BREAKINGVIEWS-Insurers’ special sauce is losing its punch

By Jonathan Guilford

NEW YORK, Feb 2 (Reuters Breakingviews) - Insurers’ special sauce is losing some of its punch. Collateralized loan obligations, the funds that buy risky debt and slice it up into safer IOUs, are the $1.4 trillion engine powering the U.S. corporate credit market. Annuity peddlers have piled into the asset class, which is set for torrential demand in 2026. Slimming returns and the specter of past excesses loom, however.

CLOs rose from a $263 billion market in the United States after the post-Lehman recession thanks to two major forces. One is the retreat of banks, who back in the 1990s owned most so-called leveraged loans, the lower-rated debt often issued by buyout barons to fund deals, according to S&P Global data. Since then, stricter capital regulations forced Wall Street to parcel up and sell debt on to investors.

Meanwhile, life insurers seeking extra returns to fund their policies flocked to the market. Between 2011 and 2016, insurers held around 19% of the debt issued by CLOs comprising such syndicated loans, according to the Federal Reserve. The figure spiked from there, hitting 36% in 2022.

CLOs’ core magic is the transmutation of risky loans into safer debt. Think of them as a box into which a manager dumps a bunch of disparate IOUs, in this case loans used to fund buyouts. Those assets pay regular interest into the box, and a manager then sells a bunch of securities backed by them, sliced into tranches that win various safety ratings from agencies like Standard & Poor’s or Moody’s. At the top, gold-standard AAAs have first dibs on the box’s cashflows, with each lower tranche in line behind.

This is a tantalizing trick. Over the decade to 2025, even the least risky AAA-rated CLOs returned 142 basis points over the risk-free rate, according to Janus Henderson, while ordinary investment-grade corporate debt with a short maturity returned just 69 extra basis points.

Insurers prize CLOs thanks to rules promulgated by the National Association of Insurance Commissioners that award them a favorable capital treatment. This creates oddities – for instance, an insurer could theoretically buy up all the tranches of a CLO, effectively taking full exposure to the underlying loans, and wind up having to hold less capital against them than if it just bought the debt directly.

These rules are currently under review. Certainly, though, insurers – especially life insurers – have been eager buyers. Their CLO holdings stood at $13 billion in 2009. In 2024, the figure reached $277 billion, the NAIC reckons. And they are increasingly piling into lower-rated tranches to pick up extra yield: only 39% of insurers’ investments are in the safest AAA debt, down from 55% in 2011.

Private equity-backed insurers have tweaked this formula further. According to data from Moody’s, CLOs account for a mighty 18% of the portfolio managed by Security Benefit Life Insurance, owned by Eldridge Industries. More importantly, nearly 49% of its holdings are rated in the Baa range by the agency, the lowest investment grade level. Athene, the industry goliath owned by Apollo Global Management APO.N, is more evenly spread, and has recently shifted back up towards the most-senior tranches. Still, it looks nothing like traditional veterans Nationwide Life, Pacific Life or MassMutual, which overwhelmingly buy AAA-rated bonds.

The boom has also been a windfall for the CLO managers, who are paid to select and oversee the loans that go into the vehicles, and who also often happen to be owned by private equity groups. Carlyle CG.O, alone among the big four listed U.S. buyout shops in avoiding a stock-price decline in 2025, is the most prolific steward of insurers’ CLO holdings.

Yet beneath the vibrant activity, the mood among both insurers and their private-equity backers is increasingly glum. Apollo CEO Marc Rowan has even talked about the need to come up with a “replacement” for CLOs, citing “anomalies” in the way the securities are now priced.

One reason is that the supply of CLOs has not kept up with demand. The sector has hovered at a little over $1 trillion outstanding for a few years now. Part of that is down to a slump in M&A between 2022 and 2024, which limited the volume of new loans that can be packaged into the vehicles, hampering growth for the sector as a whole.

The high demand for CLO debt has squeezed returns. The extra interest rate that any tranche of a given CLO pays over interbank rates, known as its spread, has collapsed. While AAA spreads have fallen 49% from their late-2023 peak, according to Nomura data, insurer-favored rankings have slipped further. Double-A spreads are down 53%, and BBBs are down 56%.

Returns are falling during a time of elevated losses among the loans comprising CLOs. According to Moody’s, the issuer-weighted default rate on leveraged U.S. loans ticked up from around 2% at the end of 2022 to over 7% in early 2025, and was still nearly 6% as of December. The agency and others see this coming down further. Still, various managers point to a simple reason for a surge: in the wild giddiness of the post-pandemic era, buyout loans that never should have been underwritten got through. There are also spectacular blow-ups like car parts supplier First Brands. Some 1,100 CLOs were exposed to the failed company, Moody’s found. The default wave may lead to losses on lower-rated tranches, separating less-discerning managers from those more cautious.

For now, however, the sector is still going strong. Practitioners speaking with Breakingviews pointed to a historically frenetic pace of new managers emerging in the United States and Europe. The difference in spread that these upstarts must pay on their CLO debt has collapsed, these industry veterans say, yet another sign of the still-bulging demand. Analysts at Moody’s expect $143 billion of fresh issuance in 2026 even if it just keeps up with recent history. Yet, unless Apollo’s Rowan can make good on his plan to come up with a replacement for the product, some insurers may end up with less than they bargained for.

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