CLOs: Opportunities for insurers

AAA CLOs can help insurers increase yield, manage risk, and diversify portfolios

As global financial markets continue to evolve, investors are increasingly looking for new ways to diversify their portfolios and enhance returns. One asset class that has attracted growing attention in recent years is Collateralised Loan Obligations (CLOs), with the CLO market expanding significantly to $1.4 trillion globally.¹

Traditionally, CLO investments were utilised by select institutional investors, but this landscape is evolving. The growth of the market and further introduction of CLO ETFs has opened the door to broader participation, with ETFs adding the operational simplicity, liquidity and transparency needed for a wider range of market players, while still providing a number of attractive features.

For European insurers, investment grade CLO tranches — especially AAA-rated — offer a practical way to increase yield, manage risk, and diversify portfolios. While the regulatory environment requires careful navigation, the benefits of these investments, when managed prudently, can be substantial.

What are CLOs?

A CLO is a structured finance vehicle that pools together broadly syndicated loans — typically senior secured loans issued by corporate borrowers.

The acquisition of these loan assets is financed through the issuance of multiple layers, or “tranches”, of securities. These consist of several classes of debt ranging from senior, highly rated notes to more junior tranches alongside an equity tranche. Each tranche has a defined priority of payment and risk profile.

Cash flows generated by the underlying loan portfolio are distributed by a “waterfall” structure whereby interest and principal payments are first directed to the most senior tranches, while subordinated debt and equity tranches absorb losses before senior investors are affected. This provides substantial credit enhancement to senior and investment grade (IG) tranches while junior and equity tranches are compensated for their additional risk with higher return potential.

Unlike the senior and junior debt tranches, equity tranches do not have a stated spread; instead, coupon income is generated as the arbitrage between income generated by the CLO and costs for the remaining CLO debt tranches, with equity receiving the residual.

The case for AAA CLOs

Beyond all other tranches, CLO AAAs have seen the largest increase in demand, and we believe they present an especially compelling opportunity. AAA CLO tranches may offer a compelling blend of attractive yields² and no historical credit impairments.³ Over the last five years, AAA tranches have delivered yield enhancements significantly above similarly rated corporate bonds,² with volatility two to three times lower than broader investment grade markets.⁴ Importantly, CLO AAAs have maintained a record of zero principal losses, rapid recovery during market drawdowns,⁴ and lower relative correlation to other IG asset classes, making them a preferred choice for capital preservation and incremental income for longer term investors.

All these features stem from their structural advantages, (high level of subordination, overcollateralisation, and interest coverage), their floating rate and diversified income stream, and overall resilient cash-flow mechanics present in the underlying senior loan market.

For insurance providers, who rely on stable, long-term income to support their liabilities, CLO AAA and IG CLOs in general offer several notable advantages:

• Enhanced yield: CLOs have historically provided higher income levels than other similarly rated assets due.² This premium is the result of numerous factors, including accounting for the structural complexity and liquidity of the CLOs.
• Limited impairment history: Coverage/collateral tests, coupled with the cashflow waterfall, have helped enable relatively low levels of historical principal impairments compared to similarly rated corporate bonds, with no impairments in AAAs.³ If such tests are breached, then the CLO structure:
  - Redirects cashflows to best cushion senior note holders.
  - Puts further restrictions on CLO managers’ reinvestment flexibilities.
  With cash redirected away from equity distributions to amortize down the senior or AAA investments, the overall structure de-levers and de-risks.
• Diversification and floating rate benefits: CLOs are backed by hundreds of loans across various industries and regions, reducing the risk tied to any single borrower. Their floating rate nature also minimizes interest rate sensitivity, enhancing portfolio resilience.⁴

Regulatory considerations

Alongside a compelling investment proposition, recent and forthcoming developments in insurance regulatory frameworks are reinforcing the attractiveness of this opportunity for European and UK insurers.

For example, Solvency II has long applied a rigorous, risk-based approach to capital adequacy, historically assigning higher capital charges to structured products such as CLOs than to corporate bonds, reflecting their complexity and perceived risk profile. But recent and proposed reforms under Solvency II are beginning to recalibrate this treatment.

Revisions to the Standard Formula are expected to materially reduce capital charges for senior CLO tranches — particularly AAA-rated notes — with reductions of up to 70%–80%, broadly aligning their capital treatment with that of BBB-rated corporate bonds. This recalibration enhances capital efficiency and is expected to support increased CLO allocations among EU insurers, who have historically maintained limited exposure relative to US peers. While senior tranches benefit most from these changes, mezzanine and junior tranches remain comparatively capital intensive, underscoring the importance of careful portfolio construction.

CLO ETFs provide easy access for insurers

As an alternative to either direct investment or a separately managed account (SMA), a CLO ETF can offer insurance investors cost-efficient and diversified access to the market. These ETFs can provide easy access to a diversified pool of CLOs, with daily liquidity and full portfolio transparency — a convenient alternative to the purchase of individual CLO tranches, which requires both substantial security-level due diligence and operational capacity.

Invesco’s CLO ETFs are managed by the Private Credit team and can benefit from the platform’s extensive experience in managing both US and European CLO Notes across the rating structure, and the underlying broadly syndicated loans.

Learn more about CLOs, regulatory considerations, and the benefits of active management in our white paper.