Insurance While private asset-based lending is all the rage, insurers should not overlook public ABS

Introduction

It is well known that insurers are significant investors in fixed income assets, particularly investment grade (IG) credit.  Historically the industry’s focus has been IG corporate bonds, but in recent years structured credit – and particularly private asset-based lending – has gotten much attention thanks to the incremental spread that can be earned on such assets relative to corporate bonds.  Private asset-based lending can certainly be additive to insurers’ risk- and capital-adjusted returns, but as private assets they do entail greater liquidity risk.  In this piece we focus on private asset-based lending’s more liquid counterpart – public asset-backed securities (ABS).

Diversification Benefits

Public ABS are backed by pools of diverse assets including mortgages, auto loans, and credit card receivables to name just a few collateral types. This asset pooling disperses credit risk across many borrowers, lowering the impact of any single default. By contrast, corporate bonds concentrate risk in one issuer.  This difference in exposure has resulted in historical correlation of about 0.54 between IG corporate bonds and public ABS over the past 25 years*.  For insurance companies seeking to reduce portfolio volatility and mitigate concentration risk, ABS can effectively complement corporate bond allocations.

Structural Protections and Credit Enhancement

Most ABS feature robust structural protections such as credit enhancement layers (subordination, reserve accounts, overcollateralization) and payment waterfalls. These features have the potential to shield investors—especially those holding senior tranches—from losses, even during economic stress. Corporate bonds, generally lacking such protections, expose investors to the direct fortunes of the issuer. Consequently, ABS with similar credit ratings may present lower risk of capital loss than their corporate bond counterparts.

Yield and Spread Comparisons

One of the most compelling advantages of public ABS lies in their yield and spread profile. Currently, ABS offers spread advantages over similarly-rated corporate bonds. For example, current spreads on a variety of public ABS collateral types have provided more than 100 bps of additional spread as compared to corporate bonds (for example, Table 1 below shows A-rated digital infrastructure ABS spreads at 182 bps vs. A-rated corporates at 72 bps).  This yield premium is partly due to the perceived complexity and opacity of structured products, as well as investor demand for simplicity and familiarity with corporate issuers.  Those perceptions are often unfounded; in reality, public ABS can be thoroughly analyzed and vetted by investors with the tools and experience to do so, offering insurance investors an opportunity to capture additional spread without taking additional credit risk.  Furthermore, by accessing ABS via public markets rather than via private mandates, investors can maintain relatively higher liquidity with the ability to adjust positions more quickly and easily than in private markets.

Regulatory and Capital Treatment

While some jurisdictions outside the U.S., particularly Europe, apply onerous risk-based capital (RBC) charges to various forms of structured credit, U.S. insurers investing in ABS enjoy a more favorable RBC environment.  The intrinsic price framework for residential and commercial mortgage-backed securities evaluates an insurer’s carrying value compared to an independently-calculated intrinsic value.  However this intrinsic price framework is not used for ABS; a ratings-based framework continues to drive RBC requirements for ABS.  Of note, the National Association of Insurance Commissioners (NAIC) continues evaluating changes to the RBC treatment for CLOs but expectations are that the final framework will very likely consist of a ratings-based approach with the possibility of further refinement based on CLO tranche thickness.  In short, while exceptions do exist, generally RBC charges for ABS bonds tend to be no more punitive than corporate bonds and are often lower in practice.

Conclusion

Public asset-backed securities, when compared to corporate bonds of similar credit ratings, offer insurance investors several benefits: diversification, enhanced structural protections, and risk-based capital efficiency. Most notably, ABS provide higher spreads as shown in Table 1, affording insurance companies improved risk-adjusted return potential.  And by focusing on the public ABS universe, liquidity and portfolio flexibility are greater as compared to their private market counterparts.  Insurers may hold ABS exposure as discretionary allocations within their broader core fixed Income mandates, while others incorporate structured credit as a dedicated allocation managed by a specialist team.  Either approach can be effective, but when adding ABS with novel underlying collateral types – whether in public or private form – a dedicated allocation managed by a specialist is likely prudent.  Regardless of how asset-backed investments are accessed, we believe the current market backdrop warrants a close review of public ABS exposure.