A segment of the extremely high-risk, high-yield bond market is seeing its volume soar to record levels.

Catastrophe bond issuance just hit a record high, as the market prepares for a tough hurricane season with the potential to cause substantial damage.

Sales of so-called cat bonds are 38% higher this year through May than during the same five-month period in 2023, which was already a record, according to Artemis, a compiler of data on insurance-linked securities. What’s more, the $4 billion issued in May alone represents the largest volume of catastrophe bonds ever sold in a single month, Artemis said.

It looks set to reshape a market that last year supported the world’s best-performing hedge fund strategy. Cat bonds, which allow insurers to transfer risk to capital markets, can leave an investor with huge losses if a catastrophe occurs and huge profits if it doesn’t. In 2023, cat bonds soared 20%, marking the best annual performance in their nearly three-decade history.

Now, some veteran cat bond investors are looking for ways to reduce their exposure as forecasts point to a particularly active hurricane season.

Tenax Capital, an asset manager specializing in cat bonds, says greater scrutiny is needed when multiple forecasting agencies predict a busier-than-usual hurricane season, which is then reflected in daily portfolio decisions.

Bonds in the firing line are those that matter the least in an extreme weather event, said Toby Pughe, an analyst at London-based Tenax. The fund manager is now “even stricter on what we buy” and is limiting investments to cat bonds that are triggered by large, statistically rare events, he said.

Extreme weather events are among a number of parameters driving catastrophe bond issuance. Others include inflation and population density. All of these parameters have increased in recent years, leading insurers and reinsurers to rely more on capital markets to cover potential losses.

Bond issuance, including private and non-real estate transactions, reached an all-time high of more than $16 billion in 2023. The current value of cat bonds outstanding is $49 billion, Artemis estimates. Crucially, last year there were relatively few weather events that ended up triggering catastrophe bond payout clauses, leaving investors exceptionally well off.

This year, the risks appear to be greater.

Thanks to near-record ocean temperatures and a shift to La Niña conditions, the United States is expected to witness an extremely active hurricane season. Scientists at Colorado State University predict 23 named storms, 11 hurricanes and five major hurricanes, which is significantly higher than the historical average. They also warn of an increased likelihood of at least one major hurricane making landfall this year.

No one can accurately predict the size or track of a storm in the Caribbean. But a series of accumulated risks – climate change, increased real estate exposure and inflation – have increased the financial impact of any storm season, and especially a more active one.

“The United States avoided a truly catastrophic hurricane season last year, but if forecasters are right, we may not be so lucky in 2024,” said Adam Kamins, an economist at Moody’s Analytics, a unit of Moody’s. “With little sign of a slowdown in construction in high-risk coastal areas, a major storm would have significant consequences.”

The outlook for Florida, where insurance is increasingly difficult to access, is now prompting catastrophe bond investors to treat some corners of the market with caution.

“I wouldn’t be surprised if some investors said they’re not going to issue catastrophe bonds in case of wind storms in Florida this year,” said James Eck, Moody’s chief credit officer.

Given the increasing risk associated with holding securities, investors are now demanding higher returns from issuers. Artemis notes that cat bond spreads shot up 23% between March and the end of May.

Meanwhile, insurers and reinsurers continue to transfer large portions of their natural disaster risk to capital markets. Notable issuers include Citizens Property Insurance Corp., Florida’s property insurer of last resort, which recently finalized a $1.1 billion cat bond ahead of the hurricane period. The Texas Storm Insurance Association recently sponsored a $1.4 billion cat bond, the largest in its history.

Countries exposed to extreme climate risks are also turning to the catastrophe bond market. In April, the World Bank issued three catastrophe bonds providing $420 million of storm and earthquake insurance coverage for Mexico. A week later, the bank priced a $150 million catastrophe bond for Jamaica against named storms. The deals are part of the World Bank’s goal to increase the amount it has outstanding in catastrophe bonds to $5 billion in the coming years.

To be sure, a more active hurricane season does not always mean more catastrophe bond losses.

“It all comes down to where a hurricane makes landfall,” said Charles Graham, an insurance analyst at Bloomberg Intelligence. A storm in a sparsely populated rural area might cause little damage, “but if something happens through Miami, it will be a different story,” he said.

History shows that “an active season need not precipitate larger losses,” according to a recent report by Man AHL, a unit of Man Group Plc, the world’s largest publicly traded hedge fund manager.

That said, climate change is increasingly becoming a wild card for catastrophe bond investors. Moody’s notes that 17 of the 19 costliest U.S. hurricanes occurred in the past 20 years, even after adjusting for inflation. Added to this is a sharp increase in the frequency of multi-billion dollar events.

The costly storms threaten to “destabilize” the insurance market as some insurers flee high-risk areas such as Florida and California, Moody’s said.

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