The Covid-19 pandemic and the portfolio diversification effect of catastrophe bonds

Chi Feng and Xudong Zeng

Abstract

This study investigates the role of catastrophe (“cat”) bonds in an international multiasset portfolio, including stocks, private equity, infrastructure and commodities, before and during the Covid-19 pandemic. By employing the dynamic conditional correlation (DCC) generalized autoregressive conditional heteroscedasticity (GARCH) model, we find that cat bonds serve as an effective diversifier throughout, and as a safe haven against stocks and private equity post outbreak. These properties are robust under alternative model specifications, including desmoothed returns and the corrected DCC-GARCH model. In addition, we conduct a hedge ratio analysis and confirm cat bonds’ superior diversification benefits, despite their sensitivity to hurricane risks. Lastly, using a model-free asymmetry test, we observe asymmetric correlations between cat bonds and commodities, with stronger downside correlations during the pandemic. Our findings provide further insights into the interrelations between cat bonds and other assets during the Covid-19 pandemic, as well as the role of cat bonds as an alternative investment during general financial uncertainties.