Collateralised loan obligations (CLOs) are debt instruments that have existed for over 30 years. In recent years, US insurers have significantly increased their exposure to CLOs, reaching approximately $158 billion by the end of 2019. CLOs are becoming more popular due to their combination of high yields and potential for appreciation. They are especially appealing to insurers because of their capital efficiency, relatively low interest rate durations, and high spreads, providing a strong return on risk-based capital.
Despite these benefits, many insurers remain cautious, largely due to the complexity of CLOs and associated misconceptions. Concerns over liquidity, costs, and the resources required to manage these investments also deter some companies. However, smaller and midsized insurers may benefit from adding CLOs to their portfolios. Although complex, CLOs offer yields that adequately compensate for their risks. Those without in-house expertise or who wish to invest in riskier CLO tranches may consider outsourcing management to third-party specialists.
CLOs are essentially portfolios of leveraged loans that are securitised and actively managed. These portfolios are divided into tranches, each representing bonds with varying levels of risk and return. The first CLOs emerged in the late 1980s, and after evolving through several iterations, the current version—CLO 3.0—was introduced in 2014. The global market for CLOs stands at $891 billion, with the majority issued in the US.
Leveraged loans, which serve as collateral for CLOs, are senior secured loans rated below investment grade or yielding at least 125 basis points above a benchmark rate. These loans have features that make them well-suited for CLOs, such as consistent interest payments, liquidity in the secondary market, and high recovery rates in case of default. As of December 2020, there were $1.19 trillion in US leveraged bank loans outstanding.
CLOs are primarily issued and managed by asset managers. The ownership of CLO tranches varies; insurance companies and banks tend to own the senior tranches due to their lower risk and income-generating potential, while equity tranches, which carry more risk but offer potential upside, attract a broader range of investors.
Insurance companies have been allocating significant assets to CLOs, with life insurers representing the majority of exposure. According to the National Association of Insurance Commissioners (NAIC), life insurers accounted for 79% of the industry’s exposure to CLOs in 2019. Larger insurance companies dominate this market, with insurers managing over $10 billion in assets accounting for nearly 80% of the industry’s CLO investments.
CLOs are structured to generate above-average returns through income and capital appreciation. These structures consist of several tranches, each representing different levels of credit quality, asset size, and risk. CLOs follow a defined lifecycle, starting with warehousing and ramp-up, where the manager purchases collateral, followed by reinvestment and eventually repayment and deleveraging. Throughout this process, managers conduct regular tests to ensure the portfolio’s ability to meet interest and principal payments.
Cash flow management is essential in CLOs. Payments are distributed sequentially, starting with the highest-ranking tranches, and any residual cash flows go to the equity tranche holders. To safeguard against collateral deterioration, CLOs include coverage tests, such as interest coverage and over-collateralisation tests. If a test fails, cash flows are redirected from lower-ranking tranches to pay off senior tranches.
CLOs also incorporate several risk protections, including collateral concentration limits, borrower diversification requirements, and borrower size restrictions. These mechanisms help mitigate risk and ensure the stability of the CLO structure.
While CLOs are intricate and can be intimidating to investors, they offer significant opportunities for insurers, especially those willing to manage or outsource the complexities. With the right strategies in place, CLOs can provide a solid balance of yield and risk for insurance portfolios.
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