NAIC’s results of CLO stress-testing expected early next month

Aug. 7, 2019– The National Association of Insurance Commissioners expects to have the results of stress tests on collateralized loan obligations in early September as the standard-setting organization is finding CLOs have recently been using more aggressive earnings assumptions and fewer guardrail conditions, known as covenants.

That’s according to prepared remarks from Eric Cioppa, NAIC’s president for 2019 and Maine’s insurance superintendent. Cioppa hilighted the issue as part of his opening remarks at the NAIC’s summer meeting in New York the first weekend in August.

The remarks come on the heels of a special  report released July 23 by the NAIC’s Capital Markets Bureau assessing exposure to CLOs by the insurance industry for 2018. The remarks also come soon after state insurance regulators, coordinated by the NAIC,  have made changes to better scrutinize the risk of certain financial instruments such as CLOs.

Fitch Ratings announced Aug. 7 that U.S. and European CLO issuance was higher in the second quarter of 2019  than the first quarter, helped by ” flexible structures and spread stability” and brisk activity in April.

The vast majority–90% to 95% of CLO transactions are arbitrage CLOs where equity  investors get the cash  flows after the debt on the bank loans are paid to the note holders, based on an NAIC primer on the subject.

CLOs are structured securities sold in tranches by asset managers and collateralized  mainly by leveraged bank loans. They are collateralized by what the Bureau identifies as a pool of below investment grade first lien, senior secured, syndicated bank loans as well as smaller pools of  middle market (MM) loans and second lien loans.

According to Fitch Ratings’ statement on its new report, Global CLO Chart Book: Market Review – 2Q19, the portfolio quality for CLOs has been “fairly stable” in  both the U.S. and Europe, but the  U.S. MM CLOs’  wearer reveled to be “comparatively weaker,” Fitch stated. This because of a lower portfolio rating-mix, it said Aug. 7.

The NAIC’s Capital Markets Bureau found that at year-end 2018, the amount of CLO investments in book value held by U.S. insurers totaled $122 billion, with about a third of that exposure in the top 10 U.S. life  insurance companies.

However, even this amount of exposure represents but 2% of the total cash and invested assets of the insurance industry in the U.S., the NAIC’s capital markets research arm found.  For 2018, CLO issuance overall reached $128.1 billion, up from $118 billion in 2017, and surpassed the previous high, set in 2014, by more than $4 billion. Middle market loans comprised about $62 billion of the new 2018 issuance, according to the NAIC, citing Securities Industry and Financial Markets Association data.

Most U.S. insurers’ CLO investments were of a high credit quality, rated single A or higher,” said Eric Kolchinsky, director of NAIC Structured Securities in a statement accompanying the report’s release.

“However, recently underwritten leveraged loans are adopting more aggressive EBITDA [earnings before interest, taxes, depreciation, and amortization] assumptions and have fewer covenants. These trends call for a closer examination of this type of investment,” Kolchinsky stated.

The NAIC has been working to make some structured finance products less attractive to insurers with changes to investment incentives at the rating level through its Securities Valuation Office in New York. 

 A report by PineBridge Investments  back in August 2017 identified three “vintages” of  modern CLOs, the latest version appearing in 2014 and characterized by risk reductions such as elimination of high yield bonds and the advent of new regulations. PineBridge noted that CLOs there are about 250 CLO managers globally with about 75% in theU.S. the remaining asset managers of CLOS are in Europe, the report, entitled Seeing Beyond the Complexity: An Introduction to Collateralized Loan Obligations, noted.

This report also found that insurance companies top the list of largest CLO owners in the mezzanine tranches, rated A/BBB/BB. In the higher-rated senior tranches, insurance companies are the third-most prevalent owner, following banks and institutional asset managers, according to PineBridge’s research.

The NAIC’s Capital Markets Bureau said in its special report that CLOs “have the potential to be more volatile in an unstable economic environment, such as at the turn of a credit cycle,” but as of yet, they haven’t gone through anything alarming or too severe and withstood the financial crisis.

The credit quality of U.S. insurer CLO exposure was mostly BBB or higher, with the majority in the A to AAA range, according to the NAIC chart on CLO credit quality.

Even though U.S. insurers’ high credit quality exposure is expected to thwart major CLO problems if the securities go sideways, a cautious NAIC said it would “continue to closely monitor insurers’ CLO exposure.”

The anticipated early September–or even early fall  — results of the stress testing should show just how closely the NAIC needs to monitor CLOs going forward. 

There appears to be time to weigh the options presented by stress testing.

Deborah Ogawa, senior director  ofU.S. Structured Credit for Fitch Ratings said in a statement accompanying the inaugural Global CLO Quarterly market review that  European CLO asset recovery expectations are for those in the U.S. , on average for a variety of reasons. However, she said that the research shows  the CLO product to be stable, while Fitch round that not many CLOs failed their covenant quality tests in the second quarter.

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