Credit analysts, reporters and others have worried about the possibility that the commercial real estate loans inside collateralized loan obligations (CLO) could go bad.
Roy Chun and other rating analysts at Kroll Bond Rating Agency (KBRA) say in a new report that, in the real world, borrowers with loans inside CLOs are surprising investors in another way: Many of those borrowers are doing so well that they’re paying their CLO loans off early.
In recent years, “the prepayments led to increases in credit enhancement levels,” the analysts write in the KBRA CLO prepayment report.
KBRA has responded to recent early CLO loan payoffs by increasing 11 commercial real estate CLOs’ ratings, the analysts write.
But the CLO prepayments could make managing CLO assets a little more challenging for life insurers’ investment managers.
Life insurers ended 2017 with $60 billion, or about 1.5% of their cash and invested assets, in CLOs, according to Moody’s Investors Service.
Many life insurers are hoping CLOs will provide reasonably steady income over a designated period of time, to help make sure that cash will arrive when the insurer is supposed to send payments to life insurance benefits claimants, annuitants, and other customers.
Commercial real estate companies often borrow money through arrangements with flexible prepayment rules, the KBRA analysts write.
That flexibility makes it harder for observers to determine the duration and maturity of commercial real estate CLO notes, the KBRA analysts write.
What State Insurance Regulators Say
The Capital Markets Bureau, part of the National Association of Insurance Commissioners (NAIC), talks about CLO prepayment risk in a CLO primer posted in August 2018.
The bureau says in the primer that CLO net yields are often attractive, even after CLO manager fees and expenses are subtracted.
In a discussion of CLO risks, the bureau suggests that falling interest rates could increase prepayment risk, by encouraging borrowers to refinance floating-rate loans.
Early CLO loan payoffs can reduce the underlying CLO portfolio principal value, the bureau says.