Even Covid couldn’t stop insurers buying risky CLO tranches

NAIC rules make mezzanine debt more attractive than AAAs or corporate bonds with similar ratings

US insurance companies invested more money in collateralised loan obligations last year, even as the Covid-19 pandemic threatened to trigger a wave of defaults on the loans backing the securities.

Life insurers held 13.1% of their assets in asset-backed securities – the investment category that contains CLOs – at the end of 2020, compared with 11.4% in 2016, according to Mary Pat Campbell who researches the sector for Conning, a specialist asset manager.

“Yields for the entire US life industry have dropped, but some insurers have done everything to slow the drop,” Campbell says. “Some insurers have ensured higher yields than others. And some of that has been through higher allocation to ABS.”

The insurance industry’s continued appetite for CLOs – securities backed by pools of leveraged loans – means even the sharpest economic downturn since the Great Depression has failed to slow the asset class’s dramatic growth since the 2008 financial crisis.

A new report from the Federal Reserve Bank of New York shows the value of outstanding US CLOs reached $647 billion on the eve of the pandemic, double what it was a decade earlier. Insurers have emerged as the largest buyers, especially of mezzanine tranches, increasing their holdings of CLOs almost ninefold to $125 billion over this period. They accounted for 19% of the total market in 2019, compared with 4% in 2003.

The Fed report details insurers’ proclivity for riskier mezzanine investments. CLOs are made up of tranches with different credit ratings. Equity investors take the first loss if the underlying loans default. The mezzanine tranches with the lowest credit ratings are next, while the AAA-rated senior tranche is the last to lose money. Yet insurers, which buy assets to match liabilities stretching over many years, mostly invest in the lower-rated tranches.

According to the Fed report, insurance companies owned less than 15% of AAA-rated tranches in 2019, compared with 42% of AA tranches, 39% of BBBs and more than 50% of A-rated tranches. The authors attribute this preference for lower-rated tranches to capital requirements set by the industry’s regulator, the National Association of Insurance Commissioners.

The NAIC’s risk-based capital framework requires insurers to the hold the same amount of capital against AA and A-rated debt as they do against AAA investments. The same capital charges apply to both corporate and structured debt. As AA- and A-rated CLO tranches have higher yields than AAAs and corporate bonds with comparable ratings, they provide bigger returns for the same amount of capital.  

The NAIC plans to revise its capital requirements for floating-rate securities at the end of this year – the first major adjustment in more than 20 years – though some worry the changes could encourage insurers to shop even further down the ratings scale.

Apocalypse postponed

Insurers that have piled into mezzanine CLO debt narrowly avoided disaster when Covid struck. If the Fed had not hosed debt markets with liquidity in the spring of 2020, many more companies could have defaulted on leveraged loans that had been securitised, leaving insurers holding lower-rated tranches exposed to losses.

“There was a lot of cash washing around the system that allowed things to be propped up for a while,” says Conning’s Campbell. “I think we have not seen a lot of credit events because of bailouts and that sort of thing.”

At the end of 2019, no CLO tranche rated higher than A2 by Moody’s had ever defaulted. After 18 months of pandemic, that remains the case, but some high investment-grade tranches “temporarily deferred interest” during the lockdowns, according to the ratings agency. They have since caught up on their late payments.

The Fed’s intervention and dollops of fiscal support stopped a wave of defaults. It also pushed insurers to dive back into the CLO market. With interest rates lower than before the pandemic, insurers needed yield more than ever. Many increased their holdings of mezzanine CLO tranches as soon as the danger from defaults had passed.

“CLO exposures went up a lot last year,” says a risk manager at a US insurance company. The percentage of mezzanine tranche ownership among insurance companies was 52% at the end of 2019. It definitely went above that in 2020.”

The US CLO market continued to grow in 2020 – and is now approaching $800 billion – despite the economic turmoil in the first months of the pandemic, says Peter Sallerson, a senior director of financial engineering at Moody’s Analytics. “It was strong at the start of the year and strong at the end of the year, but it shut down for a while.”

Some insurers are keener on CLOs than others. An NAIC report in July showed that ABS, including CLOs, accounted for 25% of bond investments held by private equity-owned insurers at the end of 2020, compared with 10% for the average US insurer. Athene, which merged with private equity giant Apollo in March, had $17.2 billion – roughly 11% of its portfolio – invested in CLOs at the end of June, according to its latest earnings report.

As interest rates increase, it’s going to smack investment-grade corporate bonds

Laila Kollmorgen, PineBridge Investments

The arrival of higher inflation in the spring, and with it the threat of higher interest rates, may encourage insurers to buy yet more CLO tranches. The yields on CLOs rise as interest rates go up, while corporate bonds will continue to pay a fixed income.

“As interest rates increase, it’s going to smack investment-grade corporate bonds,” says Laila Kollmorgen, a managing director at PineBridge Investments, which runs mandates for insurers. “Taking a look at the potential for a steeper curve, floating-rate assets are going to benefit. We have been seeing it since the beginning of 2021. If you have anything that’s fixed rate and an 11-year duration, all you have to do is increase interest rates and it will go down.”

CLOs’ popularity with insurers comes from the fact that the capital rules impose the same charges on A and AAA-rated securities, across corporate and structured credit. That will change at the end of this year if the NAIC goes ahead with a plan to introduce different capital charges for each rung in the ratings scale.

The revisions would reduce the charges for triple-A investments and make insurers hold more capital against A-rated securities than they do today. The difference, however, is small. “It has minorly changed some capital on some tranches,” says Kollmorgen, who manages $2.5 billion of CLO tranches for insurer clients. “For the most part, it continues to benefit CLOs in the investment-grade tranches. We are going to see insurance companies increase their holdings.”

The revisions might even prompt insurers to invest more in lower-rated tranches. While capital requirements for single-A securities will rise, the charges for the highest quality BBB-rated investments remain unchanged, while BB and B securities will see their capital charges lowered.

“If anything, the new factors may push insurers to purchase more BBB versus A tranches, given the increase in A factors,” says the risk manager at the US insurance company.

Insurers have been drawn to CLOs over the last decade because they have a higher yield and a lower default rate than corporate bonds with the same ratings. The risk manager says their appeal to insurers is unlikely to diminish unless the NAIC takes more onerous action than it is currently planning.

“[The new capital rules] still treat corporate bonds and structured bonds exactly the same,” he says. “While that remains the case, it doesn’t change at all the incentives for insurers to buy the structured bonds over the corporate bonds.”

Additional reporting and editing by Kris Devasabai