For many fixed income investors, we believe high-quality securitized assets can play a valuable role in a diversified credit portfolio — and they have become even more attractive thanks to new risk-based capital (RBC) factors being adopted by the National Association of Insurance Commissioners (NAIC).
Should non-insurance entities care about these changes? We think so because the changes could impact credit spreads and investor demand across the securitized sector. For instance, we may see greater demand for AAAs/AA rated bonds and less demand for As, which could affect their valuations.
Overview of NAIC changes
The NAIC is updating its RBC bond factors for insurance entities in an effort to better align risk-based capital charges with actual investment risk. The planned changes will introduce more granularity into said bond factors, including expanding the number of classifications from six to 20 based on an individual bond’s nationally recognized statistical rating organization (NRSRO) rating. This will result in increased capital charges for the insurance industry as a whole, driven by substantially higher charges for A and BBB rated securities, while AAA and AA rated securitized assets stand to benefit the most under the new RBC factors.
Old risk-based framework at a glance
The NAIC’s prior RBC framework created “cliffs” in capital charges from A- to BBB+ rated securities and from the BBB- to BB+ range, incenting insurers to invest in the lowest-rated bonds within a given category to boost yield without increasing capital charges.
As shown in Figure 1, using collateralized loan obligations (CLOs) as an example, the level of yield per RBC charge rose as credit quality went down under the prior framework. There was little benefit to owning AAA rated bonds, which had the same NAIC rating/capital charge as A- bonds but with lower yields. This led many insurers to invest in A rated bonds in pursuit of their yield targets. However, that incentive will no longer exist going forward.
Material capital relief for higher-rated securitized
Under the new RBC framework, very high-quality fixed income assets will be more capital efficient and have lower credit risk. This, combined with a dearth of high-quality corporate bonds, means we are likely to see greater insurance demand for AAA and AA securitized assets. In our view, higher-rated CLOs in particular will likely be the biggest beneficiaries (Figure 1) given their more attractive yields versus other credit sectors, coupled with their relatively strong performance potential.
What about lower-quality securitized?
On the other hand, insurance demand for A rated securitized may decrease as these assets become less capital efficient, which could weigh on their credit spreads. However, we don’t foresee mass forced selling because most large insurers already have sufficient capital buffers. We may see reduced supply in certain esoteric asset-backed security (ABS) sectors that were specifically structured for insurers.
For commercial mortgaged-backed securities (CMBS) and non-agency residential MBS, implementation of the new RBC matrix won’t occur until 2022. While it’s unclear how some of these bonds will eventually map to the new NAIC designations, bonds with zero assumed losses will be assigned the highest NAIC designation. This is a near-term positive for zero-loss modeled CMBS bonds (one of the few sectors where below-AAA rated bonds will map to the lowest RBC factor), likely resulting in greater demand for credit CMBS, especially from life insurers.
Key takeaway for insurers
Global insurers are significant buyers of fixed income, holding ~$4.5 trillion in such assets as of year-end 2020, and the NAIC changes could have a meaningful impact on insurer demand for certain fixed income market segments. For example, while securitized assets currently comprise only around 10% – 20% of insurance companies’ fixed income portfolios, that could grow going forward. Insurers might consider adding high-quality securitized, especially CLOs, in lieu of corporates as one way to help maximize their yield/RBC ratio.