Insurance Investors: Esoteric ABS and Private Asset-Based Finance

At this past Insurer Investment Forum, Craig Armstrong of Insight Investment provided an overview of the changing landscape for insurers and their use of ABS and asset-backed finance. As a follow-up to this presentation, we spoke with Insight Investment to provide an update and overview of this (potentially) versatile asset class.

Craig Armstrong, CFA | Senior Portfolio Manager | Insight Investment
craig.armstrong@insightinvestment.com | Learn More >>

SAA: Why should insurance investors consider ABS and asset-backed finance today versus traditional corporate credit?

Insight Investment: ABS and asset-backed finance can offer insurers a compelling way to improve income while also diversifying risk away from traditional corporate credit. One of the biggest differences is that these investments are backed by specific pools of assets or contractual cashflows, rather than the general credit of a single corporate issuer. In addition, ABS structures include certain protections such as subordination, amortization, covenants and excess spread, which can help protect bondholders if collateral performance weakens.

From an insurer’s perspective, that combination can be potentially very attractive. Investors may be able to pick up additional spread versus similarly rated corporates, while also gaining exposure to a broader set of underlying risks across consumer, commercial and specialty finance sectors.

We would frame ABS as a complement to corporate credit, not a replacement for it. For insurers seeking book yield, diversification and capital preservation, we believe selected ABS sectors can play a very constructive role in the portfolio.

SAA: How should insurance investors think about the relationship between complexity, liquidity and spread across the ABS market?

Insight Investment: We believe, one of the most important concepts in structured credit is that ABS is not a single market. It is a spectrum, with simpler and more liquid sectors such as SEC-registered prime auto ABS on one end, and more complex and less liquid sectors such as CLOs, esoteric ABS and private ABF on the other. In general, as complexity increases and liquidity declines, spreads tend to widen.

At the simpler end of the market, sectors like prime auto ABS are more standardized and generally supported by a wider investor base. As an example, AAA rated prime auto ABS may offer spreads of 30-45 bps over US Treasuries. Moving further along the spectrum, CLOs and many esoteric ABS transactions require more specialized underwriting, deeper structural analysis and a greater willingness to accept lower secondary market liquidity. AAA rated CLO debt may offer spreads closer to +125 bps, while other investment grade esoteric ABS opportunities may offer spreads of +150 bps or more, depending on structure, rating and market conditions.

For insurers, we believe this framework is useful because it helps explain what can drive the higher potential compensation earned from investing in various ABS structures. In many cases, the additional spread is less about taking more credit risk and more about accepting greater complexity, reduced liquidity and a narrower buyer base. The key is to be selective and ensure the premium is adequate for the risks being assumed.

SAA: What are the key risks insurance investors should focus on when allocating to esoteric ABS and private ABF?

Insight Investment: The key issues to consider include collateral quality, deal structure, liquidity, legal protections and the strength of the originator or servicer. These are not sectors where broad labels or headline ratings tell investors everything they need to know.

In many cases, the work has to go deeper than it would in traditional corporate credit. Investors need to understand the underlying assets, the cashflow waterfall, downside protections and what happens if performance deviates from expectations. In private transactions especially, investors also need to be comfortable with limited liquidity and a hold-to-maturity mindset.

For insurers, we do not think the answer is to avoid complexity, but rather to be selective and size allocations appropriately. If underwriting is strong, structuring is disciplined and liquidity is properly understood, we believe these sectors can be very attractive. We believe a manager’s skill and transaction selection matter a great deal.

SAA: How can insurers use ABS and asset-backed finance to enhance yield while remaining aligned with liquidity, capital and risk objectives?

Insight Investment: In our view, ABS and asset-backed finance can provide important benefits to core fixed income portfolios, including the potential to enhance yield through both complexity and liquidity premia, to improve diversification through exposure to secured structures and a broader range of underlying collateral, and to support risk management through amortizing cashflows that may align well with liability needs.

ABS remains one of the few areas in public fixed income where insurers can still earn a material liquidity premium. Traditional core bond markets have become increasingly liquid with the growth of ETFs, electronic trading and portfolio trading. While that has improved efficiency and price transparency, it has also reduced the compensation available for holding liquidity risk. ABS generally does not benefit from the same level of liquidity due to the structural complexity, a more specialized investor base and the lack of a broad ETF ecosystem. That can create opportunities for insurers to earn additional spread.

We also believe ABS can improve the credit profile and capital efficiency of insurance portfolios. These securities are backed by diverse pools of collateral and often include structural protections that are not available in unsecured corporate credit. At the same time, high quality ABS can offer wider spreads than corporate bonds with similar, and in some cases lower, credit ratings. Because the NAIC’s capital framework is driven primarily by credit quality, rather than explicitly charging for liquidity risk or structural complexity, ABS can also deliver more attractive income per unit of regulatory capital.

The cashflow profile of ABS can be a valuable portfolio construction tool for managing reinvestment, duration, and liability matching with greater precision. Some ABS bonds amortize over time, providing regular principal return for reinvestment. Other short duration structures can help to match short- to medium- dated liabilities.

The yield spread, credit diversification, capital efficiency and cash flow profile make ABS an important allocation in core fixed income portfolios. We believe a well-diversified allocation of 10-15% can offer material benefits to core portfolios. For insurers with short liability profiles, larger allocations may also be appropriate, provided they are carefully managed with disciplined credit and structural analysis.

Source: Strategic Asset Alliance, Insight Investment. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.

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