A look at 2019 NAIC designations
admin | January 4, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
More RMBS migrated into the highest rating category and expected losses fell in the National Association of Insurance Commissioners latest review of structured products. But the modest changes look unlikely to have a significant impact on RMBS supply or demand from insurers.
The population of NAIC 1 securities rebounded modestly in the latest NAIC review after a steep year-over-year decline last year, likely driven by modestly lower prices with little change to expected losses.
- NAIC 1 designations rose by 2.7% year-over-year, totaling 78% of all bonds submitted in 2018
- Year-over-year IDC prices on bonds submitted fell by a point on average from $91 to $90
- NAIC expected losses fell by 24 bp to 9.15% after adjusting the 2017 forecast to account for actual pay downs and losses realized in 2017
The NAIC scored roughly 14,800 bonds in 2018, down from 15,500 bonds the year prior. The share of bonds designated NAIC 1 rose to 78% from 75.3% the year before driven by both lower average dollar prices and a decline in expected losses. That marked a reversal from the prior year when NAIC 1 designations fell by more than ten points, driven by both higher prices and increased losses. (Exhibit 1)
Exhibit 1: Year over year NAIC designation changes by sector
Migrations were by and large positive across cohorts but were most pronounced in fixed-rate bonds. Fixed rate seniors and mezzanine bonds each saw NAIC 1 designations increase by 5% to 6%. These increases were partially driven by rising rates and lower dollar prices on longer duration fixed-rate collateral. Lower dollar prices were by and large coupled with more benign loss estimates. The increase in NAIC 1 bonds across seniors was mainly driven by lower dollar prices as average prices fell by roughly four points year-over-year. The rise in mezzanine cash flows was primarily fueled by lower loss estimates, which fell by an average of 4%. Migrations to NAIC 1 and 2 appear to have come from the NAIC 4 bucket as NAIC 1 and 2 designations increased 8.3% collectively while NAIC 4 designations fell by 9.3%.
NAIC 1 designations declined in two cohorts. Floating rate subs saw NAIC 1 designations fall by 3.8% year over year and floating rate mezzanine bonds fell by 50 bp. Floating rate subs saw both a material price change as well as an increase in expected losses with prices up 4.5 points and a 77 bp increase in expected losses. Floating rate mezz also saw an increase both prices and expected losses driving a modest migration into lower designations.
Exhibit 2: Year over year expected loss and price changes by sector
Expected losses fell by 24 bp year-over-year. Deriving the change in expected loss does not simply imply subtracting this year’s expected loss number from last year’s as that would disregard the impact of a year’s worth of actual payments and losses a bond had incurred. Accounting for this requires calculating the expected loss as a dollar amount on each bond based on last year’s projected value. For example, if a bond had a current face of $100 million and an expected loss of 10% in last year’s forecast, the calculation assigns a $10 million loss to the bond. Next the actual pay downs and losses incurred over the year are applied. For simplicity’s sake we assume that the same bond incurred no losses and had principal pay downs of $10 million. Based on those cash flows the expected loss would be $10 million on $90 million or an increase in the expected loss from 10% to 11.1%.
After cutting the universe by credit, the largest increase in NAIC 1 designations were in prime and Alt-A seasoned and fixed rate seniors whose NAIC 1 concentrations increased by 7.2% and 6.7% respectively. Option ARM seniors were the only cohort that actually saw a decline in NAIC 1 designations despite a 1.5% decrease in expected losses and roughly flat prices. Expected loss projections also declined modestly across both seasoned and later vintage subprime seniors as well as floating rate prime and Alt-A seniors. (Exhibit 3)
Exhibit 3: Year over year expected loss and price changes by credit
Given the fairly modest changes, this year’s designations should not have a material effect on either supply or demand. Demand for fixed-rate bonds or the lack thereof will likely be driven by the future path of interest rates. Higher rates and lower dollar prices will likely meet with increased demand while lower rates and higher dollar prices should be commensurate with less support for those bonds from insurance buyers.