Advantage Insurance of San Juan, Puerto Rico, is no one’s idea of a financial colossus.
But this little insurance company is making a giant bet on some of the hottest investments around: collateralized loan obligations.
That a company with about 50 employees and $4 million of profit is diving headlong into CLOs says a lot about the state of the credit markets these days.
CLOs, relatives of those arcane mortgage investments that blew up a decade ago, have been booming like never before. Beguiled by better yields, insurance companies and others have piled in, feeding a lucrative financial complex built on riskier corporate loans. This year is shaping up to be the busiest ever for CLOs, with over $120 billion of new issuance so far.
Enter Advantage Insurance, which specializes in insurance for businesses and wealthy individuals. It’s invested roughly $60 million of its $96 million of shareholder equity into U.S. CLOs, according to a prospectus the company filed for an initial public offering.
To some, the CLO boom seems eerily familiar. Back in the subprime era, Wall Street bundled U.S. home mortgages into complex investments for sale the world over. When the reckoning arrived, the losses circled the globe.
But those in the industry say CLOs are different. The underlying loans to firms aren’t as vulnerable to rising interest rates as subprime home borrowers a decade ago. Managers of the deals can trade in and out of the 100-plus loans in a portfolio to mitigate against losses. Among the more than 1,500 U.S. CLOs rated by S&P Global Ratings since 1994, only 36 tranches across 21 transactions had defaulted as of mid-2018.
And Walter Keenan, Advantage’s chief executive officer, says he’s confident his CLO play will pay off.
“CLOs offer the best risk-adjusted returns and best value appropriate for our liabilities today,” Keenan said during a visit to New York. “CLOs have a self-healing mechanism in a recession: if the loan market breaks down and there are forced sellers, we will be able to invest in better priced loans to make up for any losses.”
Not everyone is so sure about America’s great corporate debt rush, for which CLOs have served as a crucial enabler.
Corporate lending standards have been weakening. Signs of stress in the credit markets (think General Electric Co.) have set investors on edge. Earlier in November Senator Elizabeth Warren, a prominent Wall Street scold, likened today’s leveraged-loan market to the subprime mortgage fiasco.
Advantage Insurance is a testament to investors’ CLO fever, as well as to the debt ecosystem that’s proven to be so lucrative for its many participants.
“The CLO monster, as I have been calling it, has been devouring more and more floating rate paper to meet this demand,” said Michael Terwilliger, a portfolio manager at Resource Alts.
Advantage has been investing in the riskiest pieces of CLOs, the equity portion, which gets paid only after all the bond portions.
Keenan says the move makes sense because while the bonds’ cost is a fixed coupon pegged to floating rate, equity holders can benefit from situations where the loans pay higher yields, such as in a recession: if a downturn harms some loans in a CLO, the CLO manager can buy others on the cheap to make up losses.
It’s easy to see the attraction. Cash yields for the securities for the first half of 2018 were 11.35 percent annualized, according to JPMorgan Chase & Co. data. While that’s lower than previous years, it still beats what’s available generally in credit markets.
Advantage Insurance received $13.4 million from CLO investments it held to maturity in 2017 and $17.8 million in the first three months of 2018. It owns CLOs managed by firms including Ares Capital, Investcorp and Blackstone Group’s GSO Capital Partners. It’s struck an agreement with GSO to manage most of these investments. The portfolio returns cash every quarter and the firm “has relied upon CLO distributions for liquidity needs,” the filing shows.
The risk is that default rates eventually rise or stay higher, longer.
Advantage Insurance said in its filing that in the third quarter of 2017, it recorded an impairment of $1.7 million for one CLO investment. About $900,000 of that represented the “credit loss component”.
The company says a key part of its strategy is sticking with CLOs to ride out any storm. It holds them to their maturity, at times as long as 20 years, meaning they have time to recover and perform.
“If an investor is unable to hold on to a CLO for sufficient time to allow for recovery, then you have to be smart enough to sell before a downturn,” Keenan said. “We plan from the beginning to hold our CLO investments to their last cash flow.”
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