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By Thomas Sweeney, Portfolio Manager and Sector Head-Structured Finance, DWS, and Lloyd Ayer, Client Solutions–Insurance, DWS

*DWS was the sponsor of the Finance and Investment Track at the 2018 AASCIF Annual Conference.

Insurers are well versed in the fixed income market and are typically quite familiar with its vast size. But in such a large and diverse market, some segments can get lost in the shuffle. We believe this is especially the case for the Structured Finance world, partially thanks to its relatively small allocation in aggregate benchmarks, reflecting a less than 5 percent allocation in the more widely recognized fixed income indices, such as the Bloomberg Barclays Aggregate Index.

This paltry allocation may make some investors think that Structured Finance is a tiny part of the fixed income pie, but that isn’t the case. Instead, nearly $600 billion was issued in the Structured Finance market last year (see issuance illustration), and it remains a vital source of funding for a wide range of companies. (1)

But while the issuance might be over half a trillion dollars for the Structured Finance market, approximately $120 billion made its way in reported indices, including the Bloomberg Barclays Aggregate Index. This leaves a sizable gap between benchmark representation and what was available in the market. (1)

This representation gap is due to a variety of Structured Finance products being excluded from traditional indexes. The reasons for the exclusions vary by index but are usually focused on coupon type, private securitizations, and underlying securities asset. The combined impact is clear though, as less than 10 percent of investable assets from the structured finance market found their way into aggregate benchmarks.

However, this lack of index representation and the overlooked nature of the market could present investors with an investment that may complement their existing portfolios. With so many avoiding or glossing over the Structured Finance market, they may present an additional investment option for a diversified portfolio. That is, of course, if investors know where to look.

Where to Look in Structured Finance

With only 10 percent making it into broad benchmarks, significant opportunities may exist in the Structured Finance market that could be flying under the radar. One in particular that is worth highlighting at the current juncture is Collateralized Loan Obligations (CLOs), a segment that made up nearly 20 percent of Structured Finance issuance in 2017 but was virtually nonexistent in aggregate fixed income benchmarks, as shown below.

(1) Estimates based on DWS comparison of 2017 issuance and Bloomberg Barclays Aggregate holdings as of March 31, 2018

Source: DWS, Bloomberg, Barclays Capital Indices, Wells Fargo, as of March 29, 2018.

There are a few reasons why these actively managed pools of leveraged loans could be intriguing complements to traditional fixed income portfolios. Not only does the sector have low correlations to other sectors of fixed income—based on analysis we conducted looking at correlations on total returns dating back to the start of the JPM CLO index in 2012 versus major fixed-income asset classes—but the Structured Finance exclusion from traditional benchmarks may provide managers possessing strong research capabilities with a chance to add value by selecting securities that may be poised to outperform traditional fixed-income sectors.

Diversification is also a key feature of CLOs, which may help in potentially reducing overall portfolio risk.  In a typical structure, no single obligor makes up more than 2.5 percent of a given CLO either, so risks are well diversified from a company-specific level. Using Bloomberg information and based on our analysis of deals coming to market this this year, on average, more than 80 issuers are represented in a typical CLO with industry diversification principles taken into account as well, spreading out the portfolio’s risk profile.

Yield

Beyond the diversification of CLOs, investors should also consider the yield perspective. CLOs are generally tied to LIBOR and are typically less sensitive to interest rate risks because they are floating rate structures, at least when compared to traditional long-duration fixed income securities.

Consider a representative CLO capital stack below. An average CLO (as of early second quarter 2018) may be heavily weighted to AAA-rated debt, which may target a yield of 100 basis points above LIBOR. However, it will also include lower-rated securities which, although in a less favorable credit position, help to boost yields. As the illustration shows, BBB-rated debt may offer up yields of 275 basis points above LIBOR, and although there is no guarantee these targets will be achieved, such returns can provide a nice income boost for investors without materially changing the overall risk level in the portfolio.

[NOTE: TO BE ADDED TO DISCLOSURE ABOVE.] No assurance can be made that projected results will be achieved or that similar characteristics will be available in the future.

By spreading out the holdings while still being opportunistic when it comes to lower-rated securities, CLOs can offer the potential for higher yields without a proportionate increase in risk. This may potentially give CLOs an edge in terms of yield efficiency, at least when compared to other types of fixed-income instruments.

The Bottom Line

CLOs are having a renewed interest among insurance company portfolios, specifically among P&C insurers, as not only part of core/core+ strategies but also as a satellite allocation through a separate account. Their RBC capital charge can make them capital efficient while providing the potential for a higher income opportunity without taking on significant duration and default risk. This could be particularly important in an extreme rising rate environment; having exposure to a floating rate instrument may help preserve principal without sacrificing too much in terms of income.

CLOs, however, have grown in the past few years, which has led to some deterioration of investor protections.  Along those lines, with some underlying loans taking on more leverage, with fewer protections than in previous cycles, CLOs could experience higher losses in a future downturn. Furthermore, the asset class can be fairly illiquid with larger trading costs relative to other similarly rated securities products.

With that said, CLOs have also shown to be a strong diversifying asset within a core investment grade portfolio, given low correlations to other fixed income sectors. The combination of favorable yields, high liquidity, and the ability to preserve surplus in rising rate environments can make them a suitable option.

 

Notes:

No assurance can be made that an investment in CLOs will meet its stated objective. Diversification neither assures a profit nor guarantees against a loss. Past performance is not an indicator of future results.

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