Month: June 2024

The CLO Investor Podcast, Episode 6

Shiloh:

Hi, I am Shiloh Bates and welcome to the CLO Investor podcast. CLO stands for collateralized Loan obligations, which are securities backed by pools of leverage loans. In this podcast, we discuss current news in the CLO industry and I interview key market players. Today I’m speaking with Paul Nikodem, CLO researcher at Nomura Securities. Paul’s job is to provide CLO market commentary and analysis to CLO investors like myself. Our primary discussion revolved around evaluating CLO managers at Flat Rock. We do not manage CLOs, we just invest in CLO Securities. Each CLO has a manager. Their job is to pick the loans for the CLO and to keep the CLO passing its many tests. According to Creditflux, the five largest CLO managers are Elmwood, Credit Suisse Asset Management, Blackstone, Neuberger Berman, and Octagon. But CLO investors have over a hundred different managers they can choose from. Our conversation also tackled declining CLO financing costs. And now my conversation with Paul Nikodem. Paul, welcome to the podcast.

Paul:

Thanks, Shiloh. It’s good to be on. Appreciate you having me.

Shiloh:

Why don’t you tell our listeners a little bit about your background and how someone becomes a CLO researcher?

Paul:

Sure. To be honest, I didn’t start off as a CLO researcher. I’ve been covering securitized products as a research analyst since 2003, but I started my career covering mortgages and housing for the first decade. So it was a really interesting time to cover both of those markets. Obviously saw the large runup pre global financial crisis and then the whole mortgage market and the housing market imploded and then that was followed by the recovery trade aided by a lot of government support and just a slow rebuild of the mortgage market. So it was a really interesting time to think about scenarios and how to stress test bonds and just experience both the boom and the bust cycle. And then after 2010 or 2011, it was really the recovery trade where we saw government support come back to the housing market and private capital and GSEs really start to slowly expand the underwriting box.

And the mortgage market slowly came back until the housing market accelerated and then it was boom times for much the next decade. So as we covered RMBS and housing during that decade post GFC and we expanded our coverage, we started looking at other sectors as well within the securitized products research arena. One of the sectors that stood out to us was the CLO sector that was starting to gain its footing and starting to grow pretty rapidly at the time. And it was really interesting for us as research analysts to look at the performance during the GFC. Now, the mortgage market clearly did not do well and it was really housing led, but CLO market did quite well surprisingly well when we started looking at the data. And it was really interesting to see how these structures held up in this first stress scenario that we started to take a look at.

And basically around that time, our firm Nomura also decided to make a commitment to grow in the CLO business, starting with the secondary trading and followed by the primary business as well. And we started to cover the sector from a research perspective. So the idea was that we had really great technology that we built up from the residential mortgage research arena looking at loans and mortgage servicers and intext data. First thing we did is we took a look at those systems and applied them to the CLO market where we had managers and we had individual loan issuers. We tried applying similar technology to see what we can find. And it was a really interesting time to start to look at a very micro level at the CLO market to see differences in manager performance and loan performance and issuer performance. And that’s how we got started.

We were in the right place at the right time and we were able to transfer some of that technology from R and BS to really hit the ground running on the CLO side. And since then, the market has obviously grown dramatically. It’s one of the key sectors within the securitized markets and it’s very fascinating to look at the market both from a very macro perspective where we look at the buyer base and overseas investors and just supply demand dynamics and also at a very micro level looking at manager selection and loans and recoveries and drilling in very, very deep. So it’s been a very exciting time to be a CLO research analyst over this past decade.

Shiloh:

So for your research, is it that you put out a different piece each week that goes to a number of clients telling them whatever you think is interesting that’s happening in the market?

Paul:

Exactly. So we try to respond to what questions are on investors’ minds at every week, sometimes more frequently than once a week depending on what’s going on in the market. But we try to combine some of the micro interesting data analysis and manager analysis with some of the broader macro observations that we find in our research.

Shiloh:

I know Nomura has a CLO banking team and a CLO trading team. Why don’t you talk about the other things that Nomura is doing with CLOs?

Paul:

So starting in 2015-2016, we started off by having a very strong secondary trading effort. So our firm is the most active trading desks in most scenarios in Double Bs and equity and me in general, we speak with all the key investors that are active in the space and we have a very strong franchise there. A couple years later, we also made an investment in the primary business where we deal with many of the largest, most established managers in the space and we’ve really built a top 10 business in that space. So part of it is timing and getting the timing right. Part of it is investing in talent and investing in balance sheet as well as research. So our firm has really decided to make an investment in this business.

Shiloh:

So what is it about CLO equity and CLO double Bs that’s of particular interest to your firm?

Paul:

It’s a very data intensive, research intensive product where there’s a lot of differentiation and performance across managers and deals and vintages. With the right tools in place and the right investment in place, we have developed a way to find a niche and an edge in identifying opportunities. There’s a lot of dispersion in performance, so that’s one. These products trade very differently depending on the profile and requires a lot of analysis and insights into the market to figure out how to generate alpha for our clients as well as run a successful trading business. And part of it is connectivity to our primary business as well, where a lot of what’s going on in the market today has to do with optionality for issuers and equity holders to refi or reset or call these deals. So having an insight into what investors want to do both on the primary and the secondary side and what are the outs for these deals has a large impact on valuations, especially given that most of the market is trading at a premium now. So the timing of that refi reset is also crucial. We feel like we’ve developed an edge in that as well.

Shiloh:

Interesting. So one of the things I wanted to focus on today was just how to evaluate a CLO manager. So if we’re talking about broadly syndicated CLOs, which is around 90% of the market, I think there’s a hundred different active CLO managers. What do you think the first step is in identifying a CLO manager that’s going to outperform?

Paul:

From a research perspective, we’ve developed a large variety of metrics to evaluate manager performance over a long period of time. So in the past I’d say that bill was the most relevant metric that we used.

Disclosure AI:

Note par build refers to the CLO manager growing the par balance of the loans. This can sometimes be thought of as loan gains.

Paul:

To benchmark and compare manager performance over a long period of time. Although in recent months and quarters, it’s become a less useful metric by itself given that a lot of managers have been focused on risk reduction and defending against tails, whether it’s downgraded loans or lower price loans picking up. And the stats have been skewed based on the par build metric alone. So we’ve done a couple of things to try to identify who’s outperformed in recent years. Number one is we’ve tried to improve on the par build metric. And what I mean by that is we’ve created a new sub metric within par build to try to decompose the two effects that drive par build. One is original portfolio quality or credit selection, how has that original portfolio performed over time, absent any subsequent trading activity and also the value add of trading. So we have a metric, we like to call it active versus passive par build. So we decompose that performance by manager. That gives a lot of interesting insights. First being that original credit selection matters a lot more than trading activity and driving performance for many managers over the past two years. So that’s one observation that we rely on from this metric.

Shiloh:

So is what you’re saying here that the CLO begins its life with 400 million or 500 million of loans and it’s really that initial loan selection that’s going to be the key driver of returns over time? That’s your view?

Paul:

In the last two years, that was the primary driver of differences in performance, not necessarily true in previous episodes of distress, but over the past two years, definitely the case. Another thing is looking at how CLO managers manage tails. So on the surface you could take a look at what’s the triple C concentration by manager, and that’s one thing that the market does tier for. But looking under the hood, there’s some managers that don’t sell a lot of triple Cs and they might have a credit view that some of these loans might recover and the market prices are too low at the time and you have other managers that might be very aggressive in selling. And then you also have the other dimension of high downgrade rates to triple C and lower downgrade rates to triple C. So I think it’s also very important to decompose and think about what are downgrade rate differences across managers and how does that interact with trading as well?

So sources of triple C and how managers are handling that through the cycle also matters quite a bit. And finally, just thinking more broadly, consistency matters quite a bit. So in terms of thinking about who’s done well in the past, there’s obviously no guarantee that past performance will lead to future success. So we like to look over a long time period at consistency throughout different cycles and consistency and style. But for example, some metrics we like to take a look at are unlevered returns on the underlying portfolio over time. So how does it look every calendar year going back five or 10 years depending on the 10 of managers we’re taking a look at? So consistency is important. If you’re a debt investor, you do not want to see large drawdowns necessarily equity investors, you might have a little bit more tolerance for that if you see more upside in certain years, but it all depends on where you sit in the capital stack. So consistency in general matters quite a bit as we think about forward outlook.

Shiloh:

So one of the things from my C is that the metrics that you used, I could obviously see the attractiveness of using them, but each metric is a little bit incomplete in some way. So for example, you mentioned the par balance of the loans and is it growing? So the shortfall of that metric is just, well, are the loans price at par or 90 or some other number? And then if we’re looking at CCC balances, CCC loans are certainly at higher risk of default. But one of the first experiences I had with CLO managers, I went to a prominent one and he was telling me about his philosophy on triple CCCs and he just basically said, Hey, listen, I’m just buying good loans for the CLOs and if a rating agency has a loan at ccc, it’s important to know that for the functioning of the CLOs many tests.

But at the end of the day he’s like, I just want to buy good loans. He trusted his credit team a lot more than the rating agency assessment of the risk in the loan, and he told me he might buy a CCC loan because it has a high spread or because it has a low dollar price. So sometimes the rating agencies are a little bit lagged in terms of their downgrades or upgrades. So that’s the downside to using the CCC balance as a prominent metric. And at the end of the day, really the question with CCCs are just are they going to repay at par or not?

Paul:

Yep, exactly. I think that’s very consistent with a lot of our thoughts as well. I think that speaks to original credit selection mattering a bit, and obviously you want to have a manager that’s at least aware of some of the triggers and tests and the structural constraints of A CLO versus just managing a loan portfolio as it relates to certain stress scenarios or the ability to have good metrics so that they’re able to continue to raise capital in the future. But at the end of the day, I completely agree it’s loan selection and having a good credit team definitely matters quite a bit. Those with better selection ability over the last couple of years have definitely outperformed in our metrics versus those that might be optimizing par build for example.

Shiloh:

So I think the first cut for CLO manager analysis, what we would do is just pull up their deals in Intex

Disclosure AI:

Note Intex is software market participants use to model CLO securities

Shiloh:

And look for deals that are two to three years old and see what’s happening with the loan portfolio and really just ask yourself, are these CLOs where I would’ve wanted to participate from inception? I think that’s a good way to start the analysis. One of the things that I think is everybody’s looking for the loss rate on the loans. So one manager might have 40 basis points of annualized loan losses, another might have 60 and somebody say, okay, well the 40 is better than the 60, but what you really need to do is normalize for the income or spread of the loans. So if one CLO manager has a 20 basis points of incremental loan losses, but their loans provide 40 basis points of incremental loan income, then that’s the better manager in our view.

Paul:

For equity holders, that’s definitely a valid way to look at it. I think that for example, our unlevered return metric handles that maybe not directly, but it goes in that direction where if you have a higher spread on the portfolio that’ll contribute to the returns and be offset against the market value drawdowns. So we don’t explicitly count defaults separately from market value moves. It’s counted together. And that’s a very good point for equity that you have some more cushion if you have a higher spread portfolio. So yes, absolutely, I would definitely consider that as well.

Shiloh:

If you were just going to use one metric and one metric only to evaluate a CLO manager, would it be the unlevered return of the loans versus the Morningstar loan index? So that’s just the performance of the loans outside of the CLO structure

Paul:

Over the long term in terms of identifying upgrade candidates and just thinking big picture. Yes, absolutely.

Shiloh:

So I mentioned earlier that there’s downsides to each way of measuring performance, and if you’re looking at the performance of the loans only, you’re not capturing any of the skill that’s needed to manage CLOs and the CLOs. Many tests and then also some CLO managers are just going to have more conservative loan portfolios. So those might underperform the Morningstar loan index, but with the leverage provided by the CLO structure, the returns there could still be quite favorable.

Paul:

I mean, one thing I would say for that is we tend to look at a cluster a two by two scatterplot, if you will, of returns versus standard deviation of returns versus some other risk metric. We’ve played around with a few to risk adjust those returns to do some comparative analysis. So for the higher return, lower standard deviation managers look at a quartile, for example, on this two by two grid, which managers are outperforming their peers. I agree with you. On average there are some biases to looking at it that way and it might not fully capture the equity returns, but we’re thinking more in terms of upgrade candidates or which smaller managers are outperforming some of their bigger manager counterparts and are deserving of an upgrade for equity managers. I think that definitely would look at different metrics more so in terms of leverage and distributions and cushions, but that unleveled return versus appears is more for a holistic view on upgrade potential and small versus big managers and who’s trending in what direction.

Shiloh:

So maybe the takeaway is just that there’s a number of different ways to evaluate CLO managers and you probably need to use all of them to really get a complete picture. So the result of CLO manager analysis is a tiering of CLO managers into tier one through four with one being the best. So I think starting at tier four, would you put anybody in tier four? I’m not necessarily looking for names at this point, but are there a handful of managers that have really underperformed

Paul:

In terms of underperformance? Yeah, there’s probably isn’t a quarter of all the managers outstanding. It’s probably not the bottom quartile. Maybe it’s the bottom decile of, as you mentioned, managers that haven’t issued and some of them might be trying to rebrand themselves and have much cleaner portfolios and switch their style, but there’s definitely a few that clearly have underperformed in the past and clearly have par holes or underperformed during past stress periods that are just not treated well in secondary at all. There’s stats reflect that. The other tier is just new managers in general, which we give them the benefit of the doubt and wait two to three years to see a track record before really taking on a view. To your point earlier that everything looks clean on day one, but it seems like it takes at least two to three years of history before we could start to differentiate who are the better and the worse of the new managers. And basically who deserves an upgrade to tier one or tier one and a half faster than others. That’s how we’re thinking about it.

Shiloh:

Okay. So who do you think is in the top tier if you’re able to share a few names with us?

Paul:

Sure. So top tier, the way we think about it internally, there’s a couple of different metrics, whether you’re the top, you’re the bottom of the stack, part of it’s performance, part of it is AUM, part of it is number of deals and primary spread tiering, and it’s a little bit of a circular argument. We don’t really love it as research folks, but it makes sense that managers that have been around longer who have consistently traded tight primary have better liquidity. So there’s a better refi reset optionality to get out if spreads tighten without as much extension risk and they’re going to trade better in secondary if you see another Covid scenario and spreads blow out, for example. So there’s some self-fulfilling prophecy to that. Our first blush would just be to rank by primary spread tiering as well as just AUM in general. So you’d see a lot of the usual names there, but to put a couple names out there in terms of overlaying a research view on performance and who’s been cleaner and who’s navigated through credit cycles better than others, some names that stand out within that tight spread and high AUM top quartile would be, for example, Elmwood, CS, Oak Hill, I guess BlackRock, CISC, Allstate are some names that come to mind.

Shiloh:

So do you think that most people on the market would agree with the tier one distinction for the guys you mentioned, or is it that CLO investors like myself that we are just using totally different inputs into our CLO manager analysis that would result in a different tiering?

Paul:

So at the top of the stack, I think it’s pretty self-evident given the AUM and primary spread tiering, which tends to be very sticky. And part of it has to do with the fact that larger anchor buyers tend to just set up their list and they tend to switch less frequently, although we have seen a shift in the AAA buyer base. So there’s some impetus for change, although not as rapidly as at the bottom of the stack. So at the double B and at the equity part of the stack, I think there’s a lot more opinions, especially of if a manager has tails that are increasing or has cleaned up quite a bit, the market could tier very, very differently pretty quickly after seeing some of the performance differences. Or they might tier a manager differently for vintages two years ago versus four years ago based on differences in performance. So it feels like down the stack that tiering is a lot more responsive and there’s a lot more opinions about who’s improving, who’s trending, who’s getting worse, et cetera.

Shiloh:

So from my perspective, it looks like a tier one status at the top of the stack for the AAA for example, a lot of that seems to be just based on name recognition rather than the performance of the underlying loans. And once you have that tier one AAA investor base, I think it tends to be pretty sticky. So these guys just continue to do your deals year after year and maybe aren’t looking to put new entrants on their list. And in CLO equity is totally different. So you’re daring any loan losses, it’s an issue for you. So name recognition doesn’t really pay the bills. The other part of CLO manager tiering and manager selection is just that there could be managers out there that we really like, but at the end of the day, if they can’t get good debt execution, then there’s really nothing for us to talk about because that’s the key ingredient for good CLO equity returns. So Paul, let me ask you this. It seems like every year there’s five to 10 new CLO manager entrance to the market. Have you seen any of those be particularly successful? I think it’s a pretty tough business to break into.

Paul:

This may not be the newest of managers, but Elmwood was probably the first one that stuck out. Obviously the PM came from BlackRock and the performance was pretty similar early on and conservative, but they’ve performed very well and are clearly tier one and nobody would call them a new manager, but they’re probably the first one that we would think of in terms of that upgrade cycle. But more recently, I guess Birchgrove white box stand out to us as also going down that positive trajectory.

Shiloh:

So one of the changes we’ve seen in terms of CLO management style is that pre Covid managers were doing loans with LIBOR spreads from 330 basis points all the way up to 400 basis points. And during Covid, when loan losses were elevated, a lot of the loan losses were actually in the high spread names, which makes sense. So it was really the conservative loan pools that outperformed during covid. And it seems a lot of CLO managers are really now just sticking to the lower spread pools. Is that something you’re seeing in your research?

Paul:

I’m hearing more of the latter, but as a research analyst, another thing that I point out is that a few years ago, if you take a look at a scatter plot of WAS versus performance

Disclosure AI:

Note WAS stands for, the weighted average spread of the loan portfolio

Paul:

High WAS tends to outperform. In good scenarios, they tend to have large drawdowns and bad scenarios, unsurprisingly, but more recently, over the past two years that correlation has broke down and it’s not obvious that high was has underperformed in the cycle. In fact, we’ve seen some lower spread managers that have had a small number of loans that have gone bad and unfortunately the recoveries have been so low that they’ve taken pretty big par hits. So the correlation between high and low spread and performance has really broken down in recent years and it’s hard to really show that relationship. Recently just given the market environment, the defaults have been low and just the loan recovery has been just very idiosyncratic. So anecdotally, it does feel like we’ve seen a number of higher spread managers previously that are trying to go into lower spread, more conservative portfolios rather than the other way around. But it’s not clear that that has a difference, an impact on performance as of right now over the longer run, in theory it’s supposed to have a correlation, but in the last two years it has not.

Shiloh:

Well, one of the reasons that we favored the low spread loan pools was that with the low spread portfolio, you can still generate very healthy distributions to the equity, but you’re taking less risk on the underlying loans. And if the loan pool stays strong over time, then the option value of doing resets and refis in the future is greater. Whereas if you just have the higher spread portfolio, that to me implies more risk and the higher spread loans do create more income for the CLO equity that comes quarterly and of course that’s nice, but you don’t really need to reach for the higher spread loans to get very good CLO equity returns is our view.

Paul:

Yeah, I think that makes a lot of sense. I remember I think five or six years ago, this is where we saw a switch where before that the lower spread managers didn’t necessarily have great distributions and a lot of them were shunned by the market. But after that there started to be a transition where some of the lower spread managers had really tight funding costs and they avoided a lot of the hiccups in 2017, 2018, 2019, whether it’s retail or some of the idiosyncratic issues that showed up in the loan market and they really outperformed, at least some of them started to outperform. And I think that trend has continued. So I think that makes a lot of sense.

Shiloh:

So changing topics, one of the things we’ve seen this year is that the CLO financing costs have come in really dramatically. And curious if you think the trend’s going to continue or if there’s some floor level to SEAL Lewis spreads that we may hit at some point?

Paul:

That’s a great question that we often have received recently. I feel like spreads will continue to oscillate down, but the issue is that every time you tighten a few bps, you could see another wall of refi reset supplied pickup, and that could temporarily cause spreads to widen before they tighten again. But the general direction continues to be tighter. So across all the securitized products assets that I cover now, the conversation is really spreads are pretty close to post pandemic tights or near two year tights. And now take a look at where spreads were before the pandemic and look at that comparison. And CLOs are not in a vacuum by any means. I don’t think that there’s anything preventing CLOs to go into the low to mid one-thirties by year end with a couple of fits and starts where spreads might temporarily widen with refi reset supply.

But there’s a couple of important factors here. One, just from a broader macro environment, we think the macro environment will be relatively benign and fund flows will be positive and insurance and annuity flows will be positive and more importantly, bank demand for securities has gradually picked up and we think that trend will continue going into year-end positive for CLOs just given the duration profile and the floating rate nature. But I think all the major investor groups are either investing quite a bit or rising as a share of buyers in terms of the CLO market and broader securitized products. Also, net issuance is very, very limited for CLOs and even more limited for triple eight given that amortization speeds are elevated and most of the amortization happens at the AAA part of the stack. So to give some context, CLO AAA net issuance is barely above zero year to date, whereas overall CLO net issuance is about 15 billion year to date.

So the net amount of growth and the AAA part of the market is pretty close to flat and that’ll probably continue for the remainder of the year. Taking a look at some of the bank data, banks have been roughly flat down in terms of their holdings over the last quarter and they could pick up a little bit. ETFs obviously are growing and accelerating, especially at the top of the stack, and it doesn’t take much of ETF or bank flows to really push AAAs tighter given that they’re not really creating new AAAs. A lot of it is recycling from short to long and amortization. But in general, we think the technicals should be positive, think the macro environment should be positive. We think the Fed first rate cut, we’re calling for July with some risk that it gets pushed to September, but we’re calling for two cuts this year, possibly slightly less, but at least one cut this year. Even if some of the inflation prints are a little bit hotter in the near term, it does feel like a risk on environment and general spread tightening environment. So we are positive at the top of the stack continuing to tighten.

Shiloh:

Do you think that spread tightening is really a function of the fundamental performance of the underlying loans or is it more technical in nature?

Paul:

I think it’s very technically driven recently, so a year ago agency spreads at 180 bps was certainly an impediment to CLOs tightening given that you saw some crossover buyers look at both, that issue has gone away. Agencies have tightened in quite a bit and we think they are slightly below where fair value is right now. So that’s one. The technical environment of issuance is very, very limited and the buyer base has expanded tremendously. Used to be a couple of anchor buyers in Japan and a couple of domestic banks sponsoring the majority of deals. Now you have deals that are syndicated, you have money managers, you have insurance, you have ETFs, so you just have much more players, especially in retail sponsoring the sector. And on the fundamental side, we see no issues at the AAA part of the stack. It’s as positive as ever. So we think that all signs point to continue tightening

Shiloh:

Well. I think the higher base rate has certainly attracted a lot of people to our market, the science CLO equity. The other really important security to me is the CLO double B. So by our math, there’s been about 25 basis points of annual defaults there over the last 30 years. And s and p publishes a stat on that. I think there’s about 35 different names that have defaulted. So it’s a pretty small number. Given the size of the overall market. Do you think that the favorable risk adjust returns of BBs will continue here or is there any reason to think that the default rate will pick up from the 30 year history?

Paul:

We’re very positive on double Bs. We think it’s a very stable structure. We don’t think that default rates will materially pick up. Obviously there’s a manager bias where if you take a look at some of the deals that have taken write downs or have not paid principal in the past or have been downgraded to default in the past, they tend to be some of the smaller managers, maybe managers that have taken on more of the risk, but not necessarily in the large top tier managers that have had more of a defensive posture and an active trading posture in general. So overall on a model basis, it’s extremely hard to break double Bs. You need to annualize the fall rate of at least five, maybe seven or 8% per year for life depending on your other assumptions. And it’s like a GFC scenario extrapolated multiple times, but we know that averages don’t tell the full story. And for the deals that have taken losses in the past, they were unlucky with concentrated bets in the wrong sectors multiple years through multiple cycles. And we just don’t see that happening with many of the large managers with diversified portfolios and experience and dedication managing these structures. So in general, we’re very positive on double B credit and just the structure itself, especially with rising credit enhancements over time. So we see no reason for that to get worse compared to those historical stats.

Shiloh:

Yeah, well the stats that I quoted, by the way, those are for the last 30 years, but that doesn’t account for is that post financial crisis, there’s actually more equity in CLOs than there was prior. So the newer double Bs are actually the more conservative ones. And at Flat Rock we like to invest in middle market double Bs where you get 12% equity in the CLO instead of the 8% or so in broadly syndicated CLOs. So if we’re talking about a default rate requirement to break a deal to miss a dollar of interest or principal, we’d see that as a 15% annualized default rate. So as a result, we’re very bullish on middle market BBs.

Paul:

Absolutely.

Shiloh:

So one other question I wanted to ask you is just around what are investors reaching out to you on these days? What are the key topics? I assume refis and resets are the biggest, but is there any other topics that are worth mentioning?

Paul:

I think that’s a lot of it just refis and resets how to model optionality both for equity and for double Bs in light of high reset volumes. What are the characteristics driving refis and resets expectations for investor demand, whether it’s bank regulation, whether it’s overseas, whether it’s ETFs or insurance, some thoughts on that. Other than that, a lot of it’s macro and thinking about interest coverage ratios and when and how much will the Fed cut. You obviously have a large share of issuers with rate hedges on that are probably going to expire in early to mid 2025, or in other words you could say that the median issuer probably has a three-ish percent base rate right now net of hedges in terms of SOR for the loans. So depending on where SOFR and FED funds will be in mid-2025, if they don’t cut, that’s five and three eighths and that’s an issue. We think that the terminal fed funds rate can get down to something like three and an eighth. Within about two years. The Fed could cut quarterly potentially next year once they start cutting and they have confidence to cut. But where that fed funds and SOFR rate is in early to mid 2025 will have a large impact on credit and potential downgrades as these hedges are rolling off. So doing analysis on that and trying to monitor that situation in light of macro is another question we get pretty often

Shiloh:

For CLO equity. If a deal is coming off period in say six months and the capital stack is in the money, so meaning you could refinance it today, if you could at a lower rate, in your experience, would a secondary buyer, would they be willing to pay up for that optionality or is it more of a optionality where the owner of CLO equity has to execute on our refinancing or reset really to get any value?

Paul:

That’s a really interesting question. I feel like if you asked me that three or four months ago, the answer would be very different than now. But right now it feels like most of that optionality is pretty fully priced in for anything soon to roll off from no-call or past, no-call, but a few months ago the market was starting to lean into those assumptions but wasn’t really paying for it. So yeah, so a lot of the valuation in secondary equity is based on executing that refi reset and realizing those spread savings. Otherwise, the returns are definitely going to suffer

Shiloh:

For us looking for good candidates where there’s a refi or a reset coming, that’s certainly something we would focus on. But on the other hand, if it’s potentially six months off, I think you’re willing to pay something for the optionality, but you’re certainly not going to buy CLO equity under the assumption that when a on-call date rolls off, that magically the manager is going to be able to get a deal done on that date. Potentially there’s a deal ahead of you or spreads may move wider in the interim. You don’t know, so you really can’t bet on it. I agree people are starting to value the optionality more certainly in the current marks and where things trade, but for a long time I would just say there was really no value given to the optionality in these deals. So you were highly incentivized to look around in the market and find deals where you think something favorable could happen in a shorter period of time.

Paul:

I think that’s right.

Shiloh:

Well, Paul, is there anything else happening in CLOs that we haven’t covered today?

Paul:

Not really. I think we covered a lot of what we’ve done in our research and what’s interesting to investors minds in terms of our

Shiloh:

Great. Well, Paul, thanks so much for coming on the podcast.

Paul:

Great. Thanks for having me, Shiloh. I enjoyed it.

Disclosures:

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 investment or potential investors in any Flat Rock Global fund

Definition Section

AUM refers to assets under management

The secured overnight financing rate, SOFR. is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities.

A government-sponsored enterprise (GSE) is a type of financial services corporation created by the United States Congress.

The global financial crisis (GFC) was a period of extreme stress in global financial markets and banking systems between mid 2007 and early 20093.

Credit Ratings are opinions about credit risk. For long-term issues or instruments, the ratings lie on a spectrum ranging from the highest credit quality on one end to default or “junk” on the other. A triple-A (AAA) is the highest credit quality. A C or D (depending on the agency issuing the rating) is the lowest or junk quality.

Par build refers to building the par balance of the CLO loans where each that hasn’t defaulted is counted at its par value.

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

Broadly-syndicated loans are underwritten by banks, rated by nationally 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.

Global financial crisis or GFC refers to the banking downturn in 2008 and 2009.

Risk retention is when the CLO manager acquires securities in its CLO to meet regulatory requirements.

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

Spread tiering refers to different CLO managers being able to finance their CLO at different rates.

RMBS are residential mortgage-backed securities.

Morningstar Loan Index serves as the market standard for the US leveraged loan asset class and tracks the performance of more than 1,400 USD denominated loans.

A LIBOR spread is the difference between the highest and lowest rate of the London Interbank Offered Rate

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 organizations such as Standard and Poor’s, Moody’s or Fitch as an indication of an issuer’s credit worthiness. 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 US 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 advisor 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 5

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 and the CLO industry, and I interview key market players. On May 15th, I attended
the Creditflux CLO Symposium in London. Creditflux is one of the papers of record for the CLO industry and their annual conference in London is always, for me, a must-attend event. It was great to see lots of familiar faces and the panel guests were really top notch. Some of the themes of the conference were the rise of middle market CLOs and declining CLO financing rates. Usually my podcast is me interviewing other market participants, but in this episode I’m posting a fireside chat I did at the conference with Credit Flux Managing
director Tom Davidson. Credit Flux also has a podcast that I’d highly recommend. It’s called The Last Tranche, and I was a guest there a while back.  Some of the topics we discussed were CLO education, current opportunities in the CLO market and CLO equity risk adjusted returns, which I emphasize are more important to me than total returns. And now my conversation with Tom Davidson.

Tom:

Welcome, Shiloh. Before we get going on the fireside chat,
maybe if you just want to introduce yourself with your main job.

Shiloh:

Hi everybody, I’m Shiloh Bates. I’m the CIO of Flat Rock
Global. We manage about a billion of AUM. We focus on CLO equity and CLO double Bs. And then within those two asset classes we have a preference for middle market CLOs, as you know.

Tom:

Great. Now for those of you who called the first fireside
chat, my colleague Lisa Lee and Jane Lee, Lisa upped the ante on us by announcing that Jane is an award-winning documentary film producer. Luckily enough, Shiloh also
has a side gig, which is as an author. I’ve got a copy of his book here. We also have a few more copies if anyone’s interested. This is CLO Investing with an Emphasis on CLO Equity and Double B notes. So maybe we should talk a bit about the book. Why did you decide to become an author?

Shiloh:

There’s a saying that it’s great to have written a book, but
it’s not great to be writing a book. The genesis though, really is in 2020 I had some free time on my hands and so I wrote a 60 page just kind of like manual, or the way I go about approaching investing in CLO equity. And we put
that on our website. I was really surprised at how many people read it and my competitors mentioned it to me, CLO managers and people that were just kind of interested in the space, they read it. And so that gave me the idea to just go ahead and do the bigger book. It’s about 220 pages, but a lot of what’s written in the book is stuff that I’m constantly as part of my job educating investors. And so some slides from our pitch decks are in the book.

I’m frequently answering their one-off questions for
investors. And so I came up with the outline for how I wanted to tell the story of CLOs. And at the end of the day, there’s really like maybe four concepts that make CLOs different from other asset classes. So I would agree it’s not
as, especially in equity, it’s not as straightforward as investing in a high yield bond or a leveraged loan directly or certainly a stock. If you want to learn about CLO equity and Double Bs, one option is a book obviously, but if you didn’t do that, you can spend a lot of time Googling and finding different articles and you can kind of put together the information you need. But the idea with the book was to put it all as kind of like a one-stop shop for your CLO needs.

Tom:

And it’s an amazing read if you haven’t had a chance to read
it. As I say, we have a few copies, it’s come out, so come and find us. I think one of the interesting things is obviously you wrote this a few years ago now, the market’s changed pretty dramatically in a lot of ways since then. What would you change now? What do you wish you’d written in the book?

Shiloh:

In the segment about double Bs in the book, I make the point that if the MVOC, so if the market value of all the loans in the portfolio plus the cash, that if that does not cover the full balance of the CLOs debt, AAA to
double B, that means you have an MVOC of less than a hundred percent. So it might be 98 or 99, something like that. And a point that I made in the book was that you can very comfortably buy bonds that are not covered and still expect a payout. And the reason really is twofold. So one is that if the loans don’t perform well, the CLO will not pay the equity and that profitability will be trapped in the CLO and ultimately that will benefit the double B. But then the
other part of it was just that the loan index was trading at discount of the levels.

And so at the end of the day, loans are either worth par or
they default and get some recovery, but there’s no in between. That’s kind of the binary thing. And our view was that most loans trading at discounts, it was really a function of heightened risks in the market, political risks, economic
risks, and that at the end of the day, there would definitely not be enough defaults to really impair a lot of the double Bs. That part has actually paid out, I think very few double Bs. Definitely very few have defaulted. I would expect very few to default in the future, but today a double B that’s not
covered by its fair market value given how much loans have traded up, is a much higher risk situation than it would’ve been last year at this time.

Tom:

Great. You are obviously very passionate about this investor
education piece. I know as well as the book, you have a new podcast as well. I have a podcast as well. Welcome to the space. It’s always great to see some competitors joining in. Tell me about the podcast.

Shiloh:

The new podcast is called the CLO Investor, and basically in
the first episode I just talk a little bit, I do a CLO 101 and just talk about the market to establish that foundation for people who need it. And then in the second podcast I interview a colleague, we talk about our strategy in
the market and what we find interesting. The third and fourth podcast, which we will drop soon, one is an interview with David Williams, who’s a CLO banker at Scotia who I know you know. And then Evo Turkejiev is a broadly syndicated CLO manager at New Mountain Capital. From the perspective of writing the book and the podcast, I try to approach it as from the angle of somebody who’s an investor
in the space, and I hope people will find it beneficial as once you figure out how to be a podcaster, when you have good guests on, they do all the work. You just have to think of the questions that they do all the talking, and then you talk for an hour and then hopefully it’s a quality product that people like.

Tom:

Absolutely. Let’s get into the equity investing side. And I
think one of the things which I find interesting is it’s actually quite hard to unpack for people looking at equity investing. How well is CLO equity performing as an asset and how much is added on by the alpha from managers? And
I think this is something you’ve done some work on.

Shiloh:

Well. Yeah, so one of the things that we put together
starting about four years ago was a CLO equity index. And it’s available on our website, it’s public. If you invest in any of the debt securities, double B to AAA, JP Morgan has great indices for that. Palmer Square does as well. And on any
day you can see, oh, how did double Bs do today or single A whatever you’re interested in. But with equity, you really can’t do that because there’s just not enough trades in the market. So what our idea was in putting together the
CLO equity index was to take information from what’s called public filers in the US. And so I’m a public filer myself, meaning that every quarter I tell our investors, these are all the CLO equity pieces I own. This is where I mark them
at 3-31 or 12-31.

I have a number of competitors who do the same. And so if
you know that somebody owned 10 million of a specific CLO security and they had it marked at this price a quarter ago and this price, now you just need to figure out what was the payment received on the equity in the interim, and you
can calculate a return in that way. And so our index construction basically matches a Cliff Water direct lending index. They do the same analogy or the same methodology where you’re looking at other public filers figuring out what
they owned, what the specific return was in quarter. And I feel really good about the results because all those marks are marks that are coming from managers who are registered investment advisors. So there’s a lot of regulation. It’s not just people really thought about the mark, it’s not
just something that just came at thin air.

That’s kind of the regulatory setup there. And so we’re able
to mark about 500 different CLO equity tranches using this methodology. And one of the things that’s not ideal about it is that I have to wait to put the index together. So for 3-31, so for March 31st, I don’t know yet what the CLO equity return was. I need to wait for everybody to file with the SEC, and that takes 60 days for a lot of folks. But if you look at the index, one thing, the returns really for the last few years have looked very good. So last year, CLO equity did 22%, which I think people were pretty excited about. And then if you look at a three-year annualized rate, it’s about 12. And if you go back five years, it’s like nine. So the more recent performance of CLO equity has been the better.

Tom:

I think it’s interesting you can compare and contrast that
with on the credit flux side, we track fund performance a lot of CLO equity funds. And as you say, last year, I mean I guess all of the returns were above 20%. And that makes sense now because almost anything you bought would’ve
delivered that. But equally, some investors are producing returns much higher than that, more than that 30%. I think some of them were hitting 40%. So clearly there is also a lot of alpha you can add as an equity investor as well.

Shiloh:

So the way I think about it and how we approach things at
Fire Rock is it’s not, your awards are a total return award. And how I think about it is we’re going for the best risk adjusted returns. So a lot of times at Flat Rock, we’re looking at CLO equity pieces or double Bs where we think the outcome will be very favorable and the return opportunities are quite high. But there’s also just an amount of risk that goes along with the securities that’s just kind of above and beyond what our investors would want to sign up for. Internall, we would look at some of these deals and say, oh, that’s something I would do in my PA if I could. But it’s not something we’re doing with shareholder money. And so what we try to do in equity is to provide a low double digit net return to investors with a high focus on reducing the downside risk. I’m guessing that for people who hit a 30% return for last year, they probably, the trade to get there would’ve been to buy single Bs at a discount or equity that was potentially a risk of missing payments. And both of those would’ve worked out to your point. But investors in those funds are signing up for a level of potential volatility that mine are not.

Tom:

So turning to your investor hat away from the education hat,
what’d you like at the moments out there? What are you buying?

Shiloh:

We have really, since the inception of Fire Rock CLO, middle
market equity is kind of the core of what we’ve been focused on at the beginning of the year. We saw some pretty interesting opportunities there, and in the last two months we’ve seen some middle market issuance, but there really
hasn’t been a ton of new loan creation in the middle market. And so that’s been a hindrance to CLO issuance. And then we’d also seen recently that sometimes the manager takes all the equity themselves and they even take the double B
sometimes, which is another security that we would want if they would sell it. And so a lot of the recent issues or issuances have been middle market CLO where the securities offered are triple A to single A or triple B. That’s not where I’m playing. The two things that really we’ve liked about middle market equity and continue to like are the natural arbitrage in the deals, it’s more favorable.

There’s more profit in the CLO, you get higher cash
distributions each quarter one. And then through this conference today, a lot of what panelists have been talking about are a liability management exercises and low loan recoveries. Well, these are not really an issue in the middle
market. So in the middle market, it’s private market. There’s no distressed hedge funds buying the loan. And the secondary, if the loan does get into issues, usually it’s just one to three lenders who need to figure out a way to
move forward. And so in the middle market, I would expect recoveries to be around the 70% area. That is what we put into all of our modeling projections. And then broadly syndicated, the consensus is for lower recoveries. Certainly
those are the two benefits for CLO equity. We’ve, I think, benefited from that historically. And the trend should continue as well.

Tom:

And obviously, I guess from your side, its liability spreads
do keep coming in is actually good from an equity investor perspective.

Shiloh:

On the last panel, I learned that the spread between the
broadly syndicated AAA and the middle market AAA, I’ve always thought about it as about 50 bps over 10 to 12 years. That’s kind of what it’s been, but now it is certainly moving tighter. And I am all for tighter middle market aaas. I
also invest in middle market double Bs where I don’t need those to trade any tighter. And then for the equity, anything that trades tighter creates more profitability for the CLO and better equity distributions.

Tom:

Yeah. And then I thought the other interesting part of that
panel was a talk about improvements in liquidity in the secondary, and we were talking about this, the guys there were very positive about some of the work which has been done on transparency in middle market CLOs. I’m not sure we necessarily agree that it was quite there yet.

Shiloh:

When we look at a middle market equity or double B piece, for example, the middle manager sends us a list of the 200 or so loans that are going to go into the CLO, and they’ll give us some metrics around the loan, what’s the leverage, the interest coverage, the loan to value. And usually we
find seven or eight loans where they’re of particular interest or they stand out for one reason or another. And so we get the CLO manager on the phone and we talk through those credits. And usually there’s a very satisfactory answer
for why these kind of few loans stood out, if you will. And then after that, I think middle market reporting is a little bit mixed. So if you pull up the deals in Intex, sometimes you’ll see a mark for all the loans that’s relatively recent. For other CLO managers, you might see only loans that are rated triple
CA mark.

If the loan’s defaulted, there has to be a mark. Also, the
best thing for a CLO manager to produce is a mark for every one of the 200 loans. I realize it may be a quarterly mark, it may be stale, but if the manager reports the information in that way, they’re going to find that their bonds are much more liquid in the secondary market, and that will lead to
better pricing for them in the primary as well. So that’s something that they should care about. I think there’s some challenges for the managers in that if you have a publicly traded BDC, you don’t want to put out loan marks for the
same loan that’s in A BDC in another fund kind of ahead of when the BDC might be reporting. There are some challenges there, I admit, but the more current marks and percentage of loans marked is better for all the investors in the deal.

Tom:

Great. We’re pretty much out of time now, shall I? So in
fact, we are exactly out of time. Thank you so much. Thank you for joining me.

Disclosure AI:

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.

AUM refers to assets under management. 

The secured overnight financing rate software (SOFR) is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities. 

The London Interbank offer rate (LIBOR) was a broad measure of the cost of borrowing cash overnight for banks on an unsecured basis, leveraged loans or corporate loans to companies that are not rated investment grade broadly. 

Syndicated loans are underwritten by banks, rated by nationally 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 obligation (CLO) is a structured finance
product that is backed by a pool of assets other than leveraged loans. 

Global financial crisis or GFC refers to the banking downturn in 2008 and 2009. 

Risk retention is when the CLO manager acquires securities in its CLO to meet regulatory requirements. 

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 investments such as the interest received from holding a security. 

The yield is usually expressed as an annual percentage rate based on the investments cost.

Current market value or face value amortization is the process by which the CLO repays its financing after the reinvestment period ends. CLO equity missing
payments happens when there are too many triple C rated loans or defaulted loans in the CLO 

The Flat Rock Global CLO equity index can be found on the Flat Rock Global website.

Liability management exercises or LME are an out of court
restructuring of a company’s debt in which the lenders take a haircut on the principal balance of their loans. 

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 credit worthiness 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 US 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 advisor 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.