Hopefully, your bond purchase doesn't result in a catastrophe. But there is such a thing as a catastrophe bond. They are sold to help raise money for an insurance company in case there is a major event such as a tornado, volcano eruption or a plague of locusts.
The parameters of the catastrophe are laid out when the bond is issued. A certain amount of damage from a hurricane with winds of a certain top speed...that sort of thing. If the catastrophe never happens, the insurance company pays the bond off as if it were a normal bond...regular payments of principal and interest. No drama there.
But if the catastrophic event does happen, the insurance company does not have to pay the interest or repay the principal. So why would anyone in their right mind invest in a catastrophe bond?
You're basically betting against the terrible event. These bonds offer a higher interest rate compared to other types of bonds with similar durations. They typically have a short maturity, usually ranging from three to five years...so there's some visibility. It's a way to get higher-than-usual return for shorter-term bond.
For these reasons, large pension funds like to buy “CAT” bonds as a way to diversify their portfolios. And despite all the major weather events we hear about in the news all the time, there have only been about 10 instances where investors lost money with a CAT bond in the last 20 years (as of 2018).
