- What A long-awaited update to NAIC policy demonstrates that more refinement is needed
- Why The current version fails to take into account key deal characteristics
- What Next Insurer appetite for mezzanine notes will remain constrained
A long-awaited update to the National Association of Insurance Commissioners’ methodology for assessing the credit risk associated with insurers’ investments in collateralized loan obligations demonstrates how slow progress has been over the past year.
That means such institutions’ appetites for mezzanine CLO securities likely will continue to be restrained, at least among a few of the more cautious life companies.
The NAIC has been working to refine the process it uses for assigning risk weights to CLOs since 2022, aiming to implement an internal methodology in place of credit ratings as the starting point. On Sept. 8, the task force overseeing the effort received an update from the American Academy of Actuaries, an influential constituency.
The AAA is charged with reconciling the CLO methodology with the NAIC’s broader capital framework for bonds. That involves running simulations of the performance of collateral loans that the NAIC uses in its models. But CLO professionals who participated in the Sept. 8 call were struck by how poorly the models reflect the deals’ actual mechanics.
“They still have a bunch of work to do,” one CLO manager said.
One of the main issues appears to be a reluctance on the NAIC’s part to take into account that CLOs are actively managed. That is, the managers can sell underperforming loans and buy higher-quality receivables, often taking advantage of attractive pricing.
In failing to credit managers for that flexibility, the models appear to assume that the opposite occurs – that underperforming loans always sell at discounts to face value while stronger loans always are acquired at face value, the manager said.
The resulting sentiment among some market participants is that the methodology is too punitive for lower-mezzanine securities, those rated double-B and single-B and are the first to feel the effects of any shortages in cashflows from their underlying loans.
For its part, the AAA acknowledges that there are refinements to be made in reconciling the CLO methodology with the NAIC’s broader capital framework for bonds, according to a synopsis from consultancy Bridgeway Analytics. They include taking into account lower correlations of defaults among below-investment-grade loans, the relationship between loan defaults and recoveries, and the typically shorter maturities of CLO securities.
The task force overseeing the NAIC’s CLO methodology has proposed delaying implementation by a year, to yearend 2026. Comments on the proposal were due Sept. 12, but many see the extension as unavoidable.
And that means insurers’ current CLO investment strategies are likely to remain in a holding pattern, with those skittish about mezzanine securities remaining on the sidelines and appetite for investment-grade notes undiminished.
Fortunately for issuers, there is plenty of demand for investment-grade and below-investment-grade CLO notes from other kinds of investors, including banks in the U.S., Europe and Japanese, as well as money managers and exchange-traded funds.
Ten CLOs totaling $3.9 billion priced in the first three days of the week, compared with 11 totaling $4.7 billion the holiday-shortened prior week.
The only new issue, as opposed to a repricing, came from Crescent Capital, which priced a $372 million CLO on Sept. 9 with Jefferies running the books. The senior tranche, rated AAA by S&P, pays 133 bp over SOFR. That’s wider than some of the tightest prints on recent new issues, which have been below 130 bp over SOFR.
