Global credit funds & CLO's
May 2020 | Issue 223
Published in London & New York.
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May 2020 | Issue 223
Looming CLO downgrades will not force insurers to sell despite seven-point trading basis
Michelle D'Souza headshot
Michelle D’Souza
Sayed Kadiri headshot
Sayed Kadiri
Insurance companies are unlikely to be big sellers of CLO paper, despite the threat of mass downgrades as rating agencies last month put over 1,000 global CLO tranches on negative watch.
If a CLO triple B note is downgraded and loses its investment grade status, it will typically drop from a National Association of Insurance Commissioners (NAIC) category two investment to category three. Depending on the type of insurer, that could result in risk-based capital charges increasing from 1.3% to 4.6%.

Secondary CLO investors seem to have priced in pending downgrades. Creditflux reported last month that triple Bs on negative watch are trading seven points below triple Bs that have the all-clear (72 cents versus 79 cents, in US and European markets).

However, NAIC capital charges apply to an insurer’s entire credit portfolio and the fact that corporate credit assets are also being downgraded en masse means CLO downgrades may be less painful, depending on how much has been allocated to CLOs versus single name credit. Most insurers also tend to buy high-quality CLO paper where the impact of a downgrade results in a modest increase in capital charge.
“CLOs will be treated as corporate debt with the same rating,” says Rich Sega, global chief investment strategist at Conning in Connecticut. “If a CLO is downgraded to below investment grade it carries a more onerous capital charge and you may have to mark to market instead of being able to carry it at cost, but it’s essentially treated the same as high yield debt. Whether or not insurers will need to sell depends on how big their exposure is and how much capital is drained from them.”

A CLO tranche investor at a large insurance company agrees with this sentiment, but concedes that although forced selling is unlikely, the spate of credit downgrades means that most insurers won’t be buyers for the time being.

The most likely source of forced selling is in cases where CLO investors used leverage, rather than due to rating-based triggers, sources say.
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“Whether or not insurers need to sell depends on their exposure”
Rich Sega, Global chief investment strategist | Conning