Investment Grade CLO Tranches for Insurers: A Relativist’s Guide

June 12, 2024

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 would therefore be well-advised to consider IG CLO tranches given their compelling characteristics:

  • Higher yields than similarly rated corporate debt
  • Structural protections that support capital preservation
  • Improved market liquidity

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, thereby keeping CLO debt tranches and loans relatively insulated from interest rate volatility.

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.

Click below to continue reading Conning’s Viewpoint, “Investment Grade CLO Tranches for Insurers: A Relativist’s Guide."


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Risk Factors Associated With CLO Debt Investing May Include (But Are Not Limited To):
COMPLEXITY: CLOs often involve risks that are different from, or more acute than, risks associated with other types of debt instruments: 
The complex structure of the security may produce unexpected investment results
Ratings agencies may downgrade their original ratings of CLO debt tranches
Majority equity holders retain the right to call or refinance/reprice a CLO, creating uncertainty for minority equity and debt holders
CLOs may be difficult to value and may constitute illiquid investments
During periods of economic uncertainty and recession, the incidence of modifications and restructurings of investments may increase, resulting in impairments to the underlying asset value and reduced “subordination” to the tranched CLO liabilities
CLOs are susceptible to changing regulations, influencing eligibility of certain investments, risk retention requirements, and other factors that can influence availability and liquidity
CLO debt and bank syndicated loans historically used LIBOR as an interest rate benchmark. On June 30, 2023, following a multi-year transition away from LIBOR, all USD LIBOR tenors ceased to be representative. Accordingly, most CLO debt notes and bank syndicated loans now use CME Term SOFR as a reference rate (with a minority of bank syndicated loans referencing 6-month USD LIBOR or synthetic USD LIBOR). Some CLOs have experienced or may experience a degree of mismatch between their liabilities and assets after June 30, 2023, with certain CLOs’ issued securities tied to Term SOFR and certain of their underlying collateral tied to LIBOR (or vice versa). In addition, different assets may have adopted different credit spread adjustments as part of their transition to SOFR, further contributing to a possible mismatch between CLO assets and liabilities. The aforementioned mismatch may be greater at certain points in the future versus others, and the basis risk created by this mismatch could potentially have a negative impact on returns for CLO equity noteholders. Moreover, different assets will reference Term SOFR rates for different periods of time, e.g. 1-month or 3-month. While CLO securities will typically reference 3-month Term SOFR, leveraged loans can reference different rates or time periods; accordingly, it is likely that CLOs will experience a mismatch between the CLO securities (debt and equity issued by the CLO) and underlying leveraged loan collateral. Such a mismatch could result in the CLO not collecting sufficient interest proceeds on underlying collateral to make interest payments on the CLO debt. This could result in deleveraging a CLO or could impact returns for CLO debt and equity holders. 
The activities of any CLO will generally be directed by a collateral manager; consequently, the success of any CLO will depend, in large part, on the expertise of the collateral manager’s investment professionals. Underlying assets in a CLO “turn over” over time due to sales and repayments.
Changing economic, political, regulatory or market conditions, interest rates, general levels of economic activity, the price of securities and debt instruments and participation by other investors in financial markets may affect the value of CLO