Industry comments are due Monday, September 12, on a National Association of Insurance Commissioners (NAIC) proposal to model collateralized loan obligation (CLO) securities based on stress tests, which would increase insurers' risk-based capital (RBC) charges to invest in them.
The comments would be the latest in discussions between the capital markets industry and the NAIC, addressing the NAIC staff's responses to an earlier round of industry comments about the proposal, which was issued May 25.
The NAIC stated at its August meeting that the earlier industry comments had expressed concerns about the proposal's timeline, potential impact and the historical strength of the CLO structure, BofA Securities said in its CLO Alert report published September 7.
Final implementation of the changes would likely occur by the end of 2024, the NAIC's Investment Analysis Office clarified at the August meeting.
In the proposal, the non-governmental organization argues that an insurer purchasing every tranche of a CLO holds exactly the same investment risk as purchasing the entire pool of loans backing the CLO. The risk-based capital for each investment, therefore, should be the same. It adds, however, that investing in the B-rated strip of a CLO results in risk-based capital for insurers that is approximately one third that of investing directly in the B-rated loans.
Research from BofA, however, concludes that investing in the CLO tranche is less risky for two reasons. For one, CLOs invest in diversified pools of loans in uncorrelated industries. Also they are actively managed and managers typically sell loans well before default.
Meredith Coffey, executive vice president of research and co-head of policy at the Loan Syndications Trading Association (LSTA), noted in a June 30 post "there may be good reasons to like CLO investments." CLO securities have experienced much lower default rates than corporate bonds with equivalent ratings, Coffey said.
NAIC's staff highlighted that it would need more data to support the claim that CLO pools have outperformed the loan market, according to the recent BofA report. The NAIC staff also said that default rates in CLOs might be lower precisely because managers can sell troubled loans prior to default, and that their ability to purchase discounted loans to "build par" should not be modeled into RBC calculations, since that "incentivizes managers to purchase distressed loans."
The bank's report countered that the NAIC proposal cites a 2003 paper from Moody's Investors Service which argued that purchasing discounted assets in a deteriorating credit environment can result in even greater portfolio deterioration. The bank said that analysis is flawed because CLOs were still at a nascent stage and it overlooks their performance in the 20 years since.
"The ability to build par by discounted assets is one of the driving factors of CLO outperformance, particularly during the [Great Financial Crisis) and COVID," BofA added. "We think the NAIC should give some credence to this in their modeling approach."
In its analysis, the LSTA calculates that CLOs' par build resulted in CLO portfolios seeing a cumulative loss of 1% over four years, while diversified passive loan portfolios saw 4% cumulative losses over the same period.
"In addition to the benefits of diversification and active management–which provide value across the capital stack–[the] rated notes in a CLO benefit from structural safeguards," the LSTA said. "Finally, the higher rated notes also benefit from subordinated notes beneath them."
The LSTA noted the NAIC's own estimates that insurers' investments in CLOs have increased significantly in recent years and that they hold more than half of CLOs' notes rated 'A' and 'BBB.'
"Thus, if these notes – particularly BBB notes – became less attractive to insurance companies, there could be ramifications for CLO originations generally," the LSTA says.
