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Rising interest: Why insurers may want to consider CLOs

Dec 6, 2017

Insurers have been pressured by low rates for nearly a decade. They have responded in myriad ways, from increasing duration to moving down in credit quality to embracing alternative assets and private markets.

Now, with rates starting to rise amid a sustained uptick in global growth, it may be an opportune moment to reassess current asset allocations and to fine tune them for the road ahead.

Scott Snell, co-head of BlackRock’s U.S. CLO team, discusses some of the unique ways CLOs can potentially help insurers meet the evolving challenge of getting more from their investment portfolios.

Why should insurers be interested in collateralized loan obligations (CLOs) right now?

There are a few factors at work. The first is the structure of CLOs and the capital efficiency they may offer. CLOs provide exposure to a portfolio of leveraged loans, all of which are non-investment grade. If insurers were to purchase these loans individually, they would incur a hefty capital charge on each holding. However, when CLO managers purchase a portfolio of these loans and securitize them, they can offer a number of investment tranches that carry different ratings and risk exposures. Because CLOs need to be diversified across industries, issuers and regions, the senior tranches will have a higher rating than the average rating of the underlying loans, and with that higher rating comes a less punitive capital charge.

I think that’s particularly attractive to insurers at the moment, and the results of our 2017 Global Insurance Survey clearly bear that out: More than 40% of respondents agree that their organizations are increasingly under pressure to produce excess returns in their investment portfolios, but just 9% intend to increase their investment risk over the next 12-24 months. Add to that the fact that 69% of respondents agree that there is “significant room” for their organization to improve “capital efficiency management,” and the case for CLOs becomes clear: They may help provide a yield pickup that insurers sorely need, without having to move too far down in credit quality and without incurring significant capital charges.

The fact that CLOs are floating rate, and therefore low-duration, has also helped to attract interest. Say you are an insurer and you have cash from maturing higher-yielding investments, purchased before the low-rate regime began. If you reinvest that cash in the same asset class with the same maturity, you are now looking at a significant decrease in yield. One option would be to move out in duration, but that’s not going to be attractive, or practical, to all insurers. But CLOs may provide insurers with a way to potentially earn some additional yield without increasing duration.

How are the current macro and market environments affecting the outlook for CLOs?

If you look at fixed income markets right now, two things stand out. One is that, certainly in the U.S., we’re finally starting to see rates move higher, but they are still very low by historical standards. So again, this provides something of a tailwind for floating-rate assets like CLOs. Why lock up capital for an extended period of time at a fixed rate if you expect rates are going to continue to move higher over the next year or two?

Perhaps less appreciated is how flat the yield curve is and what that means for different asset classes. In the U.S., we are looking at a roughly 100 basis point difference between three-month LIBOR (the CLO base rate) and the ten-year Treasury yield as of November 2017, according to Bloomberg. To give that some historical context, the curve steepened to approximately 275 basis points in September 2013 and, aside from a dip below 100 basis points in the second and third quarters of 2016, it is currently sitting near all-time lows. So looking at the relative value of certain CLO tranches versus other longer-duration assets, I think CLOs present an attractive value proposition, with the curve as flat as it is. To put it another way: You’re not picking up much yield in exchange for taking on significantly more duration risk, and that makes lower-duration assets appear more attractive.

While the current environment is providing a few tailwinds, insurers also need to keep the longer-term picture in mind and to think about how their portfolios will perform when the credit and economic cycles eventually turn. There's no doubt that the current credit cycle has gone on for an extended period of time. As a result, we are seeing some spread compression, leverage ratios have been creeping up, and documentation has been loosening in certain cases. This applies not just to the CLO market, but also to the broader credit landscape. I don't think you'll see a pick-up in defaults anytime soon, given the sustained strength of the global economy, but risk mitigation is something that is, and should be, on investors’ minds.

While there are no guarantees as to how any asset class will perform when the cycle turns, we can examine CLO performance over many years, including the time of the global financial crisis. Here, the results are encouraging as CLOs have historically defaulted at significantly lower rates than similarly rated corporate bonds. See the Default dichotomy chart.

Default dichotomy

Default history of U.S. CLO tranches and corporate bonds

Default History of U.S. CLO tranches and corporate bonds

What is required for success in
CLO investing?

We believe successful CLO investing is centered on analyzing the underlying loan credits, assessing collateral manager capabilities, and understanding structural and language nuances in the governing legal documents. Being both a manager of CLOs and an investor in CLO tranches is critical to our approach and success. We believe being in the market day in and day out in both capacities really gives us heightened perspective on credit trends and allows us to assess the overall quality of a CLO manager’s investing capabilities.

Size and scale can be also be advantages, particularly when sourcing and structuring deals. The ability to speak for large portions of the capital structure gives us the potential to negotiate attractive terms for investors. It also makes us a valuable counterparty for managers and arrangers bringing new deals to the market, as they typically want direction and certainty around deal execution. Those opportunities are often limited to market participants that are large and can bring sufficient capital to the table.

Finally, risk management is critical. There is a tremendous amount of data to process when evaluating hundreds of underlying loan positions. So having both the personnel and the technology to understand and react appropriately to risks at both the individual security and total portfolio levels is key. A dedicated risk group that really understands the CLO market and isn’t afraid to ask difficult questions is a valuable resource for us.