eccleston Law LLC:

Although not sold directly to individual investors, investors should be aware of catastrophe bonds and other event-linked securities, which can be part of their mutual funds, closed-end funds or other investments.  Highlighting the extreme risk that these bonds can carry, the Financial Industry Regulatory Authority (“FINRA”) previously issued an Investor Alert regarding catastrophe bonds and other event-linked securities.

Catastrophe bonds usually are issued by an insurance company through a “special purpose vehicle.”  A catastrophe bond will be linked to a specific natural disaster (the “triggering event”), which will be detailed in the bond’s offering documents. As long as the natural disaster linked to the catastrophe bond does not occur, investors in a catastrophe bond will receive interest payments and, upon maturity of the bond, their principal investment. The typical maturity period for a catastrophe bond is three years.

However, if the triggering event does occur during the life of the bond, the investor could lose most, or even all, of their principal investment and also lose any unpaid interest payments. Because investors in catastrophe bonds face the possibility of big losses, these bonds are usually rated as “non-investment grade” or “junk” bonds. Catastrophe bonds are sometimes packaged into securities known as collateralized debt obligations (CDOs).

Catastrophe bonds do provide some benefits, including higher interest rates than those paid by traditional corporate bonds.  Additionally, because catastrophe bonds’ performance is not correlated to the performance of other asset classes, these bonds can be a good way to diversify a portfolio.

However, catastrophe bonds also include considerable risk.  Catastrophe bonds can lose most or all of their value if a triggering event occurs.  Compounding this risk is the fact that the secondary market for catastrophe bonds is very limited. 

Additionally, the pricing, yields and ratings of these bonds are based on computer modeling, which can be inaccurate and/or based on limited data.  In its Investor Alert, FINRA described the models used for catastrophe bonds as “essentially untested.”  Catastrophe bonds frequently put the burden on the investor to evaluate a catastrophe bond and the likelihood of a triggering event occurring.

Adding to the risk of catastrophe bonds is the fact that these products are not subject to the SEC’s registration and disclosure requirements. Because these products are not registered with the SEC, they lack many of the investor protections found in registered investments.  

As with other bonds, there is the risk that the party responsible for making the principal and interest payments to investors will experience a financial problem and be unable to make payments to investors.

Individual investors, who are concerned that funds they own may be invested in catastrophe bonds or other event-linked securities, can consult the fund’s prospectus and statement of additional information, as well as the fund’s annual and/or semi-annual report to shareholders.

The attorneys of Eccleston Law LLC represent investors and advisors nationwide in securities and employment matters. The securities lawyers at Eccleston Law also practice a variety of other areas of practice for financial investors and advisors including Securities FraudCompliance ProtectionBreach of Fiduciary DutyFINRA Matters, and much more. Our attorneys draw on a combined experience of nearly 65 years in delivering the highest quality legal services. If you are in need of legal services, contact us to schedule a one-on-one consultation today.

 

Related Attorneys: James J. Eccleston

Tags: eccleston, eccleston law, james eccleston, catastrophe bonds, special prupose vehicle, insurance, collateralized debt obligations

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