Month: April 2024

The CLO Investor Podcast, Episode 2

Shiloh:

Hi, I’m Shiloh Bates, and welcome to the CLO Investor podcast. CLO stands for Collateralized Loan Obligations, which are securities backed by pools of leveraged loans. In this podcast, we discuss current news in the CLO industry and I interview key market players. Today I’ll be joined by my colleague at Flat Rock, Derek Russo. Some of the topics for today’s podcast include what we enjoy the most about our niche CLO market, CLO issuance, re-fis/resets, loan recoveries and CLO equity returns. Now let’s get started. Derek, welcome to the podcast.

Derek:

Thanks for having me.

Shiloh:

Why don’t you take a few minutes and go through your background for our listeners?

Derek:

Sure. Had a pretty interesting start to my career. I came into the finance industry the summer of 2008, joined UBS there and floated around at the firm for the first 18 months or so, while the great financial crisis was playing out, ultimately ended up finding my way onto the high yield bond desk covering the gaming, lodging and leisure sector. I did that for a couple of years and then moved to a Business Development Corporation of America, where I was working with you, Shiloh, and our founder here at Flat Rock Bob Grunewald, doing leveraged loan underwriting. So for direct originated private credit transactions, I also spent some time at that shop doing aviation finance. So we built a bit of an internal portfolio of aircraft equity and ABS securities. From the BDC, moved into the operating role in the aviation finance side directly, and worked with that aviation team for a number of years before thinking back up with you and Bob here at Flat Rock. And now I’m doing CLOs.

Shiloh:

And so is it about two years that you’ve been solely focused on CLOs?

Derek:

So I think it was right around the beginning of 2022 that we joined back up. Yeah. And it’s been great.

Shiloh:

It’s great to have you. What do you find most interesting about the CLO space?

Derek:

I kind of gained my first exposure to structured finance products through the aircraft ABS sector, and it really turned out, you know, in the aircraft ABS, the underlying assets. So first off, they’re diversified but still exposed obviously to the commercial aviation sector. And as we saw with Covid, right, having exposure to one specific sector can really be a problem when that sector experiences a black swan event like a global pandemic. And I think one of the most interesting things looking at CLOs for me was just the broad diversity of the underlying collateral in the asset base and what that means in terms of resilience for the product. So we’ve seen CLOs perform very well through numerous economic cycles, and I think a lot of that has to do with the fact that you’re getting exposure to basically a broad swath of the US economy via the types of underlying loans in the CLOs. Another really interesting thing is just really how inefficient the market is was very surprising to me when I stepped in, and I think it’s still a pretty opaque market where you can generate a lot of alpha by having good connections and knowledge in the sector.

Shiloh:

I agree with that. I mean, each CLO equity tranche might be 50 million in size. And it’d be very surprising to a lot of people to know that even in the primary market where CLOs are created, a lot of times people are actually buying that security at different prices. And then in the secondary market, things do kind of trade all over the place. So I think if you’re a sophisticated investor in this space, you should be able to outperform peers

Derek:

What do you find most interesting about the CLO space?

Shiloh:

Well, I think the CLO self-healing mechanism is one of the most interesting things about the asset class and, as you know, how that works is that the loans in a CLO are constantly prepaying at par. And during the CLO reinvestment period those par proceeds are used to buy more loans.  And if you find yourself in economic conditions where defaults on the loans are picking up for you, that’s, you know, negative as a CLO investor. In recessionary times, leveraged loans should trade down in price. And that gives the CLO manager the opportunity to buy discounted loans.

And so from the perspective of a CLO equity investor, it’s not just loan losses that you care about. It’s really net loan losses. And the CLO should be able to book some gains on loans bought at discounted levels. 

If you look at any CLO fund’s marketing deck, I’m sure they’ll have the famous 2007 vintage CLO in it. And 2007 was a long time ago, but that’s a vintage where if you would have bought CLO equity right before the GFC, what you would have experienced is a default rate on loans significantly higher than you would have ever expected when you bought the CLO equity, and, like other asset classes, it would have traded down dramatically in price during the GFC.

But again, as the loans in the CLO prepaid, new loans were bought often at substantial discounts during the GFC, and that resulted in IRR in the high 20s for CLOs that started their lives right before the financial crisis.

For me, that highlights the resilience of the asset class and a favorable outcome for that vintage of CLOs. 

Derek, isssuance is off to a tear this year, both for new issue and for refinancings or resets, which are, as you know, an extension of the life of the CLO. What do you think’s driving that?

Derek:

When I joined flat Rock at the start of 2022, we were coming off of a year of very strong issuance in 2021 for CLOs and very quickly entered into sort of this post Ukraine environment, where liabilities for CLOs blew out dramatically and it became much more challenging to issue CLOs economically. There were, though, a lot of investors that were still in warehouses that had been opened prior to the invasion of Ukraine, as well as a number of managers had raised captive equity funds prior to the invasion, and a combination of those that were sort of stuck in these warehouses and managers that had access to equity capital continued to drive the new issuance market. The issuance was down in 2022 and 2023, but they were still respectable years in terms of new issuance. What we really did see largely evaporate was deals that were seeded by new third party equity. The arbitrage just really stopped making sense when liabilities widened out. And there were a few deals that we call print-and-sprint deals, where equity investors were trying to capture a dislocation in the loan market and, you know, sort of play for price appreciation and the underlying loans. But by and large, third party equity kind of fell away from the space. And really that continued almost until I guess the start of the start of this year and sort of now we’re seeing liabilities kind of tighten up to the point where it’s starting to make sense again for third party equity investors.

The other part of the market that really shut off during the last couple of years was the refi and reset market. So with liabilities so wide deals that had printed prior to 2022 with attractive cap stacks just really didn’t have the incentive to refinance into a much wider market. So now with again, with liabilities starting to tighten up, we’re seeing a lot more of this refi and reset activity coming back to the market. We’ve also seen some interesting transactions recently with the top of the cap stack. So rather than resetting the entire transaction, maybe the equity will have the triple-A get repriced. And when short dated, it gets very good execution at the top of the stack. So we’re seeing some pretty tight Triple-A prices.

Shiloh:

So let me expand on one of the key drivers for good CLO debt execution.

At the top part of the capital stack, which are securities rated AAA to single A. Those are usually bought by banks and insurance companies around the world.  And in 2022, a lot of the banking regulators said to the banks, instead of buying new CLOs, why don’t you keep the cash on hand for a rainy day and we’ll see how economic conditions play out. And so now, economic conditions have improved and the probability of a recession has receded in a lot of people’s minds. And the result is that banks have really strong demand for Triple-A. And for CLOs, that’s the most important funding cost for the market.

Lower Triple-A rate means higher equity distributions over time. And the market is really moving fast. And so a lot of deals are becoming refi/reset candidates. Even for the 2021 vintage of CLOs, which got great debt execution, even some of those deals are beginning to look like refinancing candidates, given where spreads have gone.

So I think the setup for CLO equity at the beginning of this year is really pretty favorable.

Derek, you’re the keeper of the famous Flat Rock CLO Equity Index. Could you talk a little bit about how that’s put together?

Derek:

One of the things that we’re often asked is to sort of compare the asset class to a benchmark. There was no benchmark before we created the CLO Equity Index that really measured directly how CLO equity has performed over time. And it’s a really hard thing to pin down. Right? Because this is, as I mentioned before, an opaque asset class that really there you don’t get a lot of trading color out of the market. But what fortunately, we are able to see is where some of our competitors and ourselves that file publicly have to release, where they have their CLO equity positions marked on a quarterly basis, and we can use that, plus our knowledge of what payments have come in during the quarter and the size of the equity tranche to triangulate how those positions have moved over time. And what we do is we look through to five different owners of CLO equity that file publicly, and we look at how those transactions have moved. And on a quarterly basis, we roll all of that up into an analysis that results in a proxy for the CLO equity index as a whole. We mark something close to 500 separate line items in the index right now. And unfortunately, we have to work on a quarterly lag because we’re waiting for filings to be published. But that’s roughly how the index is formulated.

Shiloh:

And when does the index start?

Derek:

The Index: We looked back as far as we could get reliable data. It starts in 2014 and has quarterly numbers through, I guess most recently, the end of 2023.

Shiloh:

Have CLO Equity investors made any money?

Derek:

Yeah so it’s an interesting question. I think the index, just by nature of starting in 2014, has a little bit of a handicap in the sense that we missed out on some strong years coming out of the GFC that just unfortunately aren’t in the data set. But if we look back to the starting point, annualized returns since inception of the index are 7%, five year returns are 9%, three year returns are 11.9, and last year the index did 22.1%.

Shiloh:

Okay, so last year’s return was very good. What would you attribute that to?

Derek:

The year before 2022 when we saw rate increases throughout the year, CLO equity actually performed fairly poorly as an index. The index was down 11.6%. That was driven by degradation in the underlying loans. So the Morningstar Loan Index was down significantly during the year, trough somewhere in the 92 area. And in 2023, we saw that basically rally back, particularly in the back half of the year. So that 22% really was the back half of the year story, and that largely driven by the idea that we may be entering into a soft landing and sort of less fear over an imminent default spike. I think that those were some of the big factors.

Shiloh:

I think the other thing happening for the negative returns for 2022 was just that the required rate of return for CLO equity increased. Prior to that year, we were targeting CLO equity returns of mid-teens. And then as spreads widened really across all asset classes that year, the required rate of return for that equity was more like very high teens. As a result, the fair market values of CLOs across the board was written down.

The big picture, though, is that I think CLO equity came into last year priced for a pretty substantial downturn in the economy, and that just wasn’t realized. And with CLOs paying high teen distributions and, you know, not seeing a big uptick in loan losses made for a really good year.

And as we’re in talking today in the end of March, is the trend continuing into Q1?

Derek:

Uh, definitely. So I think there’s less room to the upside given that the loan index has traded up significantly. But what we’re seeing now are this wave of, uh, refis and resets that we talked about before that I think could be very material to equity returns going forward. And I think, you know, !Q numbers at least should look very strong as we’re approaching the end of the quarter here. And I don’t see anything kind of slowing the trend down.

Shiloh:

Well, I also see the trend continuing. I was on a panel recently where someone asked if private credit was a bubble, My answer to that is of course no. And one of the biggest reasons I point to is that the loans that go into CLOs start their lives with a 40% to 50% loan to value. And so, you know, occasionally the loans do default. But at the end of the day, there’s a lot of junior capital supporting these businesses. And so as long as the wheels don’t fall off the cart, the loans really should be money good at the end of the day.

The CLO’s loans need to pass tests that come from the rating agencies, you know, for weighted average rating and maximum CCC loan exposure. And so, the rating agencies certainly haven’t relaxed their rating standards for the loan. So I feel pretty good about the credit quality of what’s going in.

I’d also point out that our asset class is different from others and that it’s not a zero loss expectation that we have. By that I mean, if there’s 200 different loans in a CLO, and I’ve never met a CLO manager that goes 200 for 200. Right? So there’s always going to be some cats and dogs that default. Fortunately, the loans are first lien and senior secured, and usually the recoveries are high. We’re generally budgeting for a 2% loan default rate. I think that is the market standard, actually. And that’s really different from other asset classes. If you invest in a loan fund directly, when a loan defaults, there is no loan loss reserve. If you invest in a BDC and a loan defaults, there’ll be a decline in the share price. But again there’s no loan loss reserve. So I think that’s something unique and attractive about the asset class.

Derek:

Yeah, same. And then I’m going into this rally that we saw there was sort of the expectation on the street of significantly higher than average levels of defaults. I think those expectations are starting to be moderated down. And the other big topic that people are, you know, discussing in the market right now is where recovery rates will ultimately end up being. So historically, the types of loans that are in CLOs have recovered 65 to $0.70 on the dollar. Last year we saw that materially inside. So something more in the 40s to $0.50. Shiloh where do you see that sort of going over the next few years here?

Shiloh:

Yeah. So I think that’s certainly been a headwind for CLO equity. There have been some defaults with very low recoveries in some cases. That was because the loan documentation was written in a way that gave the lender less options in downside scenarios, and not all the business’ collateral was available to back the term loan. 

But one of the things that I think is important to know is that if you see a headline number for defaults or a headline number for recoveries on Bloomberg or in the Wall Street Journal or wherever, it’s important to know that that’s usually for the overall loan index. CLOs own a very conservative slice of that index. Some of the recoveries that came in very low were for companies that it really wouldn’t have never been in CLOs in the first place. Some of them were called chapter 22 where the business already did one chapter 11, and it’s coming back for another one. And so those are the kind of assets that would be targeted by a CLO manager.

So whenever I see a headline with the default rate or recovery rate that looks negative, My next question is “what’s happening just in CLOs?” And then obviously much more important to me is “what’s happening in my CLOs?”.

One of the reasons that we favored middle market CLOs over the past few years is that in the middle market, the loan documentation is more favorable to the lender. And as a result, I would expect loan losses in middle market clos to outperform broadly syndicated CLO portfolios.

And so this year, again, we talked about refis and resets. But I think even in a market where there is an uptick in loan losses, I think some very attractive things can happen with the CLO liabilities.

Derek:

Yeah. And another thing is we assume sort of the average, or if you look back at the average loan loss rates over the life of the leveraged loan, and leveraged loan market, it’s not a straight line. Right? So what we’ve seen happen is when there are periods of higher than normal defaults, that’s often followed by long periods of lower than normal defaults, which is the environment that we were in pre Ukraine. So I think it tends to even itself out over time.

Shiloh:

Right. So the industry standard modeling assumption is a 2% loan default rate per year. And so obviously some years it’s going to be higher than 2%. And, in recent past, it’s been much lower than the 2%. So let me tell you a story that highlights how the loan loss reserve works in practice. During the Covid period, we were calling around to our CLO managers trying to get an update on the loan portfolios and one of the managers that we work with a lot, Blackrock, we had them on the phone. The manager was giving me a very favorable update on the loan portfolio, actually more favorable than I really would have expected during the depths of Covid. So what I wanted to do is take it from a qualitative description of the loans to something more quantitative. So I said to them, we run a 2% loan default rate through all of our modeling and profitability assumptions. How would you expect your portfolio to compare to that this year? (This year being 2020.) There was a really long pause. I didn’t really know what how they were going to respond. But the answer was, “you know, Shiloh, after all these years of us working together, I cannot believe that you’re still running my deals with a 2% loan default rate.” And so that was a very funny experience from the 2020 year. And their CLOs were a highlight in terms of CLO performance.

Derek, let’s spend a minute talking about the arbitrage and CLOs. So that’s the natural profitability, or expected profitability, the CLO equity investor is signing up for over the last two years. I mean we have seen a fair amount of CLO issuance. But the equity investors have not been traditional third parties like us. Could you talk about that?

Derek:

Yeah. So a couple of things driving that I think. So some people found themselves stuck in warehouse facilities where they had ramped a portfolio of assets prior to the CLO liability market widening out. And after a certain period of time, they just had to sort of bite the bullet and print a deal that maybe didn’t look quite as attractive as they expected it to look initially. And another thing that we’ve seen is sort of a proliferation of CLO managers raising captive equity funds where they actually have a fund themselves that they can use to seed the equity in their deals. The managers are in the business of printing deals and managing assets. So what we’ve seen is some transactions that got done where the equity returns may not have been attractive enough to attract third party equity, and historically that might have meant that the deal didn’t get done. Since these managers have these captive funds now, though, they were able to continue printing deals in a market that was less attractive for third party investors. One contrasting point I’ll make though is for middle market CLOs. The arbitrage actually continued to make sense through the cycle, at least for select deals, and we found that just the wider spreads on the assets in those structures were able to overcome the higher liability costs. We saw some transactions that we found attractive even through the last couple of years through this wider liability cycle. The arbitrage actually continued to make sense through the cycle, at least for select deals. We found that it’s just the wider spreads on the assets in those structures were able to overcome the higher liability costs. And we saw some transactions that we found attractive even during the last couple of years through this wider liability cycle. And now in the broadly syndicated space, the market is really starting to come back a bit as well. With debt costs coming down, we’re starting to see broadly syndicated CLO equity come back on sides.

Shiloh:

Could you spend a few minutes talking about you know the process for underwriting, I don’t know, CLO Equity and double-Bs, and if it’s different for the different type of security.

Derek:

For CLO Equity, we’re really focused on just the top-tier managers. We’re really focused on outperformance on defaults as the key driver of CLO returns. When we look at double-Bs, it’s a little bit different.

We have significant equity subordination below us absorbing the first loss. And as a result of that, we may be happy with managers that have historically performed at that average 2% default rate. And to the extent that we’re able to pick up a little bit of excess spread for going to a tier two manager, that may be something we would consider when we’re looking at a double B, we probably wouldn’t do equity in that same transaction, and that’s just one of the sort of differences in how we focus on equity versus double B.

Shiloh:

So for the typical double B, how bad would defaults have to get on the CLOs loans such that you’re not money good at the end of the day?

Derek:

So I’ll throw a little bit of a distinction here between broadly syndicated CLOs. So CLOs backed by large syndicated deals, you know, $1 billion-plus  in size versus middle market CLOs where the loan pool there looks more like a private credit loan pool. The reason for the distinction is in the broadly syndicated CLO markets, you know, 90% of the current outstanding CLO market, the CLO starts its life with 8% equity below the double B, whereas in the middle market CLO, the double B will have 12% equity below it. And those yield two fairly different results. Generally speaking, a typical broadly syndicated CLO will start its life and be able to survive 7% annual defaults, and a middle market CLO will start its life with the double B being able to survive 15% annual defaults. And when I say survive here, what I’m really talking about is receive all of its expected interest in principal. It’s not a zero IRR thing. It’s really at those levels of defaults you’re getting full payments.

Shiloh:

Well how do the default rates that you just mentioned, how do those compare to what we experienced during the GFC and during the Covid period?

Derek:

During the GFC, we saw the highest level of defaults that we’ve seen in the leveraged loan market. It spiked to about 8% and stayed around that level for about a year. Uh, well they quickly kind of fell off of that and then normalized even below that 2% level. During Covid, we saw a spike up to around 5% and again, a very quick drop down. So we’ve never seen an economic environment that looks anything even remotely like even a 7% annual default rate sustained over a long period of time. And that might beg the question, so how these Double B’s performed. And the answer is we’ve seen very, very low default rates in the sector. So if you include the entire universe of Double B’s, both broadly syndicated and middle market, uh, the annual default rate has been about 22 basis points per year. And if you look just at the middle market, so the CLOs that have more equity subordination, we actually haven’t found any of those that have defaulted.

Shiloh:

One last question for you. What are the interesting opportunities in the spring of 2024?

Derek:

We here at Flat Rock have had a middle market bias, or I would say since the founding of the firm, and we continue to find the middle market sector on both the equity and double-B side, maybe even increasingly attractive going forward. So we talked a little bit about recovery rates before. Sort of the House view is that middle market collateral will outperform broadly syndicated collateral in the future as a result of stronger documentation. And the arbitrage for middle market CLO equity has remained strong. We’ve seen continued sort of high teens returns coming out of out of that asset class. Middle market double Bs have tightened significantly since their wides sort of at the beginning of last year. And you’re still picking up a significant premium over broadly syndicated double B notes there. And with base rates, you know, still over 5%, those have offered attractive returns and we think continue to offer attractive returns.

Shiloh:

Great. Well, thanks so much for being on the podcast, Derek. We’ll talk to you soon.

Derek:

The content here is for informational purposes only and should not be taken as legal, business, tax or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investors or potential investors in any Flat Rock Global Fund.

Definitions 

The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. 

Chapter 11 is the process by which companies are reorganized under bankruptcy law.

Leveraged Loans are corporate loans to companies that are not rated investment grade.

Broadly syndicated loans are underwritten by banks, rated by national recognized statistical ratings organizations, and often traded by market participants.

Middle Market Loans are usually underwritten by several lenders with the intention of holding the investment through its maturity.

A collateralized debt obligation is a structured finance product that is backed by a pool of assets other than leveraged loans.

Securitization divides cash flows amongst different investors in a pool of assets.

Global Financial Crisis or GFC refers to the banking downturn in 2008 and 2009.

Asset backed securities are securitizations usually backed by non first lien loan collateral.

Junior capital is financing that has a lower priority claim in debt repayment to a secured term loan.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus treasury bonds or another benchmark bond measure.

Yield is income returned on investment such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment’s cost, current market value, or face value.

The Flat Rock Global CLO equity index, and its legal disclaimers are available on the Flat Rock Global website.

General Disclaimer

References to interest rate moves are based on Bloomberg data. The credit quality of fixed-income securities and a portfolio is assigned by a nationally recognized statistical rating organization (such as Standard and Poor’s, Moody’s, or Fitch) as an indication of an issuer’s creditworthiness. Ratings range from triple A (highest) to D (lowest). Bonds rated triple B or above are considered investment grade. Credit ratings double B and below are lower-rated securities also known as junk bonds.

Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of, or potential or actual portfolio changes related to, securities of those companies.

Unless otherwise noted, all discussions are based on U.S. markets and US monetary and fiscal policies.

Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Flat Rock Global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation, offer, or solicitation to buy or sell any securities, or to adopt any investment strategy. Neither Flat Rock Global, nor the Flat Rock Global speaker, can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in, or refrain from, any investment-related course of action as neither Flat Rock Global, nor its affiliates, are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. This broadcast is copyright 2024 of Flat Rock Global LLC (all rights reserved). This recording may not be reproduced, in whole or in part, or in any form, without the permission of Flat Rock Global. Additional information about this podcast along with an edited transcript may be obtained by visiting FlatRockGlobal.com

The CLO Investor Podcast, Episode 1

Hi, I’m Shiloh Bates and welcome to the CLO investor podcast. CLO stands for Collateralized Loan Obligations, which are securities backed by pools of leveraged loans. During this podcast series I’ll cover a CLO 101, relevant topics in the CLO industry and interview key market players. I’ll put a heavy emphasis on CLO equity and BB rated securities as those are the securities I find most interesting.

By way of background, I’m the Chief Investment Officer of Flat Rock Global. I’ve spent two decades in the CLO market, working for CLO managers, and investing in CLO securities. And in 2023 I wrote a book on CLO investing. As CLOs are gaining in popularity, I believe investment professionals of all varieties will benefit from understanding this unique market.

Now, let’s get started.

Our first episode is CLO 101. But first off, let’s discuss why the CLO market is important today.

When I started my career, there were around $6 billion in CLO assets under management and a handful of CLO managers. Today there are over one trillion in CLO assets under management and over one hundred different CLO managers.

CLOs, in my opinion, can offer attractive risk adjusted returns for numerous investors with different risk and return profiles. CLOs issue securities rated AAA and sell them to banks and insurance companies, while investors who can handle more risk and might be targeting double-digit returns invest in CLO BB Notes and CLO Equity.

CLO securities are floating rate so there is almost no interest rate duration. The income from CLO securities varies based on the Secured Overnight Funding Rate or SOFR, which is tied closely to the Fed Funds rate. In recent years CLO investors have benefitted from Federal Reserve Interest Rate increases.

I don’t think any MBA programs offer courses in CLOs, but I think they should. The CLO market sits at the intersection of leveraged buyouts, high yield bonds, leveraged loans, credit analysis and securitization.

I like to say that CLOs are a little complicated but in a fun way. And I believe investors who take the time to understand them can be rewarded.

Lots of people enjoyed the movie, The Big Short, and I’ve read the book a few times. In fact, Michael Lewis is one of my favorite authors. But that movie is about CDOs not CLOs. The nomenclature is similar, but the results for investors were not. Both CLOs and CDOs use securitization, which takes a pool of assets and repackages them into other securities. Securitization is a powerful tool, but the quality of the underlying assets is key. CLOs own highly diversified pools of senior secured loans to large US businesses. CDOs from the financial crisis often owned portfolios of subprime mortgages of dubious credit quality. CDOs, as a result, saw defaults on securities rated initially AAA. For CLO equity, which takes the most economic risk, those securities ended with realized IRRs in the high 20% area. If they make a movie about CLOs, I believe it would have a happy ending.

In 2003, there were $16BN of new CLOs created. Twenty years later, in 2023 there were $116BN. During the 2008-2009 Global Financial Crisis CLO, issuance dried up. Excluding this time period, CLO issuance has been on a two decade upswing. The two primary drivers, in my opinion, are investors seeking exposure to actively managed portfolios of first lien loans combined with the performance of CLO securities over extended periods of time.

Let’s get into the CLO structure. The easiest way to think about a CLO is that it’s a simplified bank in one business line, commercial lending. The typical CLO has approximately $500M of assets. The assets are first lien loans that float based on SOFR. The loans are generally secured by all the assets of the company, both physical and intangible. Assets pledged to the lender would usually include cash, accounts receivable, inventory, physical plant, real estate, and any other assets. If a loan were to go bankrupt, the first lien lenders are the first in line for any recovery. These loans are created in leveraged buyouts. Imagine that a private equity firm is buying a company. They might put up half the purchase price in equity. The remainder could be a first lien term loan. The private equity firm wants to lever its investment, because it believes the businesses its acquiring will grow revenue and cash flow over time. In a typical CLO there might be 200 plus of these types of loans. In fact, a requirement to form a CLO is a highly diversified loan portfolio.

The loans in a CLO are actively managed and there are over 100 CLO management firms in the market. Realistically, we have more CLO managers than we could possibly need. The largest publicly traded alternative asset managers all have large CLO management teams. They earn 40 to 50 basis points annually to pick the initial loans that go into the CLO and keep the CLO fully invested during its reinvestment period. The CLO manager’s job is also to keep the CLO passing its many tests.

Many of the leveraged loans that can be found in CLOs were issued by businesses that may be familiar to you. Asurion, for example, is the company that does insurance contracts for Apple and Samsung phones. Cablevision, Virgin Media, and McAfee are a few more familiar names. My gym in New York, Equinox, has a term loan owned by many CLOs and they have great yoga classes too. While these are large companies, you aren’t going to find many of these companies in the S&P 500. Companies like Apple and Google are rated investment grade and borrow at rates too low to be included in a CLO. The borrowers in CLOs are ”speculative grade” with an average rating of single B or B2 from Standard and Poor’s or Moody’s. Fortunately, these loans default rarely, and when they do default, recoveries are usually high. The attraction of lending to speculative grade companies is they pay attractive interest rates to the lender, in this case the CLO. It’s important to note that the pool of loans in a CLO is not random; the borrowers in a CLO are, for the most part, owned by sophisticated private equity firms that did lots of due diligence on the borrower before acquiring it. And the credit quality of the loan is acceptable to the CLO’s manager.

Earlier I mentioned that a CLO might have $500 million of assets. To finance itself, a number of securities will be issued including ones rated AAA, AA, A, BBB, BB and Equity. Of the seven securities, three will be the most important for this podcast. The AAA is critical because it makes up 65% of the CLO’s financing and provides the CLO’s most favorable funding cost. The CLO BB is usually the junior most CLO debt tranche and therefore offers the highest projected CLO debt security return. The CLO equity receives the quarterly profitability of the CLO but takes the first loss risk on any of the CLO loans. CLO equity investors target mid to high teen returns net of expected loan defaults. Similar to my bank analogy, CLO equity returns are generated because the CLO’s assets earn a higher interest rate than the CLO’s financing cost. The result is distributions to the CLO equity are made quarterly.

The beginning of the CLO is often a CLO warehouse, which is used to acquire loans prior to the formation of the CLO. When the CLO begins its life, all of the CLO debt securities that were issued start accruing their interest expense. From the CLO equity investor’s perspective, it’s best to start a CLO with minimum cash, which would be a drag on returns. Once a majority of the CLO’s loans have been purchased in a warehouse, the CLO’s arranger, which are some of the largest US investment banks, find buyers for the CLO’s securities. An indenture is negotiated that details the rules the CLO will follow. The CLO’s reinvestment period usually runs five years. During that time, loans are frequently repaying at par, and the CLO manager is buying new loans with the proceeds. After the reinvestment period ends, when loans repay at par, new loans are not purchased. The cash proceeds are used to repay the AAA CLO debt until it is fully retired. Then proceeds will go to the AA, etc. As the CLO’s highest rated debt repays, so goes the CLO’s lowest cost of capital. From the CLO equity investor’s perspective, as the CLO delevers, the profitability of the CLO is reduced. At some point the CLO’s equity investors will decide the CLO should be called. Calling a CLO means selling all the CLO’s loans and repaying the CLO’s debt securities. After that the remining proceeds are distributed to the CLO equity.

The debt the CLO issues usually has a two-year non-call period on it. That means the rate on the AAA for example cannot be changed. However, after the non-call period, the CLO equity may attempt to refinance the CLO’s debt at lower costs and or extend the reinvestment period of the CLO, this is called a reset. Both of these transactions can be accretive for the CLO equity investor. I’ll do a future podcast on this subject as refinancings, and resets are prevalent in the market today.

A key concept in CLO investing is the value of the self-healing mechanism. In periods of economic stress, defaults on loans pick up. This is negative for CLO equity investors and the other debt investors in the CLO. However, the CLO’s assets, its leveraged loans, are constantly repaying at par. And during the CLO’s reinvestment period, those par proceeds are used to buy new loans. If defaults on the CLO’s loans are picking up, it’s likely that many leveraged loans will be trading at discounts to par value. Purchasing these discounted loans, if they end up paying off at par, provide loan gains that can be a valuable offset to any uptick in loan losses. This is the CLO self-healing mechanism, and it’s powerful.

Why would someone invest in CLO Equity? It provides exposures to actively managed pools of senior secured loans, but with attractive long-term financing attached. CLO equity pays high current income, today in the mid-to-high-teens area.¹

Many Investors get exposure to leveraged loans using loan funds or BDCs. In these structures investors take a loss whenever a loan defaults. Usually, I think this is a good risk to take. However, investors in CLOs generally budget for a loan loss reserve using a 2% default rate. If the default rate ends up below this number, it’s likely the CLO equity can outperform the buyer’s base case returns projections. CLO equity projected returns are quoted net of loan losses.

CLO equity has low correlation to other asset classes like high yield bonds or the S&P 500. That means investors can potentially increase overall returns and lower the overall risk of client’s portfolios by including CLO equity. Finally, one of the reasons I’ve gravitated to CLO equity as an asset class is that it’s an inefficient market, and an experienced investor can outperform peers.

For CLOs issued between 2002 and 2019, the average CLO equity tranche returned 21% – not too shabby. ²

CLO BBs, on the other hand, which take less risk, returned 9.5% since 2012, which isn’t bad considering how low interest rates were during much of the time period.³ Again, CLO BBs and most of the other CLO’s financing is floating rate.

Now why would someone buy a CLO AAA? Well, none have ever defaulted, so that’s nice. Banks and insurance companies buy them to make a return on a security that requires little regulatory capital, given its high rating. CLO AAAs are, of course, floating rate, and the performance was in sharp contrast to the investment grade bonds that traded down substantially when interest rates increased 2022. I’ve actually never bought a AAA rated CLO Note and probably never will. BBB is the most senior note I’ve owned. The reason is that the CLO’s junior-most tranche, the BB Note, default rarely but pay much higher returns that the AAA. The 30-year default rate on CLO BBs is around 20bps per year, so defaults on these securities are exceedingly rare.⁴

Many financial firms have gotten into trouble because their assets are of longer duration than their liabilities. The banking crisis of the spring 2023 is one prescient example. If the assets are illiquid and the financing market isn’t open when liabilities come due, it can be a big problem. CLOs are structured with financing longer than the expected life of all the CLO’s leveraged loans. There should never be a time when a CLO is a forced seller of assets in a depressed market.

CLOs have historically been an asset only available to large institutional investors. Given what I believe are the attractive risk/return characteristics of CLOs and CLO equity and BB Notes in particular, I believe retail investors will increasingly want access to the asset class. And recent years have seen the launch of CLO focused closed-end funds, interval funds and exchange-traded funds or ETFs. The key question for investors is what CLO security best fits their targeted return and risk profile.

So, that is your CLO 101 in a nutshell. Throughout the podcast series I’m going to delve deep into the concepts I discussed here. And in the interim, there are also numerous educational resources that can be found on the Flat Rock Global website. Until next time, thanks for listening.

The content here is for informational purposes only and should not be taken as legal, business, tax or investment advice or be used to evaluate any investment or security. This podcast is not directed at any investors or potential investors in any Flat Rock Global Fund.

Definitions Section:

The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. 

Leveraged Buyout is the acquisition of a company using debt as an important funding source.

High Yield Bonds are debt investments, usually unsecured and fixed rate, that are rated below investment grade.

Leveraged Loans are corporate loans to companies that are not rated investment grade.

Collateralized Debt Obligation – A collateralized debt obligation is a structured finance product that is backed by a pool of assets other than leveraged loans.

Credit Analysis is the process of evaluating the creditworthiness of a borrower.

Securitization divides cash flows amongst different investors in a pool of assets.

Delever is the process by which an asset becomes financed more with equity and less with debt.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus treasury bonds or another benchmark bond measure.

Yield is income returned on investment such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment’s cost, current market value, or face value.

General Disclaimer Section:

References to interest rate moves are based on Bloomberg data. The credit quality of fixed-income securities and a portfolio is assigned by a nationally recognized statistical rating organization (such as Standard & Poor’s, Moody’s, or Fitch) as an indication of an issuer’s creditworthiness. Ratings range from AAA (highest) to D (lowest). Bonds rated BBB or above are considered investment grade. Credit ratings BB and below are lower-rated securities also known as junk bonds.

Any mentions of specific companies are for reference purposes only and are not meant to describe the investment merits of, or potential or actual portfolio changes related to, securities of those companies.

Unless otherwise noted, all discussions are based on U.S. markets and US monetary and fiscal policies.

Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global speaker are those of the speaker as of the date of the broadcast and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Flat Rock Global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research, or investment advice. It is not a recommendation, offer, or solicitation to buy or sell any securities, or to adopt any investment strategy. Neither Flat Rock Global, nor the Flat Rock Global speaker, can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in, or refrain from, any investment-related course of action as neither Flat Rock Global, nor its affiliates, are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. This broadcast is copyright 2024 of Flat Rock Global LLC (all rights reserved). This recording may not be reproduced, in whole or in part, or in any form, without the permission of Flat Rock Global. Additional information about this podcast along with an edited transcript may be obtained by visiting FlatRockGlobal.com

Source:

1. Flat Rock Global Market Analytics
2. Nomura CLO Research
3. Palmer Square BB Index
4. Standard and Poor’s