Viewpoint: Investment Grade CLO Tranches for Insurers: A Relativist’s Guide
In Short
Most insurers would concede that relative value often guides decision making. Higher interest rates have shifted insurers’ focus, and previously niche asset classes have garnered more attention given their compelling advantages in today’s environment.
The floating-rate debt tranches of collateralized loan obligations (CLOs), particularly tranches with investment grade (IG) ratings (AAA-BBB), are one such asset class attracting the interest of insurance companies. In a “higher for longer” rate environment, insurers are capturing elevated yields in an asset class which has historically exhibited less default risk than corporate bonds.
With a typically significant allocation to fixed income, insurers may want to consider IG CLO tranches given their compelling characteristics:
Higher yields than similarly rated corporate debt
Improved market liquidity
Structural protections that support capital preservation.
Yield Advantage
Absolute yields for floating-rate assets increased considerably in tandem with the U.S. Federal Reserve’s (the Fed) aggressive rate- hike campaign in 2022-23.
Coupons for CLO debt tranches (and the broadly syndicated loans that make up the CLO’s collateral portfolio) are floating rate and quoted at a spread over a base rate, primarily the Secured Overnight Financing Rate (“SOFR”). The base rate typically resets every three months, which addresses the impact of interest rate volatility for investors.
As SOFR rose to over 5%, coupons on floating-rate assets increased to levels not seen since the Great Financial Crisis (GFC) of 2008-
2009. With the Fed in a holding pattern, SOFR-linked CLO debt coupons will likely remain elevated for some time. As such, there is a strong case to be made that yields for IG CLO debt tranches should continue to exceed comparably rated, longer-duration fixed rate assets. As Figure 1 illustrates, IG CLO debt tranches currently offer a significant yield advantage over their corporate bond counterparts (shown as a comparative yield-to-worst).
This pickup in yield reflects two misconceptions of the CLO asset class: perceived illiquidity and structural complexity.
Figure 1 - IG CLO Tranches’ Yield Advantage Vs
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