Alyssa Irving, fixed income portfolio manager at Wellington Management, talks about the asset manager's work in helping insurance investors navigate a sometimes challenging structured debt environment.
How has Wellington been assisting insurers to manage their structured debt assets this year?
Rising inflation has been top-of-mind for our insurance clients this year and we have been helping them better understand the implications of an inflationary environment for structured debt. Many of these assets are floating rate which would benefit in such an environment. We have also been keeping our clients apprised of the structural changes affecting certain property types in the commercial real estate space. For example, retail – particularly lower quality malls – has been challenged given the rise of ecommerce, which has been exacerbated by COVID-19. Additionally, work-from-home has raised some concerns about the long-term demand for office space. These are important topics given insurers' exposure to commercial real estate.
Another important topic – and a risk that we believe is underappreciated by many market participants – is the looming LIBOR sunset date. We have been analyzing the LIBOR language in each and every structured deal and selling ones that have weak language to avoid any potential market disruption to our clients' portfolios during the transition.
What are the key challenges for insurance investors moving to these assets?
There is still lingering stigma from the Global Financial Crisis that inhibits investors from allocating to the space. However, it is important to keep in mind that the market is very different than the one that existed prior to the GFC. Underwriting standards are stronger, structural protections have improved, and post-crisis regulations require issuers/sponsors to maintain economic interest in the deals they originate for certain structured sectors. Wellington works to help educate market participants about the nature of today's markets to mitigate this challenge.
What kind of opportunities have you seen in structured debt in the last 12 months?
Broadly syndicated CLOs – both debt and equity tranches – have presented compelling opportunities. The economic recovery has been very supportive, and their valuations are attractive relative to other structured sectors and corporate credit. We also see opportunities in assets tied to US housing in the non-agency RMBS space, such as prime jumbo loans, non- qualified mortgages, and credit-risk transfer deals. The housing market has proved resilient through the COVID-19 crisis and the substantial home price appreciation we have seen over the last year has benefitted the credit performance of the underlying collateral in those sectors.
We have also been finding select opportunities in a number of other "off-the-run" sectors including higher- rated Middle Market CLOs, Commercial Real Estate CLOs, and esoteric asset-backed deals. More recently, we have been involved in some "quasi-private", lightly syndicated off-the-run deals where we are comfortable with the credit risk and where we believe we are being paid a liquidity premium.
Lastly, some of our clients have taken advantage of the low-cost funding from Federal Home Loan Banks, and we have been working with clients to design a portfolio of floating-rate structured debt at attractive spreads, capturing a spread "arbitrage".
How should insurers manage the risks of a further market downturn in allocating to structured debt?
Insurers can still maintain yield while increasing the overall quality of their portfolio and reducing risk by investing in assets with shorter spread durations and/or shifting to a higher-quality bias to help mitigate the risk of a drawdown. We caution against reaching for additional yield at current valuations; spreads have tightened substantially amid the strong market recovery and yields are low, leaving little room to absorb the potential for spread widening in a market selloff.
Instead, we believe insurers could focus on managing the downside risks, leveraging the strong fundamental credit research from their investors to selectively invest in attractive securities that are better positioned to weather an economic downturn.
How can insurers incorporate ESG into their structured debt holdings?
Incorporating ESG into structured debt investing varies by asset class. In certain sectors of the structured debt markets, we are seeing growing issuance in green bonds, ESG focused CLO's, and impact bonds backed by affordable housing and other socially responsible programs.
For structured debt, we typically focus on the application of ESG at the collateral level. This is especially true in the RMBS and CMBS markets where we believe environmental or climate risk is the biggest ESG factor. RMBS and CMBS have the most direct exposure to climate change given both the nature of the real assets backing the deals and the longer tenure of the loans. Broadly speaking, the impact from climate risk will vary greatly depending on the collateral. As certain sectors and sub-sectors will be affected more than others, we believe it is important to think about the risk in terms of collateral type and tenure of the underlying collateral/bonds. The life of the collateral is also a key consideration; shorter-life assets will be impacted less than longer- life assets, especially if the longer-life asset is a real asset in a high-risk zone.