While US insurance companies have been investing in private credit since 2009, S&P is sounding the alarm about the risks of this asset class, which has experienced rapid growth aided by falling interest rates. However, it is not just the dynamics of interest rates that attract insurers, but rather the liquidity premium that these assets guarantee, which is considered attractive even when it amounts to only ten basis points. This premium is, however, very difficult to quantify.
The private credit market took off after the 2008 financial crisis, when stricter regulations forced banks to tighten their lending criteria. It is therefore not surprising that it now provides trillions of dollars in loans to companies. The US insurance sector, which has more than $8 trillion in invested assets and manages the retirement savings of millions of people, is one of the largest investors in this asset class.
But how is private debt investment structured? S&P estimates that $530 billion, or about 23% of corporate bonds held by life insurance companies, were issued through private placements rather than public offerings. Of these, approximately $218 billion had a “private letter” credit rating, i.e., confidential scores accessible only to the issuer and certain investors, and $71 billion was placed through structured financial bonds with private ratings. These are the famous Collateralized Loan Obligations (CLOs).
Let’s take a moment to understand what they are. They are essentially structured securities that group together a pool of corporate loans with ratings below investment grade that can be placed and sold in tranches. These investments offer investors the opportunity to earn above-average returns by assuming the risk of default and illiquidity. CLOs are similar in structure to collateralized debt obligations (CDOs), but differ mainly in that they are backed by corporate loans rather than mortgages. Each tranche within a CLO has distinct risk/return characteristics, with equity tranches offering higher potential returns at higher risk levels and obviously having the highest seniority or lowest repayment priority. This complex financial instrument therefore allows investors to diversify their portfolios and potentially mitigate market volatility by investing in different tranches based on their risk appetite. In particular, they help insurers reduce the capital they would need if they held loans to medium-sized companies and other products directly.
But let’s get to the point that really interests us. In a previous Insight, we argued that the trigger for the bursting of a speculative bubble is almost always “bad” debt, which generates insolvencies that accumulate like an avalanche. This happened with mortgages in 2008, and the current situation is all too reminiscent of that, almost like déjà vu! Here, the “black sheep” is not mortgages, but private equity loans, a sector characterized by total opacity.
It is precisely the fear of an imminent bursting of one or more bubbles that makes us lean towards investing in gold. We already said last week that the rise in the price of gold in recent months is partly due to retail euphoria. This is also confirmed by an article in the FT on October 14, which tells us about a real gold rush in Japan and retail sales by the British mint at unprecedented volumes. Even the Britannia coin, made from one ounce of silver, has completely sold out: this means that those who cannot afford gold are investing in something “within their means” so as not to be left out of this race.
However, the reasons behind this euphoria are always the same: uncertainty about the future structure of the Fed, fears about US debt, and the resurgence of inflation. After all, inflation is notoriously an effective tool that a government can use to reduce debt. We are not disputing these reasons, but we would simply like to suggest another rationale for investing in gold and/or precious metals in general: the likelihood that a vicious spiral of insolvencies will start in the US, which in turn will drag the insurance sector into crisis. This sector is as delicate as the banking sector and is capable of destabilizing the system as much as, if not more than, the US investment banks did in 2008: “too big to fail,” it would be useful to remember.
There are already signs of this: credit markets have been shaken by the collapse of First Brands Group and Tricolor Holdings. Apollo Global Management CEO Marc Rowan said the collapse of the two businesses follows years in which lenders had turned to riskier borrowers. JPMorgan Chase announced solid earnings, marred by Tricolor’s collapse, which caused a loss of $170 million, and its CEO, Jamie Dimon, said, “My antenna goes up when things like this happen. I probably shouldn’t say this, but when you see one cockroach, there are probably more.”
Here, too, there is a disturbing resemblance to the two Bear Stearns funds (it was a bank, like Lehman Brothers) stuffed with subprime mortgages worth a cumulative total of about $3 billion, both of which failed in March 2007.
We hope that these are just reminiscences, but in our opinion, this investment sector needs to be monitored closely.
Disclaimer
This post expresses the personal opinion of the Custodia Wealth Management staff who wrote it. It is not investment advice or personalized advice and should not be considered an invitation to carry out transactions on financial instruments.
