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Growing Appetite: Insurers have nearly tripled their collateralized loan obligation holdings since 2012 in the hunt for yield.

The insurance industry has embraced collateralized loan obligations, thanks to external pressures and the asset-backed security's improved structures.

Insurers have nearly tripled their holdings since 2012, increasing their exposure from $19.4 billion to $57.6 billion in 2016.

Asset managers have turned to CLOs seeking higher returns, portfolio diversification and a minimal increase in risk as traditional asset classes become exhausted in the hunt for yield in the low interest rate environment, explain A.M. Best's Ken Johnson, senior director, and Jason Hopper, associate director, in a recent interview.

New issuance of CLOs in the U.S. soared to a record $37 billion in the first quarter, largely due to unusually high demand from Japanese investors, Bloomberg reported in April. However, the asset class is under pressure and demand may begin to ebb due to prolonged low rates and low spreads.

Johnson and Hopper explain the rise of CLOs, which are largely comprised of senior secured bank notes made mostly to small- and medium-size businesses, in the following interview.

Insurers nearly tripled their holdings in collateralized loan obligations from 2012 to 2016. What is fueling the rise?

Johnson: The increase in exposure is driven by a few factors, including the persistently low interest rate environment, which is continuing to be an earnings drag on those insurers with more interest-sensitive liabilities. Also, from an overall portfolio standpoint, asset managers are aggressively marketing CLOs from the standpoint of lower historical default experience and good relative performance from a yield standpoint. The overall structure of the CLO has improved, providing more investor-friendly features such as improved subordination protection for the investment grade tranches.

For some, the attractiveness of CLOs as an investment vehicle is that they generally consist of private loans with spreads that are typically wider than corporate bonds of similar quality. This in turn allows the CLOs to offer attractive yields on investment grade tranches, relative to comparable investment grade corporates.

Market volatility has been the rule, not the exception, for months. What makes CLOs better equipped to withstand volatility and risk?

Johnson: CLOs are not immune to market volatility per se. Their advantage, however, is that they are generally floating rate instruments, which therefore provide some protection against rising rates, reducing interest rate risk. The risk performance, as measured by defaults, is somewhat shielded by the fact that these underlying loans are generally secured loans allowing for better recoveries than comparable corporates.

Although the life/annuity segment accounts for more than 80% of industry CLO holdings, the health and property/casualty sectors have increased their allocations as well. What is spurring that growth?

Hopper: CLO investment characteristics present the same positives and negatives for P/C and health insurers as they do for the life/annuity segment. Scale is important to consider here. The health segment has increased their CLO holdings by less than $800 million since 2012. They had roughly $100 million of CLO investments in 2012, and less than $1 billion as of year-end 2016. UnitedHealth Group, Anthem and HCSC [Health Care Service Corp.] account for nearly two-thirds of the health segment's holdings, so ultimately the larger insurers with a larger asset base will drive the trends.

On the P/C side, AIG accounts for roughly 20% of that segment's CLOs, while no other company accounts for more than 5% to 6%. So this is much more diversified with growth driven by many players, as well as AIG's scale.

The first of modern CLOs were issued in the mid-to-late 1990s. How have they evolved since the financial crisis?

Hopper: CLO structures have evolved over time. You have CLO 1.0, which usually refers to pre-2008 issues and includes some high yield bonds, as well as loans. CLO 2.0, which began in 2010 post-crisis, features higher levels of subordination, tighter collateral eligibility requirements and shorter non-call and reinvestment periods, along with other important distinguishing characteristics.

The current vintage, CLO 3.0, further reduced the risk by eliminating high yield bonds and adhering to the Volcker Rule and other new regulations. [The Volcker Rule, part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, bars banks and companies affiliated with an insured depository institution from short-term proprietary trading and limits their dealings with hedge funds and private equity funds.]

Vintages 2.0 and 3.0 represent the largest chunk of the market.

Johnson: In addition, most of the earlier CLOs were considered "balance sheet" CLOs in which banks were basically de-risking the balance sheet of loans they had made. The more recent vintages represent structures put together by asset managers in an attempt to arbitrage the spreads between the cost of originating the loans, and the spreads they need to offer at each tranche with the idea of creating upside by retaining a portion of the equity in the deal.

Will their structures change again since the U.S. Senate began rolling back parts of Dodd-Frank?

Johnson: One of the initial limiting factors was the requirement of the CLO originator to hold a portion of the equity as "skin in the game." However, in practice it turned out to be not such an issue. Rolling back that requirement may add some additional capacity, but not necessarily have a material impact.

Ninety-seven percent of CLOs held by insurers were investment grade as of 2016. But the number of rating units holding below investment grade CLOs nearly doubled between 2012 and 2016. Why the increase and will it continue?

Hopper: Still, only about one-fifth of A.M. Best rating units hold below-investment grade CLOs, not very widespread within the industry. Only four of our rating units have below investment grade--BIG--exposure exceeding 5% of their capital and surplus, with the largest being roughly 10%. We'd also point out that nearly two-thirds of BIG CLOs were rated NAIC-3. The downward shift in credit quality by insurers from NAIC-1 to NAIC-2 is notable, likely for the additional yield, given the 1.8 to 2.1 percentage point difference in yield between the two categories over the past five years. In general, these investments are of higher quality than other types of structured securities. Trends will continue, but we don't think the situation will become any cause for alarm.

Johnson: One thing to remember is that investing in CLOs requires a level of skill that not all insurers possess. Absent a few large players, including some that may originate their own business, most insurers investing in this space will require the use of outside managers. Therefore, cost may come into play when deciding to enter this space as well.Although most insurers have strong credit expertise in their investment shops to cover corporates and private placements, the additional nuances of understanding the syndicated bank loan market require an additional level of expertise, not only for the underlying loan analysis, but for the structure of the CLO as well.

The asset class is under pressure despite an extremely low number of defaults among senior tranches. Will spread compression affect demand or yield?

Johnson: Yes, as many of the underlying individual borrowers have been able to refinance their deals at lower spreads, many purchases of the investment-grade tranches of CLOs have seen their yields come down a bit. Given the sustained low rates and relatively low spreads from a benign credit market, the relative attractiveness of the CLO may start to deteriorate somewhat, lessening demand relative to other asset classes.

by Jeff Roberts

Jeff Roberts is a senior associate editor. He can be reached at jeff.roberts@ambest.com.

Key Points

Huge Jump: Insurers nearly tripled their CLO holdings since 2012, increasing their exposure to $57.6 billion in 2016.

Big Benefits: CLOs potentially offer higher returns, portfolio diversification and a minimal increase in risk.

Record Issuance: New issuance of CLOs in the U.S. soared to $37 billion in the first quarter.
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Title Annotation:Asset Management
Author:Roberts, Jeff
Publication:Best's Review
Date:Jun 1, 2018
Words:1308
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