As concern mounts about how a downturn could hit insurers’ CLO holdings, Nicholas Pratt looks at the appeal of collateralised loan obligations and the impact of recent rule changes in the US market.
Insurers have taken closer interest in collateralised loan obligations (CLOs) in recent years, especially in the US market, as a means of diversifying fixed income investments. This has led to some warnings from rating agencies that the market may be overheating and insurers could be affected when markets take a turn for the worse.
In the US alone, insurers held around $92 billion (€83 billion) in CLOs at the end of 2018. While this still represents only about 2% of their invested cash assets, the rapid growth in holdings is a cause for concern. For example, a report from Fitch issued this year stated that insurers’ growing CLO portfolios could cause problems in the next recession.
“Investments in CLOs increased markedly in recent years and could pose a significant risk if investor protections weaken later in the credit cycle,” the report states.
Aside from the worrying assumption that a recession is a case of ‘when’ and not ‘if’, Fitch also noted the drop in credit quality of insurers’ holdings from 2007 to the end of 2018, with investments in A-rated bonds falling from 69% to 61%. At the same time, BBB holdings have climbed from 25% to 34%.
This concern is echoed by another rating agency, Moody’s. Its senior credit officer Shachar Gonen points out that CLOs are backed by leveraged loans, adding that the credit quality of these loans has fallen and is expected to deteriorate more in the future.
“Demand in the market for leveraged loans has been high and this has led to a weaker standard of underwriting,” he says. “Ultimately, we expect this to lead to a higher default rate in the event of a market downturn as well as lower expectations for recovery rates if the loans do default.”
The concern, Gonen says, is not only about the potential for principal losses if defaults increase, but also capital charges if the CLOs are downgraded. Even without any direct losses from the CLO, insurers could be forced to hold more capital against any of those downgraded investments, he adds.
The rating agencies’ warnings could be all the more prescient as a result of a regulatory change in the US which puts regulation at odds with European rule-makers. The change concerns risk-retention rules, whereby the issuers of CLOs and other securitised instruments are required to hold a certain percentage of the underlying loans contained within the instruments. In other words, they have ‘skin in the game’.
As of 2014, each originator or sponsor of a CLO issued in Europe has to retain a minimum of 5% of nominal value of each transaction by either taking first-loss risk or 5% of each tranche. In 2016, the US followed suit by introducing a comparable rule whereby the originator had to retain 5% of the fair value, although not necessarily for the entire duration of the CLO.
Difference in mindset
However, as of 2018, the risk-retention rule in the US was rolled back for CLOs where the underlying loans were originated in the open market and not by the issuer of the CLO. Meanwhile in the EU, the European Securitisation Legislation was introduced in 2019 that covers multiple securitised instruments and ensures that they all have a 5% risk-retention rule.
“I don’t think it’s fair to say one regulator is right and another is wrong,” says Michael Grunow, senior portfolio manager in Union Investment’s credit solutions team, with respect to the disparity. “It is more a difference in regulatory mindset.
“The EU does not want taxpayers bailing out the banks again if there is another financial crisis, but many market participants believe their approach is overly punitive, especially in comparison to the treatment of other investments. Meanwhile, the US only introduced risk-retention at the end of 2016 and then scrapped it less than 16 months later, so you wonder if the rules will change again.”
One unintended consequence of the difference in rules is that EU insurers and investors will be prohibited from investing in some US CLOs, but that this will actually give them a less diversified CLO portfolio – one of the great benefits of CLOs.
“In the US CLO market, there are more than 1,200 broadly syndicated leveraged loan names and there is not so much overlap between CLOs compared to Europe,” says Grunow. “So if there is an increase in defaults, you will be hit harder if you are concentrated in EU transactions with higher overlap as opposed to also having US CLOs.”
And what should insurers be looking at in terms of their CLO investments? “The US market is much bigger than the EU market but it has also been on a longer credit cycle,” says Sid Chhabra, head of structured credit and CLOs at BlueBay Asset Management. “Every investor should be cautious about where we are in the credit cycle and how to deploy capital in that context. The higher you are in the capital structure, the more protection you get in a default but the lower the yield.
“EU insurers that invest in CLOs are typically investing in investment-grade tranches. CLOs generally did quite well in the financial crisis. My sense is that rating agencies have been more diligent in applying ratings than in the financial crisis, so rating agencies should be on the ball when it comes to altering the ratings in the event of a market change.”
The attraction of CLOs to insurers is quite clear. “They offer a significant pick-up in spreads compared to other fixed income instruments,” says Chhabra. “They are also quite diversified, with exposure to 100-150 leveraged loans in the European market.”
There is also a floating rate rather than a fixed rate, meaning there is very little rate duration and investors are able to choose what risk they want to take on, with different ratings and different spreads – the lower the rating, the higher the yield, says Chhabra.
Jamie Villiers, business development director at investor services provider Sanne Group, says: “Insurers like fixed income in general and particularly CLOs, because it is a yielding asset that is tradeable and with durations that are not too long or short-term. Insurers like to be ‘cash-long’ and in the current rates environment, where it costs money to hold cash on deposit, CLOs provide a much better return.”
In many ways, with non-banks holding more than half of the CLOs globally, things have turned 180 degrees in the CLO market, says Villiers. “It used to be that banks were the only ones investing in these instruments, but now they only pick up the AAAs,” he says. “Insurers have abundant capital and many of them have asset management arms.”
Meanwhile, in the US, some banks are returning as issuers, says Villiers. “They have been helping to structure these deals and have the distribution network. And with the scrapping of the risk-retention rule, they think they might as well become issuers.”
Should the market be worried that the dominance of insurers creates some sort of systemic risk? Not according to Villiers – not least because the market is quite stable and has been for some time, with performance and ratings staying high and default rates remaining low.
However, there is no room for complacency, he adds. “I would advise insurers to look at the diligence and track record of the managers they’re investing with and the diversification of the assets within the CLO and to keep a general eye on the performance of the syndicated loan market.”
As for the disparity in EU and US risk-retention rules, EU investors know what they can and cannot buy – all EU-based CLOs and some US ones, says Chhabra. “If investors want US exposure, it is a problem and greater choice is always preferable. But the EU is still a large and quality market.”
Fundamentally, CLOs are investing in high-yield loans, so anything that affects default rates should be on an investor’s risk radar, says Grunow. That said, the fact that there is so much talk of overheating in the leveraged loan market, despite the absence of a significant market event, is a positive development and a sign of conscientiousness from investors.
“Leveraged loan structures and documentation have become more aggressive, which often is a sign of a late stage in the credit cycle, and while we don’t see a global recession in the next 12 months, growth may slow,” says Grunow. “However, we do not anticipate a mass of defaults. In addition, the leveraged finance market has not significantly increased in recent years and especially in the context of the growth of other fixed income asset classes such as investment-grade credit.”
For CLOs, it will be important that the investor base stays broadly the same or increases further, he says. “If that is the case, CLOs will in our view remain relatively attractive in comparison to other fixed income securities.”
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