Table of Contents

Page

I. Executive Summary ......................................................................................................................... 1

II. What is a Structured Security? ......................................................................................................... 2

III. IG Structured Credit Offers Safer Credit Risk than Equivalently Rated Corporate Credit ............. 4

IV. Securitization Markets Have Experienced a Wholesale Change Since 2008 ................................ 17

V. Why Does Structured Credit Yield More than Corporates? - Illiquidity & Complexity Premia ... 22

VI. Structured Credit in the Context of Insurers .................................................................................. 25

VII. Conclusion ..................................................................................................................................... 28

Appendix A: Types of Structured Credit .................................................................................................... 29

Appendix B: Case Study Where IG Structured Credit Clearly Has Less Credit Risk than Corporate Debt
of the Same Rating ...................................................................................................................................... 31

Appendix C: Illustration of Multiplicative Benefits from Structured Credit .............................................. 32

I. Executive Summary
Change is a constant, and change in the financial markets is no exception. The 2008 financial crisis resulted
in profound changes in many aspects of financial markets. Investors and rating agencies demanded
wholesale changes in securitization. The result of those changes is that today’s structured credit products
bear little resemblance to the risky, highly-levered, undiversified structured credit products that played a
role in the 2008 crisis. Structured credit products now provide investors better diversification, credit
enhancement, and structural protections. As banks have pulled back from lending to U.S. businesses and
consumers, these new, safer forms of securitization have provided the necessary financing for credit cards,
cars, homes, commercial real estate, consumer loans, and small and medium sized businesses.

At the same time, corporate bonds have become more levered, illiquid, and exposed to idiosyncratic risks.
Accelerating macro trends like technological disruption, climate change, geopolitical tension, pandemics,
and demographic change have increased the idiosyncratic risk to a particular company or industry. These
trends have threatened previously unassailable corporate titans, subjecting creditors to loss. Amazon and
internet shopping have disrupted Sears, JCPenney, Circuit City, and RadioShack. Netflix has disrupted
Blockbuster. In the past decade, BlackBerry, General Electric, JCPenney, Kmart, Macy’s, and PG&E have
all experienced significant credit dislocations or bankruptcy. The average lifespan of a company in the S&P
500 is half of what it was in the 1960s.1 In this context, previously held assumptions about corporate debt
need to be challenged. Prudent investors are considering whether the pace of change from macro trends is
accelerating and are rightfully recognizing the increasing benefits of diversification offered by structured
credit.

Today, three key features mean investment grade (“IG”) structured credit offers safer credit risk than
comparably rated corporate credit: (i) diversification, (ii) credit enhancement, and (iii) structural protections
that divert cash from lower quality tranches to support IG debt tranches in periods of stress. Over the last
decade, no IG debt issued by a collateralized loan obligation (“CLO”) or other asset-backed security
(“ABS”) has defaulted, compared to annualized default rates of 0.08% for BBB corporate debt.2 In 2021,
BlackRock ran the aggregate assets of U.S. insurers through the Federal Reserve’s Severely Adverse CCAR
scenario, and modelled projected losses of 0.2% for CLOs, 0.3% for ABS, and 7.0% for investment grade
corporate holdings.3

Despite being safer credit risk, IG structured credit can provide incremental yield over equivalently rated
corporate debt because it is more complex to appraise and may be less liquid. An investor requires greater
expertise and resources to appraise the credit risk in structured credit because of the diverse underlying
collateral pools and unique security waterfalls. This additional complexity reduces the buyer base and,
hence, liquidity. Together, these attributes can mean that structured credit can experience greater price
volatility than corporate credit in stress, even though it is safer credit risk. Experienced investors with the
expertise to understand the complexity and long-dated, stable funding to withstand illiquidity and price
volatility can capture incremental yield without taking on incremental credit risk.

1 Innosight 2021 corporate longevity forecasts, available here.

2 Average default rate of U.S. securities. Source: Moody’s Annual Default Study (February 2022). S&P Annual Global Structured
Finance Default and Rating Transition Study (May 2021). Moody’s Impairment and loss rates of Global CLOs (June 2021).
3 BlackRock risk analysis on Life Insurance Industry holdings as of December 31, 2020. The Severely Adverse macro-economic

scenario is defined to align with the Federal Reserve’s 2020 supervisory scenarios that the Board will use in its bank holding
company stress tests (i.e., CCAR). Loss is expressed as percentage of public fixed income for which discounted cash flows were
generated. Sources: Q12020 GDP U.S. Bureau of Economic Analysis, Apr 2020 Unemployment and Apr 2020 CPI – U.S. Bureau
of Labor Statistics (series LNS14000000, CUSR0000SA0).

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II. What is a Structured Security?

Securitization is the process of pooling a group of financial assets in a “special purpose vehicle” (“SPV”)
that issues debt and equity to finance the acquisition of those assets. SPVs are newly established companies
created solely to own a portfolio of assets. Securitization SPVs do not have ongoing operations, employees,
property, plants, or equipment. They are not exposed to changes in a management team, operational
blunders, or poor business strategy.

Investors purchasing the debt issued by securitization SPVs are attracted to the secured nature of the
cashflows earned from the asset portfolio. While corporate debt is typically unsecured and includes only a
“promise to pay” from the corporate issuer, securitization SPVs hold assets that serve as collateral. The
cashflows earned from the collateral assets are used to pay both interest and principal on the securitization
debt.

Securitizations generally contain strict rules setting out what types of assets are permissible for them to own
and define a clear priority of payments (the cashflow “waterfall”). Assets in securitizations can include
contracts to pay from a diverse set of credit worthy companies, e.g., leases on fleets of cars from a wide
variety of companies, repayment of loans from multiple corporate borrowers, and cashflows from restaurant
franchises. Securitizations are closed systems that include strict limits on, or prohibitions against,
incremental debt incurrence, asset stripping, or cashflow leakage (e.g., special dividends). As
securitizations are not operating companies, there is no management team that can change direction and
deviate from those rules. Securitizations include “self-correcting” mechanisms whereby if assets in the
securitization portfolio underperform, cashflows that might otherwise be available to distribute to the equity
or sponsor are trapped and used to repay the debt. Unlike a corporation, it is exceptionally difficult for a
securitization to engage in fraud or other bad acts, as the rules of the securitization are set at issuance and
are largely immune to outside influence. Securitization SPVs are transparent: a third-party trustee (such as
Bank of New York Mellon, US Bank, or Wells Fargo) is required to prepare and distribute collateral reports
on a monthly and/or quarterly basis. Like most corporations, securitizations are audited annually.

The debt issued by the SPV has a maturity that matches the maturity of the underlying pool of collateral
assets, a structural requirement known as “self-amortization” or being “maturity matched.” In contrast, an
operating company (e.g., Pepsi or IBM) issuing a bond must typically find cash from its balance sheet or
issue new debt to refinance its existing corporate debt when it comes due.

Securitizations are “bankruptcy remote,” which means that the fate of the securitization is disassociated
from the credit performance of the corporate sponsor that set up the securitization. If, for example, General
Motors issues a securitization of a portfolio of its auto loans and later files for bankruptcy (as occurred in
2009), there would be no impact on the securitization. Each retail auto loan borrower would continue to be
required to pay their monthly payment, and the collection of all such payments would serve as the cashflow
used to pay interest and principal on the auto loan securitization debt. As another example, Hertz’s fleet-
lease securitization debt experienced no impairments when Hertz declared bankruptcy during the COVID-
19 shutdown in 2020.

Often, a securitization will issue multiple layers (“tranches” from the French word for “slice”) of debt with
various payment priorities and risk profiles. Senior debt is the lowest risk tranche and will earn the lowest
yield. Junior debt is riskier and therefore earns a higher yield. Securitizations also include an equity piece,
which has a claim on all residual cashflows earned from the assets after the debt is paid interest and principal
in full. The equity tranche receives the highest yield, but also has the most risk as it is the first to incur
losses. Exhibit 1 illustrates an example securitization of leases of vehicle fleets to businesses.

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 Exhibit 1: Illustration of Securitization from Fleet Finance

Who Engages in Securitizations and Why do Securitizations Exist?

Securitization facilitates the democratization of credit, allowing a broader set of investors to participate in
the financing of particular parts of the economy. The key benefit of “tranching” is that investors can target
the risk profile that comports with their risk tolerance. That permits securitization sponsors to achieve
access to a wide pool of capital standing ready – collectively – to lend them money against a discrete pool
of financial assets. Because a broader set of investors can participate in the financing, there is a greater
supply of capital that can help drive down the cost of financing for the sponsor and ultimately consumers
and businesses.

Different types of organizations might sponsor a securitization, including an auto finance company
providing loans on new and used auto sales; a government or private organization issuing student loans; a
lender to small and middle market U.S. employers; and a mortgage originator lending money to Americans
buying homes. Each of these entities will originate a portfolio of loans and sell them to an SPV that issues
debt to the capital markets backed by the interest and principal paid by each underlying borrower.

There are many different types of securitizations, each with unique characteristics. For instance, the
structured finance market covers government-backed mortgage-backed securities, private label residential
mortgage-backed securities, commercial mortgage-backed securities, collateralized loan obligations backed
by corporate loans (typically referred to as “CLOs”), and structured credit backed by consumer and
commercial receivables (typically referred to as “Asset Backed Securities” or “ABS”). Exhibit 2 below
shows the types of securitizations that exist today. Additional detail on the different types of securitizations
is included in Appendix A.

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 Exhibit 2: Taxonomy of Asset Backed Securities4

Securitization provides borrowers with a few key advantages, including (i) non-recourse financing that may
not count as corporate debt, (ii) financing that is matched to the tenor of assets and reduces refinancing risk,
and (iii) increased diversification of funding sources.

Without securitization, corporate balance sheets would be burdened by existing assets and likely subject to
higher funding costs from a narrower funding base. For example, Ford’s balance sheet would be bloated by
loans made to retail consumers to buy cars. Ford’s financial performance would be driven largely by these
loans, much like a bank, making credit and equity investors hesitant to fund new business initiatives and
growth.

III. IG Structured Credit Offers Safer Credit Risk than Equivalently Rated Corporate Credit

Three key features mean that IG structured credits offer safer credit risk than comparably rated corporate
credit: (i) diversification, (ii) credit enhancement, and (iii) structural protections that divert cash from lower
quality tranches to support IG debt tranches in periods of stress.

1. Diversification of Underlying Credit Risk

Asset portfolio theory dictates that a diversified pool of assets is likely to present more stable returns than
an equivalently sized investment in a single asset. The Basel Committee on Banking Supervision has
observed that “concentration of credit portfolios is an important aspect of credit risk” and has also attempted
to quantify the appropriate capital charge for banks with concentrated portfolios.5 For “a typical commercial

4 Source: Source: SIFMA, JPM (Agency Commercial RE) and Urban Institute (Agency Residential RE). Data as of December 31,
2021, for US markets only; market size represents total amount outstanding.
5 Basel Committee on Banking Supervision: Studies on credit risk concentration available here.

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bank with a medium to large size loan portfolio…name concentration could add anywhere between 2% and
8% to the credit value-at-risk while sector concentration can increase economic capital by 20-40%.” The
table below, which presents the results of the Basel Committee’s analysis, shows the credit value-at-risk at
the specified level of confidence expressed as a fraction of the total portfolio exposure. Moving from left
to right, diversification reduces modelled expected losses.

Exhibit 3: Basel Committee’s Stylized Example of Effect of Diversification on Portfolio Risk6

The diversification benefit achieved through asset securitization is akin to the concept of liability “risk
pooling” that underpins insurance. As Dr. Robert W. Klein, a former Associate Professor of Risk
Management and Insurance Director of the Center of Risk Management and Insurance Research at Georgia
State University, has explained:

Individuals and firms can reduce the pure risks they face through insurance mechanisms
designed to transfer and diversify risk across a wider base of exposures and/or over time.
This is accomplished by pooling losses for a group of individuals or firms in some manner…
Uncertainty and the law of large numbers make insurance valuable, as well as feasible. As
the number of members of an insurance pool increases, the random or uncertain aspect of
the occurrence of accidents and claims for benefits is reduced, and there is greater certainty
about the total losses that the pool will suffer… As the size of a pool increases, its actual
losses will tend to come closer to its expected or predicted losses based on the risk levels of
its members.7

Securitizations likewise benefit from diversification across underlying individual credits, making it easier
to predict potential losses. Risk pooling makes structured credit less exposed to the idiosyncratic risk
associated with a single corporate borrower or with any specific industry.

In fact, rating agencies and investors require every CLO to maintain a high level of diversity within its
portfolio. CLOs include formal “single name limits,” that limit any single borrower exposure (e.g., 1-2%
max per obligor) and “industry limits” that prevent one industry from representing too great a concentration
(e.g., 10-12%, sometimes with exceptions up to 15%) of underlying assets.

6Id.
7Source: Robert Klein, “A Regulator’s Introduction to the Insurance Industry,” National Association of Insurance
Commissioners, available here.

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Consider the example from a representative USD broadly syndicated loan CLO portfolio shown in Exhibit
4 below.8 In the example, the top five industries account for 48% of the portfolio and the top ten industries
account for 70%. This representative transaction owns loans in 29 distinct corporate sectors, which is typical
of today’s broadly syndicated loan CLOs.

Exhibit 4: Diversification in a Representative USD Broadly Syndicated Loan CLO

2. Credit Enhancement and Tranching of Risk

Senior, investment grade securitization tranches are repaid first from the underlying cashflows produced
by the assets and have priority in claims for repayment. In this way, IG tranches benefit from “hard” credit
enhancement from the excess of the asset portfolio balance over the liability balance. In the illustrative
CLO capital structure depicted in Exhibit 5 below, the BBB rated tranche benefits from 15% credit
enhancement, which means the asset portfolio must incur realized losses in excess of 15% before the BBB
rated tranche will begin to impair. Thus, if the securitization’s underlying assets recover 50% upon default,
30% of the portfolio must default to cause any impairment to the BBB rated tranche.

8 The representative CLO is Ares 65 Ltd.

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 Exhibit 5: Credit Enhancement in a Recent CLO

In addition to hard credit enhancement, securitizations benefit from “excess spread.” A securitization’s
excess spread is the amount of interest income earned by the assets that exceeds the funding costs (including
fees and expenses) on its debt. In periods of credit stress, excess spread is used as an immediate source of
credit support for the securitization’s debt tranches. Taking our example above, this means a BBB rated
tranche would require much more than 30% of the portfolio to default before experiencing loss because
securitizations are hard-wired to redirect cashflow to protect the debt when under stress.

3. Structural Protections

Securitizations include cashflow diversion triggers that work together in periods of stress to add incremental
credit support for the IG securitization tranches. In contrast, when a corporation suffers stress in its business,
there are fewer means to prevent the company’s management from continuing to pay a dividend or from
buying back stock.

Cashflow Diversion Triggers: Securitizations include protective financial covenants that require
measurement of the ongoing credit quality of the asset portfolio. When such a covenant is breached (i.e.,
credit quality has declined), cashflow that would otherwise be distributed to the equity (e.g., a dividend),
or used to pay interest on junior debt, is instead diverted to repay senior, IG debt. This is sometimes referred
to as “turbo” or “rapid” amortization. CLOs include a par value coverage test that compares the par value
of the assets (subject to certain adjustments for distressed or defaulted loans) to the par value owed on the
CLO’s liabilities. Mortgage securitizations include debt service coverage ratio and delinquency covenants.
Aircraft ABS include debt service coverage ratio covenants that can breach when aircraft lease income
declines. Whole Business securitizations include “systemwide sales” and leverage covenants that can
breach if performance of the underlying business declines. These are just a few examples; each
securitization contains multiple protective covenants that trap and redirect cashflow to protect IG debt.

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 Exhibit 6: Illustration of Cashflow Diversion Triggers

Active Management (primarily for CLOs): CLO managers are asset managers with teams of portfolio
managers, traders, credit analysts, risk managers, and operations personnel. Several the largest CLO
managers are owned by, or affiliated with, insurance companies. A CLO manager may purchase new assets
with proceeds received from the prepayment or scheduled amortization of loans in the existing portfolio,
which are subject to strict eligibility criteria and collateral quality tests. This active management helps to
maintain or improve the credit quality of the portfolio. Collateral quality tests restrict the manager from
buying loans with too long a maturity or with too low an average rating. The tests require the portfolio to
maintain a certain level of diversity and accrue a minimum rate of interest to ensure there is sufficient
interest income available to pay interest on the CLO’s liabilities. Unlike cashflow diversion triggers,
breaches of these collateral quality tests do not redirect cashflow. Instead, a breach requires the manager to
maintain or improve the status quo in its future trading and investment activities.

There is strong alignment of interests between CLO managers and investors, as CLO managers face strong
incentives to manage the loan portfolio to maximize risk-adjusted return. Management and incentive fees
are junior in the capital structure and only paid if a CLO is performing. CLO managers are also raising an
increasing amount of capital to sponsor the equity in their own transactions (in Europe, risk retention rules
actually require it). Successful active management by a professional manager can improve credit
enhancement levels by “building par” via trading gains or reinvestment of available proceeds into loans
issued at a discount. A CLO manager will perform detailed credit analyses—through reviewing financial
metrics, business prospects, competitive position, management team, and the macro environment—of the
corporate loans available for inclusion in their CLO’s asset portfolio. Credit analysts regularly meet with
the management teams of the underlying companies they lend to, and actively monitor those companies’
financial performance.

While other types of securitizations and CLOs are typically not “actively managed”, almost all
securitizations are administered by a servicer with responsibilities that are similarly protective of the
securitization debt. A residential mortgage servicer will advance funds to the securitization corresponding

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to the interest and principal payable by delinquent mortgages and work to sell defaulted mortgages for the
highest recovery value. A commercial mortgage “special servicer” is engaged when commercial mortgages
default. The special servicer is responsible for determining the best path to recovery, be it a loan
modification, workout, or sale. An Aircraft ABS servicer is responsible for remarketing aircraft that have
come off lease or arranging for the sale of an aircraft in the terminal stages of its life. In short, no
securitization is issued without professional oversight.

Three Key Benefits of Securitization Overlap and Reinforce Each Other

All IG securitizations benefit from structural benefits that make them safer credit risk than equivalently
rated corporate credit. Some securitizations, including those with diversified asset pools, experience more
benefits than other securitizations. However, the overlapping benefits inherent in securitizations also
provide for safer credit risks even where one benefit is absent. A securitization that lacks diversification
still benefits from the credit enhancement and structural protections. For instance, some securitizations may
lack diversification because they do not have diverse cash flows or because they include assets from similar
industries. Examples of such industries could include aircraft during COVID, as travel was limited during
the pandemic; student loans, which are reliant on a single business line and subject to regulatory concerns;
or whole-business securitization, which can depend on corporate brand. Regardless, undiversified
securitizations still benefit from both credit enhancement and structural protections such as cash flow
diversion triggers. Applying the aircraft example to this point, tranches of aircraft asset-backed securities
continued to perform well during both COVID and the Russia-Ukraine conflict.

In Exhibit 7 below we illustrate which structural features benefit different types of securities.

Exhibit 7: Overlap of Structural Benefits of Structured Credit by Type

Appendix B illustrates a real world case study where the key benefits of securitization mean that an IG
structured credit product clearly has safer credit risk than an equivalently rated corporate bond. This
example compares unsecured corporate debt issued by a Business Development Company to IG debt issued
by a CLO that benefits from diversification, credit enhancement, and structural protections but achieves the
same rating.

The risk protection provided by the benefits of securitization are multiplicative, with the greatest benefits
at the investment grade tranches. The probability of high levels of defaults are significantly reduced through
diversification, which benefits all tranches. When coupled with the benefit of credit enhancement and
structural protections, the potential losses in IG tranches becomes fractional. Equity and junior tranches
absorb first losses, insulating senior, IG tranches from the higher-probability, idiosyncratic risk of single-
name defaults. See Appendix C for a mathematical illustration of these compounded protections.

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The benefits of securitization additionally mean unrealistic annual default rates on a CLO’s underlying loan
portfolio are needed to cause an impairment on IG CLO tranches. Our analysis shows that annual portfolio
defaults of underlying loans must exceed 8% annually over the eight-year life of the CLO (almost 50%
cumulatively) to cause impairment on CLO BBB debt.9 For context, annualized default rates of corporate
loans during the Global Financial Crisis (“GFC”) peaked at about 8% annually for only one quarter in 2009
before falling towards a long-term corporate loan annual default rate of 2%. In modern history, only the
Great Depression of the 1930s would come close to causing sufficient corporate defaults to trigger
impairments on the lowest tranches of IG CLO debt. And in that environment, corporate IG debt would
also be in serious trouble with cumulatively over 60% of IG corporates defaulting from 1929 to 1939.10

Exhibit 8: Historical Corporate High Yield Loan Default Loss Rates11

One Disadvantage of Structured Credit – “Thinner” Tranches

There is one known disadvantage of securitization debt compared to corporate debt. Some tranches of
securitization debt are at risk of larger losses (as a percentage of par value outstanding) if the tranche suffers
a default. Tranche “thickness” is used to describe the amount of loss each tranche can absorb before it is
fully impaired. For example, if there is a junior mezzanine tranche of a securitization that attaches at 10%
and detaches at 20% of the par value of the collateral pool, it starts to absorb losses once it exceeds 10% of
the collateral. In a scenario where the collateral pool incurs 15% realized losses, the tranche incurs a 50%
realized loss. We say this securitization tranche has limited “thickness,” and while the probability of default
is sufficiently low, the “loss given default” can exceed similarly rated corporate debt (as a percentage of
par value outstanding). As we will see shortly, this potentially higher loss given default is outweighed by
the lower probability of default given credit enhancement, diversification, and structural protections.

9 This analysis assumes a stressed loan recovery of 40%

10 Source: Moody’s Annual Default Study (February 2022).
11 Source: LCD, Intex, S&P, Moody’s, Wells Fargo Securities.

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Corporate Bonds Are More Exposed to Idiosyncratic Risks, Increasing Risk of Default

In the past decade, a series of accelerating macro trends have increased the idiosyncratic credit risk
associated with any one company or sector of the economy. These trends include technological disruption,
climate change, geopolitical instability, and demographic change. The average lifespan of a company in the
S&P 500 is half what it was in the 1960s.12 In a working paper for the National Bureau of Economic
Research this year, John Campbell et al. measured over time the idiosyncratic volatility caused from risks
associated with one particular company. They described idiosyncratic volatility as “an empirical proxy for
the flow of firm-specific information and for the risk of human capital specialized to meet the needs of a
particular firm, and it reflects the important corporate decisions, including leverage and diversification of
project-level risk within corporations.” They observed that idiosyncratic volatility has increased since the
1960s, despite the fact that the financial crisis in 2008 and the COVID-19 crisis in 2020 meant that broader
market volatility has overshadowed idiosyncratic volatility in the minds of investors:

[A]verage idiosyncratic volatility increased relative to the volatility of a market index during
July 1962 to December 1997. . . . The average value-weighted idiosyncratic volatility since
1997 is 28%, lower than the levels reached at the end of [our prior 1962 to 1997 sample]
period but still slightly higher than the average of 26% during that period. . . . Firm-level
volatility spiked during the financial crisis and has been rising towards the end for our sample
in 2021. A main difference between volatility patterns today and those of the late 1990s is not
that idiosyncratic volatility is lower, but that industry, and in particular market volatility are
higher.13

Consider the impact of COVID-19 in 2020, when the number of defaults was 198, an increase of 115%
year-over-year. Historically, impacts from a pandemic may have been felt regionally across a broad set of
industries and considered systemic. However, given automation and trends including urbanization, online
shopping, and the globalization of commerce and travel, the heavy effects of the COVID pandemic were
concentrated in a few industries, with the energy, service, and leisure sectors accounting for 65% of
defaults.14

A series of accelerating macro trends are increasing idiosyncratic risks. New company models or
technologies are disrupting established businesses. Samsung and Apple swept past the cellphone business
models of companies such as Nokia and BlackBerry. Cellphone camera capabilities destroyed the film and
camera business of companies such as Kodak and Polaroid. Amazon and internet shopping disrupted Sears,
JCPenney, Circuit City, and RadioShack. Netflix and other video streaming platforms disrupted the
Blockbuster video rental store model. VRBO, Airbnb, and other less regulated technology companies
focused on vacation rentals are challenging traditional hotels and resorts. Deregulation of the airline
industry in the 1970s provided opportunities for new carriers such as Southwest to take market share from
larger carriers like Pan Am. COVID-19 accelerated changes already occurring in retail due to technology
and demographic shifts, straining traditional fine clothing retailers like Brooks Brothers. As office attire
fell out of favor, the online sales of casualwear boosted revenues of firms like Lululemon. In the past
decade, BlackBerry, General Electric, JCPenney, Kmart, Macy’s, and PG&E have all experienced
significant credit dislocations or bankruptcy.

12 Innosight 2021 corporate longevity forecasts, available here.

13 John Y. Campbell, Martin Lettau, Burton G. Malkiel, and Yexiao Xu, Idiosyncratic Equity Risk Two Decades Later, NBER
Working Paper no. 29916 (April 2022), available here.
14 Source: S&P Global, Default, Transition, and Recovery: 2020 Annual Global Corporate Default And Rating Transition Study

available here.

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 Exhibit 9: Accelerating Macro Trends Have Increased Idiosyncratic Risk

Prudent investors are beginning to consider whether the pace of change of macro trends is increasing,
creating greater idiosyncratic and industry risk. As a result, investors are increasingly valuing the
diversification offered by structured credit.

Corporate Issuers Are More Levered Since the Global Financial Crisis (“GFC”)

To compound matters for investors, credit quality has decreased in the public corporate bond market. The
gross debt-to-EBIDTA ratio for all corporate issuers has increased by more than 50% in the last decade.15
The net debt-to-EBIDTA ratio for non-financial investment grade issuers has risen from 1.7x in 2011 to
north of 2.5x today.

15FactSet: Analysts’ Dire Predictions for Fallen Angels Failed to Materialize in 2020, January 26, 2021. Russell 3000 - Total
Debt/EBITDA (last 12 months) available here.

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 Exhibit 10: US Investment Grade Corporate Leverage Ratios (Net Debt/EBITDA)16

The Wall Street Journal reported in 2021 that “non-financial companies issued $1.7 trillion of bonds in the
U.S. last year, nearly $600 billion more than the previous high…That torrent of inexpensive money has
benefited all types of businesses...And it permitted companies that were struggling before the pandemic to
ease the threat of bankruptcy.”17 One potential consequence of persistently low interest rates is that it might
keep unproductive firms alive. With rising rates, the cost of debt and the probability of default increases,
especially with highly levered business models struggling with the pace of change.

In 2020, Osterweis noted that “[t]he amount of leverage within each rating grade cohort remains elevated….
A full 39% of the investment grade market would be rated high yield using historical leverage ratings
metrics.”18

16 Bloomberg, ICE BAML US Investment Grade Corporate Index Net Leverage Ratios (Debt/EBITDA)
17 The Wall Street Journal, Pandemic Hangover: $11 Trillion in Corporate Debt (June 14, 2021) available here.
18 Osterweis Capital Management, 2020 Investment Grade Credit Outlook: Take a Scalpel, Not an Axe (Jan. 13, 2020), available

here.

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 Exhibit 11: Actual Ratings vs Implied Ratings
Using Current Leverage Applied to Historical Ratings Leverage Ratios19

At the same time, “covenant” packages in corporate debt have deteriorated. Covenants refer to legal
provisions in bond documents that prevent management from taking actions that could adversely affect
investors. The Moody’s Covenant Quality Index measured its record-worst reading ever in the third quarter
of 2021.20

Exhibit 12: Moody’s Covenant Quality Indicator (CQI) – Quarterly Average

Many of these looser credit agreements permit equity investors to “strip assets.” That is, the equity investors
could transfer collateral (e.g., a business unit, real estate, or intellectual property), from a borrower to a
newly created entity, which leaves existing lenders with a second priority claim on the stripped asset and a
weaker collateral package. For example, in late 2016, JCrew moved a majority interest in its brand into an
unrestricted subsidiary through the use of a “trapdoor” investment basket. This example highlights the risks

19 Id.
20 Moody’s Covenant Quality Indicator (CQI) is a quarterly indicator of the average covenant quality score for all bonds priced in
a given quarter. A higher CQI score denotes weaker covenant quality on Moody’s scale from 1.0 to 5.0: Strong (1.0 to <1.8), Good
(1.8 to <2.6), Moderate (2.6 to <3.4), Weak (3.4 to <4.2), Weakest (4.2-5.0) with High-yield-lite bonds receiving the weakest
possible CQ score of 5.0. CQI reflects all high-yield bonds, including high-yield lite. High-yield-lite bonds lack a debt incurrence
and/or a restricted payments covenant and automatically receive the weakest possible CQI score of 5.0.

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to corporate lenders of a borrower’s ability to transfer valuable collateral away from lenders. Securitization
documents do not permit such activity to occur.

Liquidity in IG Corporate Bond Markets Has Become an Illusion

Post-GFC regulatory changes like the Dodd-Frank Act, Volcker Rule, and Basel III have accelerated the
decline in corporate bond liquidity. In 2021, the ratio of fixed income mutual fund assets to dealer inventory
exceeded 140:1, compared to 3:1 prior to the 2008 financial crisis. Today, there is less cushion to absorb
redemptions and less broker-dealer liquidity in public corporate credit. Dealer inventories of IG corporate
bonds averaged just $3.3 billion this year through April 13, according to data from the Federal Reserve
Bank of New York. These figures have been broadly falling for years, and 2022 levels are nearly 50%
below the 2015-2021 average.

Exhibit 13: Liquidity in Corporate Debt21

Many insurers overvalue the perceived liquidity of public IG corporate bonds. That liquidity has become
an illusion. Especially during market stress, liquidity in the corporate bond market becomes scarce and it
can be uneconomical to sell even IG bonds. BlackRock estimated that during the peak of COVID in March
2020, the cost to liquidate a corporate bond was 58bps, 4x greater than what it was during a normal market
at the beginning of 2020.22 Rather than relying on illusory liquidity from the public bond markets, insurers
are better served by appropriately matching creditworthy assets to stable liabilities to minimize their
potential need to sell bonds to generate liquidity in stress.

Structured Credit is “Safer” Than Corporate Debt of Comparable Ratings

Certain structured credit products have had lower loss rates than similarly rated IG corporates. The
securitization features designed to protect debt investors have lowered losses on structured credit since
2008. No IG CLO nor other ABS debt has experienced principal impairment in the last decade.

21Source: Haver Analytics, ICI, New York Federal Reserve; data as of February 28, 2022.
22BlackRock Aladdin Transaction Cost Model estimate of average liquidation cost of bonds in the Bloomberg Corporate Index
for December 31, 2019 and March 31, 2020.

15
 Exhibit 14: Historical Credit Impairments Pre / Post 2008 by Type23

In 2021, BlackRock ran the aggregate assets of U.S. insurers through the Federal Reserve’s Severely
Adverse CCAR scenario and modeled losses of 0.2% for CLOs, 0.3% for ABS, and 7.0% for IG corporate
holdings.24 These dynamics are not surprising given that BlackRock considers the various credit
enhancements and risk mitigants embedded in CLOs and other structured assets.

23 Represents the average annual default rate of U.S. products for all categories, except CLOs. CLOs represent the average of US
CLO trailing 12-month impairment rate. However, 2001-2010 CLO B impairments were based the average of Moody’s trailing 12-
month impairments rates from Feb 2010-Dec 2010 as 12-month impairment data was not available prior to Feb 2010. 2001 - 2010
includes a discounted buyback of a pre-GFC CLO tranche (current CLO documents prohibit such activity); the related CLO
transaction performed as expected and repaid all of its debt at par with no underlying impairment. Source: Moody’s Annual Default
Study (February 2022). S&P Annual Global Structured Finance Default and Rating Transition Study (May 2021). Moody’s
Impairment and loss rates of Global CLOs (June 2021).
24 BlackRock risk analysis on Life Insurance Industry holdings as of December 31, 2020. The Severely Adverse macro-economic

scenario is defined to align with the Federal Reserve’s 2020 supervisory scenarios that the Board will use in its bank holding
company stress tests (i.e., CCAR). Loss is expressed as percentage of public fixed income and CML for which discounted cash
flows were generated Sources: Q12020 G DP U.S. Bureau of Economic Analysis, Apr 2020 Unemployment and Apr 2020 CPI –
U.S. Bureau of Labor Statistics (series LNS14000000, CUSR0000SA0)

16
 Exhibit 15: BlackRock’s Projected Losses for U.S. Life Insurance Holdings Under Fed’s CCAR
Severely Adverse Scenario25

While corporate bond leverage, illiquidity, and idiosyncratic risk have increased over the last decade,
investors have not been compensated for this increased risk. Corporate credit spreads have hardly changed.
In 2007 the average credit spread over risk free for A rated corporates was 1.2%, compared to 0.7% in 2021
and 1.0% in 2022.26 The market does not offer incremental yield for the idiosyncratic risk inherent in single
corporate bonds. This is in part because of the substantial increase in passively managed credit funds, which
primarily track the performance of broad indices and are inherently diversified. Over the last decade,
passively managed funds have increased from approximately 16% of the public credit markets to 32%.27
This has made it increasingly difficult to earn a higher return for taking idiosyncratic risk in particular
corporate bonds. In contrast, we will see in Section V that investors in structured credit are compensated
for incremental illiquidity and complexity premia. As a result, investors in structured credit can choose to
trade off idiosyncratic risk (for which they are not paid) for illiquidity and complexity risk and earn
incremental yield.

IV. Securitization Markets Have Experienced a Wholesale Change Since 2008

The types of assets underlying securitization have changed significantly since the 2008 financial crisis. The
collateral in structured credit issued today is considerably more diverse than the relatively concentrated

25 BlackRock risk analysis on Life Insurance Industry holdings as of December 31, 2020. The Severely Adverse macro-economic
scenario is defined to align with the Federal Reserve’s 2020 supervisory scenarios that the Board will use in its bank holding
company stress tests (i.e., CCAR). Loss is expressed as percentage of public fixed income and CML for which discounted cash
flows were generated Sources: Q12020 G DP U.S. Bureau of Economic Analysis, Apr 2020 Unemployment and Apr 2020 CPI –
U.S. Bureau of Labor Statistics (series LNS14000000, CUSR0000SA0).
26 ICE BofA Single-A US Corporate Index Option Adjusted Spread as reported by the St. Louis Federal Reserve available here.
27 Bloomberg and Apollo’s Chief Economist. Data is based on estimates from a sample of 8,789 funds.

17
residential real estate securitizations that played a significant role in causing the 2008 financial crisis. In
2007, Collateralized Debt Obligations (“CDOs”) comprised almost 20% of all issuances and were primarily
composed of securitizations of debt from other riskier asset types, including non-agency residential
mortgage-backed securities (“RMBS”), commercial mortgage-backed securities (“CMBS”), and other
CDOs. Today, CDOs represent only 1% of issuances.

Exhibit 16: ABS Issuances 2007 vs. 202128

Before 2008, there were many assets originated for which the only buyers were securitization vehicles.
Securitization was a necessary condition for these assets to be originated, rather than just one alternative
means of financing. This created a vicious cycle where if securitizations had to sell assets, there were no
other natural buyers. Mortgage securitizations bought mortgages originated under an “originate-to-
distribute” model, whereby the originator only cared about making the loan, without ensuring its credit
quality was sound. “Liar loans” abounded, whereby borrowers would self-report their income, assets, other
debt burdens. Mortgage loans with low teaser rates for two years were abundant and commercial mortgages
in securitizations often took advantage of “pro-forma underwriting,” through which the property owner
would get credit for what they believed would happen to the property (lower vacancies, higher rental rates),
rather than what the property’s financials looked like at the time of underwriting. Today, these more
troublesome types of collateral have all but disappeared from the market. There are now natural buyers for
all main types of securitization collateral beyond the securitization market.

The investor base for structured credit itself has also matured. In 2007, 37% of structured credit was
purchased by other securitizations and other SPVs. Another 28% was bought by banks that often funded
the purchases with shorter-dated retail deposits and commercial paper. Prior to 2008, regulation around
securitization was light and many rating agencies were using deeply flawed methodologies for securitized
credit. Investment bankers were incentivized to create new, and ever more aggressive, securitization
structures backed by increasingly risky collateral. As the market and economy expanded, delinquencies and
defaults were near zero, and as the rating agencies used recent history as a proxy for future performance.

28SIFMA Research. Excludes Agency Mortgage-Backed Securities. “Other” includes ABS securitizations of consumer, franchise,
timeshare, insurance, and receivables. Breakout of CLO/CDO reflects Apollo Analysts’ estimates. Non-agency RMBS issuance
was primarily in nonprime (Alt-A and subprime) through 2008, but since the GFC issuance has been primarily in various prime
categories.

18
IG ratings were easy to achieve in structures with minimal credit support and low IG tranches offered
minimal thickness, often as low as 1%.29 Tranches of one type of securitization (say, RMBS) were collected
and served as the collateral for others (say, ABS CDOs). Tranches of ABS CDOs were then acquired and
served as the collateral of “CDO squareds” (CDOs of CDOs). Today, regulations, rating agency criteria,
and investor stipulations preclude securitizations from owning other securitizations. The investor base is
increasingly composed of sophisticated, institutional buyers who have access to long-dated, stable funding.
The portion of new issuances purchased by pension funds and insurers has increased from 6% in 2007 to
over 42% today. The long-dated, stable liabilities of pension and insurance companies means that they are
focused on fundamental credit rather than temporary mark-to-market swings in price. They can help
stabilize the securitization market as willing buyers during market dislocation.

Exhibit 17: Comparison of Investor Base in ABS from 2007 to 202130

Following the crisis, regulatory and political actions brought on new standards in the asset securitization
space. Regulatory changes implemented through the U.S.’s Dodd-Frank Wall Street Reform and Consumer
Protection Act and the international Basel III regulatory framework put new governance around bank
structured credit lending; improved disclosure by requiring standardized, transparent collateral reporting;
and tightened the methodologies utilized by rating agencies. In Europe, regulators prohibited the
securitization of securitizations (“re-securitization”), including CDOs of ABS.

Regulatory action resulted in stronger, safer structured credit. Post-financial crisis, collateral support has
been strengthened and structures include higher quality collateral. Market value triggers, which created
liquidity issues and a vicious cycle of losses during the 2008 financial crisis, no longer exist.

29 Thickness refers to how much loss a non-senior tranche can incur before being fully impaired. Some mezzanine, IG rated tranches
of residential mortgage-backed securitizations pre-GFC could begin to take losses when the underlying pool of mortgages lost as
little as 5%. Once losses reached 6% or 7%, the tranche would be fully impaired.
30 Data specific to AA to BB rated CLO-issuance volumes tracked by JP Morgan and Citi.

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 Exhibit 18: Structured Credit Terms Pre and Post the Financial Crisis

Case Study: CLOs After the 2008 Financial Crisis

Since 2008 financial crisis, CLOs have become considerably less complex. Newly originated collateral
pools are now limited to corporate loans and bonds. CLOs no longer allow duration mismatch where
liabilities are shorter than assets in the portfolio. Rating agencies and investors now demand greater credit
enhancement at each ratings level, as shown in Exhibit 19 below. Under today’s rating agency framework,
a BBB rated tranche has an additional 5% credit enhancement. Under pre-crisis methodology, this is
equivalent to the credit enhancement level of A rated tranches.

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 Exhibit 19: Increases in CLO Structural Protections Pre and Post the Financial Crisis31

Rating Agency Methodology Tightened Significantly and Competition has Increased

Recognizing the miscalculation and inappropriate methodologies that occurred before and during the 2008
financial crisis, rating agencies have modified their rating methodologies to require diversification,
additional credit enhancement, and stronger underlying portfolio credit. For example, S&P, Moody’s, and
Fitch modified core inputs of their CLO ratings methodologies by either recalibrating the default
probabilities or revising other model inputs to increase required hard credit enhancement at each rating
level.

At the same time, federal regulation in the United States mandated that statistical rating organizations
“enhance governance, protect against conflicts of interest, and increase transparency.”32 The Securities and
Exchange Commission’s Office of Credit Ratings is required to submit annual reports to the U.S. Congress
since the Credit Rating Agency Reform Act of 2006. This has worked: rating agency expertise in securitized
markets is increasingly democratized across Nationally Recognized Statistical Rating Organizations
(“NRSROs”). Rating agencies like DBRS and Kroll have developed dedicated expertise in modern types
of securitization, creating more healthy competition between NRSROs for structured credit.

Since 2008, the SEC has adopted rules designed to enhance competition among credit rating agencies. For
example, the SEC created the “Rule 17g–5 Program” in 2009 to “improve the quality of credit ratings for
structured products by making it possible for more NRSROs to rate structured finance products.” Under the
Rule 17g–5 Program, NRSROs that are not hired to rate structured finance products are able to access the
same nonpublic information available to NRSROs that were hired to issue ratings, making it possible for
the non-hired NRSROs to issue unsolicited ratings of those products. The SEC created this program to

31 Source Wells Fargo Securities and Apollo Analysts.

32 Securities and Exchange Commission, SEC Adopts Credit Rating Agency Reform Rules (Aug. 27, 2014) available here.

21
“advance the Rating Agency Act’s goal of promoting competition in the credit rating industry by facilitating
the issuance of credit ratings by NRSROs that are not hired by the arranger.” The SEC believed “the
resulting increase in the number of ratings extant for a given structured finance security or money market
instrument will provide users of credit ratings with more views on the creditworthiness of the security or
money market instrument.”33

Exhibit 20: Rating Agency ABS Market Share 2008 vs. 202034

V. Why Does Structured Credit Yield More than Corporates? - Illiquidity & Complexity Premia

Structured credit can provide incremental yield over equivalently-rated corporate debt because it is more
complex to appraise and may be less liquid, not because it represents incremental credit risk. An investor
requires greater expertise and resources to appraise the credit risk in structured credit because of the diverse
underlying collateral pools and unique security waterfalls. This additional complexity reduces the buyer
base relative to traditional publicly traded corporate bonds and, hence, liquidity. Together, these attributes
can mean that structured credit can experience greater price volatility than corporate credit in stress, even
though it is safer credit risk. Experienced investors with the resources to understand the complexity and
long-dated, stable funding to withstand illiquidity and price volatility can capture incremental yield without
taking on incremental credit risk. We refer to this incremental yield as “illiquidity” and “complexity”
premia.

33 Amendments to Rules for Nationally Recognized Statistical Rating Organizations, Final Rules, 74 Fed. Reg. 63,832, 63,844,
63,851.(Dec. 4, 2009).
34 SEC’s Office of Credit Ratings Annual Staff Reports available here.

22
 Exhibit 21: Decomposition of the Illiquidity and Complexity Premium

These concepts are not unique to structured credit, and the premia offered can be material. For example,
Professor Schwert at Wharton has noted that “more than half of the typical [bank] loan spread is a premium
in excess of the bond market price of credit risk.”35

The process of securitization introduces complexity. The accumulation of assets in an SPV, and the
tranching of those assets’ cashflows for investors, adds structuring and documentation that require greater
investment understanding and resources. This complexity creates a wider dispersion of valuation
perceptions, increasing price volatility of structured credit in uncertain markets. The complexity premium
is made up of two components: a valuation premium and expenses for required resources.

The Valuation Premium

Valuation premium refers to the incremental yield an investor can achieve if they have the expertise to
value assets independently rather than through public markets and can withstand public market price
volatility in periods of stress. The valuation premium is highly correlated to the illiquidity premium.
Structured credit has greater price volatility in stressful markets for two reasons.
First, structured credit offers less price transparency than publicly traded corporate debt. It takes additional
expertise to analyze the financial reporting of structured credit relative to traditional corporate bond issuers.
Structured credit also generally trades “over the counter” and with less frequency than corporate credit.
Structured credit instruments are less likely to be included in broader credit indices. In contrast, corporate
bond trades are posted on TRACE for full price transparency. And there is an active market for credit
default swaps referencing corporate obligors (both “single name” and “index”), which means market
participants can easily assess valuation and hedge their exposure. Corporates are also easily financeable
and pledge-able into repurchase agreements and prime brokerage financing arrangements. Structured credit
typically lacks these market features. Average daily trading of structured credit reported on TRACE
represents 0.09% of notional outstanding relative to 0.39% for corporate debt.36 In this context, even small

35 Michael Schwert, “Does Borrowing from Banks Cost More than Borrowing from the Market?” Journal of Finance, (April
2020), at, pp. 905-47.
36 SIFMA Research. Structured credit excludes Agency Mortgage-Backed Securities.

23
trades, where prices are made public through TRACE or other services, can re-price entire structured credit
markets.
Second, it is more difficult and time intensive to distill valuations of the diverse sets of collateral pools held
by structured products, some of which might be challenging to analyze in times of stress. Underlying
securitization assets might not have observable market prices and may require valuation models. For
instance, during the early COVID period, the uncertainty in the aviation sector put a premium on the
valuation performed on aircraft collateral pools, which required determining the amount of the underlying
pool that flew international routes which were more adversely affected by government restrictions.
Out of expediency, investors typically extrapolate and characterize entire markets, generalizing and
overstating the likelihood of risk after a shock. The impact of such extrapolations can be profound: AAA
rated tranches of CLOs, for example, traded below 90% of par at the trough of the COVID-induced market
volatility, even though the direst scenarios projected no cashflow impairment to those tranches. With around
40% credit enhancement and the prevalence of cashflow diversion triggers, more than 80% of the
underlying loans would have to default with stressed recovery levels of 50% for an AAA rated CLO tranche
to suffer principal impairment. As Ellington Management, a prominent credit hedge fund, noted in
December 2021, “structured product investors earn a liquidity premium as compensation for the risk that
mark-to-market prices fall below fundamental value when financial markets come under stress.”37
The buyer base for structured credit has shifted, and continues to shift, towards stable, longer-term investors
like insurance companies that are better suited to hold these securities through periods of stress. As this
occurs, and the nature of structured credit is better understood, this valuation premium will likely shrink.
We expect that this will take many years.

Expenses for Required Resources

Successful investors in structured credit need dedicated credit, trading, analytics, risk, and legal resources.
They also need institutional knowledge and a disciplined process. This expertise is expensive, as it includes
investments in people, data, technology, and processes that often take years to build.

For the proper valuation and risk assessment of structured credit an investor requires data, documentation,
and expertise. The steps range from collection of documentation and selection and calibration of credit loss
models through to running a multi-period simulation “on bottom up” collateral cashflow generation
allocated with precise dependence on collateralized securities’ waterfalls.38
While structured credit carries less credit risk, it takes greater expertise and resources to evaluate. The cost
of developing that expertise is borne by the shareholders of the asset manager managing the insurance
company’s assets, not the policyholders. In contrast, the cost of additional credit risk is first borne by the
policyholders. For this reason, regulators, whose primary obligation is to policyholders, should prefer that
insurers invest in capabilities to tackle complexity risk (for which they earn yield) rather than taking on
incremental credit risk.

Ratings Volatility

In the same way that complexity means it can take the market longer to price structured credit, it can also
take rating agencies longer to determine the impact of market events on structured credit relative to

37The Cycle Repeats: Post-Crisis Opportunities in Structured Credit; Ellington Management, December 2021.
38“Relating Top-down with Bottom-up Approaches in the Evaluation of ABS with Large Collateral Pools”; Diener, Jarrow, Protter;
2011. “CMBS market efficiency: The crisis and the recovery”; Christopoulos, Jarrow; 2018. “Commercial Mortgage-Backed
Securities (CMBS) and Market Efficiency with Respect to Costly Information”; Christopoulos, Jarrow, Yildirim; 2008.

24
corporate debt. As a buffer for uncertainty, some rating agencies have historically been more likely to
downgrade structured credit in stress than equivalently rated corporates. This does not necessarily mean
that structured credit represents worse credit risk; rather, it just means that it may be harder for the rating
agency to determine that credit risk. Often, rating agencies will upgrade structured credit at higher
frequency than corporate credit once the market stress subsides. For instance, in 2020, 3.0% of IG CLOs
were downgraded by a rating agency compared to 2.5% of IG corporate debt.39 However, there were no IG
CLO impairments and subsequently there have been more CLO upgrades than the number of CLO
downgrades in 2020.

Ratings downgrades of the underlying collateral can have implications for structured credit. Prior to the
GFC, those implications were negative, as covenants could require the forced sale of assets if the average
rating of collateral dropped below a certain level. This could cause securitizations to realize losses at
inopportune times of market stress when prices were depressed. These types of ratings covenants are no
longer common. Post GFC, downgrades of the underlying collateral can have a positive benefit for the IG
securitization tranches as it can trigger the diversion of cashflow from equity or junior debt.

None of illiquidity, complexity, nor rating agency volatility premia is related to the credit worthiness of
these securities. In order to capture these premia, an investor needs expertise (valuation premia), stable,
long-dated liabilities matched to the duration of the assets (illiquidity premia), and a strong capital base
(rating agency volatility). These are precisely the attributes of the best life and annuity insurers.

VI. Structured Credit in the Context of Insurers

The portion of newly issued IG structured credit sold to insurers has increased from 6% in 2007 to 32% in
2021. The shift can be attributed to the fact that for the last few decades, persistently low interest rates and
a substantial increase in passively managed assets such as exchange-traded funds, have made it increasingly
difficult for life and annuity companies to meet the promises they made to their policyholders by investing
in public corporate credit markets. Many life insurers are no longer able to offer attractive products and
have had to exit business lines. The illiquidity and complexity premia offered by structured credit provides
an attractive alternative to those insurers with the appropriate expertise, stable liabilities, and capital.

Why Participation in Structured Credit is a Good Match for Insurers

Traditional banking built its business on highly liquid deposit liabilities and shorter term commercial paper.
These short-term liabilities are used to make long-term loans, incurring sizable liquidity and asset-liability
risks. In contrast, insurers can match long-term loans with long-term, but largely predictable, liability
profiles of insurance lenders.

39 Source: JP Morgan.

25
 Exhibit 22: Comparison of Insurance Company vs. Bank Balance Sheets

The European Commission acknowledged the prudence of this approach: “The diminished role of banks in
long-term lending opens up new needs and opportunities for other financial institutions and market-based
intermediation to channel financing to long-term investments. Given the longer time horizons of their
business models, institutional investors—such as (life) insurance companies, pension funds, mutual funds,
and endowments—represent suitable providers of long-term financing.”40

Illiquidity Risk is One of the Few Ways to Diversify

Diversification has been harder to achieve in public credit markets as correlations across public asset classes
and between different public corporate credit is at historic highs. The integration of global financial markets
and the rising popularity of passive index products have driven higher correlations. This makes it harder to
achieve diversification through public corporate credit alone. As such, it is prudent for life insurers to seek
diversification of risks beyond public credit, including from “illiquidity” risk that they are very well
positioned to take on given their long-dated, stable liabilities.

40 European Commission, Green Paper, Long-Term Financing of the European Economy. Brussels, March 25, 2013, available here.

26
 Exhibit 23: Correlation in Public Credit Markets41

The Insurance Industry is Highly Regulated and Transparent

Every asset on an insurance company’s balance sheet is disclosed publicly in quarterly regulatory filings
and submitted to focused, educated state regulators.

Insurer Risk Based Capital Appropriately Covers Each Risk

The core framework for calculating regulatory risk-based capital (“RBC”) for U.S. insurers appropriately
segregates the key risks, even though it fails to recognize some of the key benefits of structured credit. That
is, the insurance RBC framework has distinct charges for credit risk, operational business risk, and the risk
that assets are inappropriately matched to the duration of liabilities. This last risk is crucial because it means
that any insurer that does not have appropriately long-dated, stable liabilities will be highly disincentivized
to attempt to capture the illiquidity premia associated with longer-dated structured credit. An insurer that
writes shorter-dated homeowners’ or automobile insurance will be disincentivized from investing in less
liquid structured credit.

Exhibit 24: Key Components of Insurer RBC

41 Represents rolling 3 year correlation of monthly returns. Source: ICE, Apollo analysts.

27
Lower credit risk should mean lower C1 capital charges. The default experience for structured credit
compares favorably to that of public corporate bonds, specifically for structured credit originated after the
2008 financial crisis.
Insurer balance sheets should be resistant to mark-to-market volatility if assets and liabilities are duration
and cash flow matched. ALM mismatch is captured in C3 capital charges. Structured securities experience
higher volatility than corporate bonds in stressed markets. Life insurance companies match long-term,
predictable, liability cashflow profiles against these long-term assets. If ALM is matched and liquidity stress
is appropriately modeled, life insurance companies should not be forced sellers of structured credit in times
of mark-to-market volatility. Insurers therefore provide a source of stability to the broader economy in
stress.
All business and execution risks show up in C4 capital charges. Successful investment in structured credit
requires dedicated credit and structuring expertise, structuring and trading technology, legal resources,
institutional knowledge, and a disciplined investment process with extensive quantitative risk
capabilities. If an insurer lacks the appropriate investment and risk management expertise to manage
investments in structured credit, they should be charged with an additional C4 capital charge.

There Are Some Bad Securitization Structures That Are Not Appropriate for Insurers

Some securitizations are inappropriate for an insurance company’s balance sheets. In particular, some
securitization investors stray from standard securitization capital structures to achieve IG ratings on risks
that are primarily equity risk. Or an investor might collapse IG tranches into residual equity tranches and
seek a rating that only assesses the probability of return of principal, not principal and interest (thus deemed
a rating to “principal only”). This exposure is called a “combo note” as it combines tranches. As equity
tranches provide high cash returns, the cashflows generated by the combo note are often enough to support
IG ratings for the investor. But a material component of this exposure is equity risk. Well-capitalized
insurance companies have no need to seek out investments in this type of financial over-engineering.

VII. Conclusion

Both the structured credit and corporate credit markets have changed materially since the 2008 financial
crisis. IG structured credit has become less risky through increased diversification, credit enhancement, and
structural protections that divert cash from junior tranches to support IG debt tranches in periods of stress.
At the same time, IG corporate credit has become riskier as accelerating macro trends like technological
disruption, climate change, pandemics, and geopolitical uncertainty increase the idiosyncratic credit risk
associated with any one company or industry.

Given these secular changes, IG structured credit is a safer credit risk than equivalently rated corporate
bonds. Regardless, IG structured credit often offers investors illiquid and complexity premia. Investors with
the expertise to understand the complexity and long-dated, stable funding to withstand illiquidity and price
volatility can capture incremental yield without taking on incremental credit risk. In this way, investors
with long-dated, stable liabilities are incentivized to continue finance the economy through the investment
grade structured credit markets.

28
 Appendix A: Types of Structured Credit

There are multiple different types of structured credit. Real estate-backed instruments include
securitizations backed by mortgages for residential properties, called residential mortgage-backed
securities (“RMBS”), and those backed by mortgages for commercial properties, called commercial
mortgage-backed securities (“CMBS”).

Residential Real Estate securitized products include:

• Agency RMBS are securitized residential mortgages that exist under conforming terms set and
insured by government-sponsored enterprises including GNMA (“Ginnie Mae”), FNMA (“Fannie
Mae”), and FHLMC (“Freddie Mac”).
• Non-Agency RMBS are securitized residential mortgages that do not conform to the government-
sponsored enterprise’s (GSE) credit specifications.
• Single Family Home Rental are securitized loans that are collateralized by a borrower’s interest
in single family rental properties.

Commercial Real Estate securitized products include:

• CMBS are a type of mortgage-backed security that is collateralized by pools of real estate loans
secured by commercial properties that are not guaranteed by the U.S. government or any
government-sponsored enterprise.
• Single Asset Single Borrower (SASB) CMBS are backed by a single first mortgage on one
property or made to one borrower.
• CRE collateralized loan obligations are a type of CLO backed by commercial real estate loans,
often backed by properties in some form of transition.
• Agency CMBS are bonds collateralized by pools of commercial real estate loans secured by
properties that are issued or insured by a U.S. government-sponsored enterprise or federally
chartered corporation, such as Fannie Mae, Freddie Mac, or Ginnie Mae.

Asset Backed Securities (“ABS”)

At its inception in the mid-1980s, the non-mortgage ABS market first issued securitizations of automobile
loans and credit card receivables. Since then, the sector has rapidly evolved into a highly diversified $1.5
trillion market, running the gamut of collateral types.

An ABS can be constructed in one of two ways: 1) securitizing a pool of many assets or 2) securitizing
the cashflows or receivables from a single asset or whole enterprise. ABS collateral types can be grouped
into four subsectors: corporate loan backed (CLOs), consumer ABS (consumer receivables), commercial
ABS (commercial receivables), and whole business ABS (cashflows or receivables from a single
enterprise):

• Collateralized loan obligations (CLOs) are backed by below investment grade corporate bank
loans.
• Commercial ABS are constructed from pools of receivables, loans, or leases on assets, such as
shipping containers, data centers, aircraft, and other commercial equipment. Other non-mortgage
securitized assets include merchant credit card advances, oil and gas future production royalty
agreements, commission agreements, drill-ship charter agreements, property assessed clean energy

29
 loans, wireless tower leases, billboard leases, consumer wireless contracts, and wireless spectrum
agreements.
• Consumer ABS are backed by cash flows from consumer financial assets, such as student loans,
credit card receivables or auto loans.

Exhibit 25: Types of Structured Credit42

42 Source: Apollo & Guggenheim: The ABCs of Asset-Backed Securities 2022.

30
 Appendix B: Case Study Where IG Structured Credit Clearly Has Less Credit Risk than
Corporate Debt of the Same Rating

Comparison Between BBB rated debt issued by a Business Development Company and CLO

Business Development Companies (“BDCs”) are corporations registered with the SEC that invest in the
debt of other corporations according to specific rules. They may invest in first lien, unitranche (a more
levered first lien that effectively combines first lien and second lien into a single loan), second lien,
mezzanine, and junior debt of other corporations. The BDCs themselves then issue senior unsecured debt,
typically BBB rated. The market, rating agencies, and regulators consider the debt issued by BDCs to be
corporate debt rather than structured credit.

BDCs will often take their higher quality first lien or unitrache assets and sell them to a CLO in exchange
for some of the equity in the CLO structure itself. In this way, the BDC keeps the highest-risk tranche of
the CLO. The BDC’s unsecured debt is now backed by its remaining first liens, second liens, mezzanine,
junior debt, and CLO equity (the equity retained from the securitization).

In turn, the CLO itself might issue A or BBB rated structured credit that has a perfected security interest
in the first lien loan assets in a bankruptcy-remote SPV. Credit enhancement from the riskier CLO equity
held by the BDC means that the IG debt issued by the CLO has substantially lower credit risk than the
equivalently rated BBB debt issued by the BDC. However, rating agencies and insurance regulators still
apply the same capital charge when insurers invest in the BBB corporate debt issued by the BDC or the
BBB structured credit debt issued by the CLO. See Exhibit 29 below illustrating the underappreciated
credit enhancement securitization affords the CLO debt in this example.

Exhibit 26: Comparison Between BDC and CLO

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 Appendix C: Illustration of Multiplicative Benefits from Structured Credit

Consider a scenario where an investor holds one high yield loan and upon default 50% of the asset is
assumed to be recovered.

Instead of holding a single loan, an investor could hold 100 equally sized high yield loans. Assume each
loan has a 3% probability of default and upon default 50% of the assets are recovered. For purposes of
illustration, no correlation is assumed across the loans when calculating the “Probability of Event” below.
This assumption is simplistic for illustration for understates the probability of multiple defaults occurring.

Further, investment could be made in a securitization of 100 loans. Credit Enhancement provides loss
protection, with the greatest impact at senior, investment grade tranches. While not shown, structural
protections provide additional loss protection for investment grade tranches.

Combined, the benefits of securitization can transform high yield loans into investment grade lending
opportunities where the credit risk premium is replaced by illiquidity/complexity premium. As
demonstrated above, the benefits of securitization are multiplicative, whereby the loss given default drops
from 50% on a single loan to 8.3% for the BBB rated tranche at just over 30% of the portfolio defaulting
withing a securitization.

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