US-based Brett Sullivan, head of alternative investments for Allianz Life, speaks Risk about the thinking behind the investments made in private credit.
Thanks for speaking with us. We'd like to start by asking, as you're based in the US, what differences you see between the UK and European markets?
I'm not an expert on those two particular markets—the UK and Europe—but one of the things that has been kind of a hot area over the market in recent years has been private ABS. It's partly because the banks moved out of the market and retrenched, leaving a hole for asset managers and insurance companies to come in and fill. That could be through fund finance, whole-loan securitisations, consumer loans, solar, and other things that the banks had really bid down to tight levels that weren't as interesting for the rest of the market. It's now become more appealing as insurance companies have looked for different ways to differentiate away from public corporates and search for higher yields.
Why have the banks moved away from ABSs?
As part of the Basel III endgame, the capital to hold a lot of these securities and whole loans on their balance sheets became a lot more expensive. As we went into the regional banking crisis, the banks started looking inwards and asking themselves what did or did not make sense in terms of their liability matching. One of those things that they were looking at was whether it was sensible to have twenty-to-thirty-year loans on the balance sheet when their deposits can disappear in a matter of days.
It seems that a lot of insurers are now taking a deeper, harder look at ABSs. Why are they glancing in this direction? What is it that's attractive to them?
You're able to pick up strong downside protections with performing collateral for underlying assets all while also getting paid a premium over public ABSs. The other thing that's been attractive over the short-term has been with the inverted yield curve. A lot of these ABS securities are one-to-four-year durations and, in many cases, are floating rate. We look at it as sort of a barbell-duration trade, and so we look to ABSs in order to take advantage of the short-end of the curve and participate in that trade. While simultaneously looking for longer duration to help to match against our liabilities.
Another interesting aspect of this market is CTLs, particularly how they help solve the duration problem. What's your take on that?
A CTL is where you are leasing against the building, but the leaseholder is a strong corporate parent which can back up any cash shortfalls. You're really kind of lending against the company as opposed to the building itself. We're not heavy buyers of CTLs, and we think that they're a bit of a niche product, but there's certainly some players that do a lot of it. We've done a fair amountin this space.
How can CTLs help solve the issues with duration?
The duration problem, which I've alluded to with ABSs, is that insurers tend to have a liability duration of seven to nine years. That means that it's harder to buy out the curve and find attractive spots for duration, especially in the inverted yield curve. That's where we look to a barbell approach. CTLs provide duration and downside protection to the commercial mortgage with the credit tenant as a backstop. Allowing more comfortto invest down the curve.
When you look at the market now, what stands out as the big themes?
One of the biggest themes is the search for yield, duration and the shift to private assets. CPACE is one area that checks all of those boxes. We have started investing a lot more of our dollars here in the last couple of years. The reason for that is as we look for duration, people have shown more reticence or concern about the commercial mortgage market. So CPACE allows us to come in at super-low LTVs, anywhere from 15% to 25%, and they also sit senior to any existing loans on the property. This is a trade that we've really liked. It is a harder market to access and it's paid to work with one of the main originators. Overall, it's been a good investment for us. The other piece there that we like about it is the impact that it has. The money is going towards rejuvenation or improvement on the building that is leading to greater efficiencies.
You've touched on ESG there. It was a hot topic in the investment space, but that focus seems to have waned. What's going on there?
It has become a very polarising topic and not something that anyone wants to raise their hand about and be at the forefront of the conversation. CPACE is one of those investments where you're able to invest in the deal and make a decarbonisation impact through improved efficiency while also making at-market and above-market returns. It's really the best of both worlds.
Is there anything else that you're looking at? One person interviewed for this series has touched on commercial and residential mortgages, as we have talked about a little. That conversation was in the context of whether we were looking at another recession.
It is something that we've been looking at and considering for a while as everybody has been shining their crystal ball and wondering what's going to happen in the next year. We continue to review each economic release to check in on the state of consumers. But there does continue to be homeowners who have a lot of equity tied up in their homes due to the HPA runup of the last few years post Covid. That's where we're seeing HELOCs or second loans being taken out by homeowners to try and unlock some of that equity that's been built up as they have tapped into other sources of savings. And for insurers, RMLs are a very efficient piece of paper from an RBC perspective. Another area that we've invested in has been private credit that we have invested in via rated notes, which allows us to invest in an insurance efficient structure via the issuance of a note and equity or residual tranche to match some of the weighted average RBC of what the underlying looks like. We're not trying to arbitrage or take advantage of any loophole in the regulation. We're just trying to get the structure that we're investing into to look like what putting the loans directly on the balance sheet would resemble. As we continue to monitor and look at the chance of recession both of these investments we continue to monitor closely.
In terms of models, and here we're talking about direct origination vs. agented club style deals. Is the best read on this that the larger players in the market will go for the former while the smaller ones will opt for the latter?
It's a good read. The smaller players find it hard to participate in true esoteric private ABSs, just because of the scale that's needed to put it all together and execute. It's billions of dollars that's needed in this respect. The smaller players are still able to participate in the agented private placement market. What's interesting is that you're now seeing more of the asset managers move in and capture more of that share when it comes to the bigger players. They've been able to take some of the middle man out of the equation, and originate, securitise, and do whatever they need to package these investments in the most-efficient manner. That's led them to be able to securitize and sell the senior tranches for insurance balance sheets and sell the junior tranches to other investors, so I think a lot of asset managers have looked to replicate that model. These days, it's become easier to hold and do the whole loan securitisation without needing to own the originator.
What model do you go for?
We have an asset-allocator model so we don't trade or securitise ourselves. We work with a number of asset managers that we view as the being the best in class and who are able to invest in different asset classes.
