Catastrophe Bonds - exotic financial instruments

In 1985, when I began my career, the Dow Jones Index was at 1,200 (now around 22,000).  NZ Trustees had been limited by legislation to certain investments.  Share investments were considered to be sophisticated, exotic investments, only a handful of people dared venture near them.

Working as a Sales Executive for giant US fund manager Fidelity Securities, from  1987-1989, my role was to explain and educate Australasian financial planners and investment advisers about why international shares should be a core part of their clients portfolio's.

Since the 1980’s, as the number of investors has grown, and portfolios grew in size, the range of investments has increased.

Over the last 20 years we have seen the introduction (and demise) of a number of 'sexy' exotic, investment options, many of which have been mis-packaged and mis-understood, and led to disappointment from investors and advisers.

These have included contributory mortgages, syndicated property investments, funds investing in Collateralised Debt Obligations and of course New Zealand's non regulated finance companies.

The movie 'The Big Short' illustrates how financial markets can get carried away with innovation and profit goals, creating artificial pyramids that can collapse, wiping out investors at the end of the chain, who were not aware of the convoluted structures behind their investments.

After the finance company crash in New Zealand and the Global Financial Crisis, many people reverted to investing in 'plain vanilla' investments, highly rated fixed interest issues, investments in companies that actually generated income and weren't layers of packaged instruments and 'tricky' financial strategies.

However, as interest rates remain low, financial institutions are continuing to innovate, creating packages of investments to fulfil the demand of higher returns from investors and their advisers.  The cycle continues, people quickly forget the pain of loss, in pursuit of return.

Recent innovations include the 'catastrophe bonds', that the New Zealand Super Fund is investing in.  These Insurance-Linked-Securities assist insurers in diversifying their risks from their own pool of capital,  to the huge pool of capital available through Wall Street.  The yields on these CAT bonds often reach double figures, but with demand out-stripping supply, some returns have fallen to around 5%.

The risk of these CAT bonds has been statistically modelled (as were the CDO bonds that failed spectacularly) but the real risk is unknown, it will only be proven with experience and claims.  Catastrophes related to climate seem to be increasing and earthquake risk is not yet predictable.

Fortunately, the major purchasers of these CAT bonds are large pension schemes with long term liabilities. At Moneyworks, we prefer to stick to the plain vanilla solutions that work consistently, without taking on additional risk for our clients.

For more information on Catastrophe Bonds, read this excellent article from