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TRANSCRIPT
The CLO Investor Podcast, Episode 8
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’m speaking with John
Kerschner, one of the portfolio managers of the Janus Henderson JAAA CLO
Exchange traded fund. As of June 30th, JAAA had a market cap of 10.6 billion,
up from 3.2 billion a year prior. I asked John to come on the podcast to
discuss his perspective on the relative attractiveness of CLO AAAs versus other
asset classes. We also discuss how his team picks CLO AAAs and if the market
should expect continued CLO tightening, some of which being driven by CLO ETFs.
And for the avoidance of doubt, there’s no business relationship between Flat
Rock Global and Janus Henderson. And now my conversation with John Kerschner.
John, thanks so much for coming on the podcast.
John:
Yeah, thanks for having me. It’s my pleasure.
Shiloh:
Why don’t you start off by telling our listeners a little bit
about your background?
John:
Yeah, sure. So I came out of business school where I went, Duke
University, in the mid nineties and joined a small money management firm called
Smith Breeden Associates based in North Carolina, but they had an office out in
Colorado, which I eventually moved out to. And so it was very mortgage-
centric. Doug Breeden, who’s an academic professor at Duke, who started the
firm, started as a lab for his research work to see if it actually worked in
real life. And so we were investing in mortgages. It was kind of early days of
the mortgage market back then. And then after a few years doing that, I wanted
something else and they decided to give me the asset backed slash non-agency
mortgage group. No one was doing that. So they said, all right, John, why don’t
you go try your hand on that? And that was the year 2000. And very quickly it
became the non-agency mortgage group because that market basically went from
zero to 2.7 trillion over the next six years. So all that growth in subprime
mortgages, I was right in the middle in so background in securitized. I joined
Janus Henderson back in 2010 and really to build out the securitized group, and
now we manage 40 billion in securitized, including our ETFs. So it’s been a
really great ride.
Shiloh:
Great. So post GFC, were you working with CLOs more or RMBS or
what were you doing then?
John:
Yeah, so during the GFC I actually
left that Smith Breeden Associates and joined a hedge fund based in Boulder
that focused on commercial real estate. So I kind of went from agency mortgages
to non-agency mortgages to commercial real estate, obviously commercial real
estate. I had a very difficult time during the GFC. Our investments were very
good. They were mostly global, but when liquidity drained out of the system, no
one really cared that much about that. They just wanted their money back. So I
did some distressed debt investing for a couple of years at this firm, and then
that platform was shrinking. So I was really looking for my next opportunity.
And Janus at the time, now, Janus Henderson obviously, back in 2010, was really
trying to build out their securitized group. They had no assets and no people,
and yet close to 20 billion in fixed income under management. Most of that was
benchmarked to the aggregate index. So they needed some securitized expertise
and that’s why they brought me in to build out that group.
Shiloh:
Okay. And so one of the reasons I wanted to have you on the
podcast was that I saw recently that JAAA, your AAA fund, had passed 10 billion
of AUM. What do you think is the biggest driver of the growth there?
John:
It’s an incredible benchmark to have passed. And look, I think
it’s very simple that before we launched JAAA, there was really no solution for
people looking for high quality, floating rate fixed income with a decent
yield. Normally most of fixed income is actually fixed rate, which does very
poorly when interest rates go up. And particularly when the Fed’s in an
interest rate hiking cycle, people were looking for a way to use those rate
hikes as a tailwind, not a headwind, but at the same time, people were
concerned about the overall economy and the fact that most people were
predicting recession. So they wanted high quality, floating rate fixed income.
And it just so happens that the CLO market is a perfect place for that. It’s
floating rate. If you buy the AAA tranche, it’s very high quality. A AAA
tranche has never defaulted in over 30 years. And yet because the Fed did end
up raising rates quite a bit, the yields are quite attractive and currently
still around 6.5%. So those three things, people just looking for a solution
that didn’t really exist out there, at least not in scale. And it’s just a
matter of fact that most people have some allocation to a cash or cash
alternative. And so this was just a product right time, right place, and it’s
just gotten a lot of take up by a lot of different investors.
Shiloh:
Do you think it mostly is taking share from the Bloomberg-Barclays
Agg or are there other asset classes where people are choosing JAAA in lieu of?
John:
I do think there’s some of that taking share from the Agg, but I
actually think it’s taking more share from what traditionally have been cash
type of investments, whether that’s money market funds or bank certificates of
deposits or T-bills, things of that nature. Because traditionally, and
obviously past performance is no indication of the future, but traditionally
AAA CLOs have outperformed cash by somewhere between 170 to 200 basis points.
Now that comes with more risk, at least a little bit more
risk. So that’s key. But there’s
still, look Shiloh, there’s still 6 trillion plus of assets out there in money
market funds. And so there’s just this massive market of people out there who
are saying, look, I still think rates may be going up, or I’m concerned about
the overall economy. I want that safety of cash and it’s given me a decent
yield, particularly compared to where cash was over the last 10, 12 years. So
why don’t I just do that? But then when they look at last year, cash basically
gave them just over 5%. That makes sense. That’s where the Fed funds rate is. But
a JAAA with a little bit more risk gave them 9%.
Shiloh:
So how are the shares of the ETF? How are they created and
redeemed?
John:
Yeah, so a lot of people when they look at a JAAA, they’re not
used to ETFs, exchange traded funds, or how they actually work. Most people are
very familiar with 40 Act mutual funds where if you want to buy a mutual fund,
you make a trade and then you get the price where that fund priced at the end
of the day, and that’s the price or level where your cash is invested in that
fund. Exchange traded funds are very different in that they trade on an actual
exchange. Our funds tend to trade on the New York Stock Exchange. So it’s just
like a stock. There’s constantly buys and sells, constant buys and sells
throughout the day. And probably most important or most different, there’s a
market maker that’s facilitating those trades. And what does that mean? So
let’s just say you have a day where you have a million buys and a million
sells.
So the market maker probably is not doing anything. He’s just
matching those buys and sells and there are no create or redeems. Now, let’s
say there’s a day where you have 10 million buys and a million sells, maybe on
that day the market maker is like, okay, I’ve taken in 10 million of cash that
people want to buy and only given out 1 million in cash that people wanted to
sell. So I’m going to ping Janus Henderson and say, we’re going to actually
have creates for $9 million. And so we have a capital markets team in
Connecticut that handles this as part of Janus Henderson, and they will tell us
we have 9 million in creates, and that’s when the risk is transferred from the
market maker to us. So we get these creates throughout the day. There is a
cutoff usually around one o’clock our time in Colorado, three o’clock on the
east coast. So if we do get creates, we can invest that cash. And so it’s
different in that you can constantly see where the fund is being priced, unlike
a 40 ACT mutual fund where it’s once a day. So that gives investors more
transparency as to where the markets are. And quite frankly, I think most
investors appreciate that transparency.
Shiloh:
Okay. So what’s the typical bite size for you guys for a new AAA?
John:
You mean as far as creates goes or when we’re buying new issue or
Shiloh:
Well, let’s say you’re buying new issue. Is it like a 20 million
investment that you’re targeting or how do you think about the appropriate size
for your fund?
John:
It depends somewhat on what class we’re targeting. So your
listeners probably, maybe some of them know this, but most CLOs new issue are
around $400 million. Some are bigger, some are smaller, but that’s kind of an
average size. And so the AAA tranche is usually somewhere 250 million,
something like that. So if you’re a CLO manager and you hire an investment bank
to launch a new CLO, usually what you have, the equity or residual tranche is
usually already spoken for by the CLO manager. They will usually buy that, but
the AAA tranche, they have to go out and buy a buyer for it. And it’s a lot of
bonds, right? 250 million bonds. So they want to find in what they call an
anchor order. Usually this is a large bank or money manager that has at least a
hundred million to put to work. And so we’ve started, as JAAA has gotten
bigger, we’ve started buying more and more in the primary market and doing
these anchor orders.
And why is that important? You get a large block of bonds locked
up, which is important when you’re getting creates almost every day. So you
have that visibility and that certainty of execution. You get it at a spread
that you’re very comfortable with. There’s some negotiation there. But if
you’re buying that many bonds, you have some say in the spread. And then you
can also dictate some of the DOC language as well. CLO documents are not
standardized, unlike every other asset class in the universe. And so you have
some say so when we started out, we were buying more and more in the secondary
5 million, 1 million, 10 million blocks, but now we’re buying as the ETFs got
bigger, we’re buying more and more in the primary market.
Shiloh:
I think there’s about a hundred different active CLO managers out
there. How do you guys decide which aaas are the most interesting to you?
John:
Yeah, there’s actually about 160 CLO managers. About 30 or 40 of
those haven’t issued in the last couple of years. So let’s just call it about
120 actively issuing CLO managers. So you’re right, there’s a lot of CLO
managers. And so we spend an inordinate amount of time doing both qualitative
and quantitative analysis on the CLO managers. We haven’t met with all of them,
but probably about 80 or 90 at this point. And we’ve definitely met with the
managers whose CLOs we’re buying. And so it’s sitting down with these managers
at conferences face-to-face or having calls with them. And principally what
we’re trying to find out there is how experienced is their team, how large is
their team, who owns them, how safe the ownership structure is. Obviously we
don’t want to be buying CLOs from managers that aren’t going to be around in
the next couple of years, how much they buy their own equity, how much skin in
the game they have, and then really how they look at risk If we have a
dislocation, are they first to sell to reduce risk or are they looking as that
as an opportunity to add risk?
And so there’s all sorts of
profiles of CLO managers. Some are more equity-friendly. That usually means
they’re managing more for the equity. They own a lot of the private equity type
CLO managers would fall into that classification. And then you have other CLO
managers that are more debt friendly, maybe don’t take as much risk. Some of
these CLO managers come from money managers or insurance companies. And so
doesn’t mean we won’t buy equity-friendly managers, but we have to be very
comfortable with the way they manage risk. And then obviously we could talk a
whole podcast on our quant screens, but we’re basically taking a look at, we
probably have 30 different, maybe even more type metrics that we’re looking at
over the portfolio, how many CCCs, how many second liens, what the rating of
the overall portfolio is, and we’re constantly monitoring that. So really just
to make sure that what the CLO manager is telling us is actually what we see in
the data month to month.
Shiloh:
Would you say a debt-friendly CLO manager is one where the spread
on the loan portfolio is low and maybe there’s a 5% bucket to buy second liens
if they want, and maybe a debt-friendly manager doesn’t take advantage of that
and then post the period ending, some managers are going to be a lot more
aggressive in terms of reinvesting unscheduled principal proceeds while others
are not. Are those the distinctions you would use to comp equity versus debt
focused managers?
John:
Those are all part of the equation for sure. There are others as
well. But basically to sum it up, it’s an equity friendly investor tends to
just take more overall risk in the portfolio, whether it’s second liens,
whether it’s CCCs, whether it’s just the overall, what we call WARF or weighted
average rating factor of the portfolio, how aggressive they are in
dislocations. Now, again, I don’t want your listeners to get the idea that if
you’re an equity focused investor, you’re way over your skis and not doing a
good job for your investors or vice versa. There are very good equity focused
investors, there are less good debt focused investors. So it’s a little bit of
a classification that you got to be careful with. But that being said,
obviously if two CLO managers are very similar in many respects besides that as
far as team and experience and track record and size and liquidity and
obviously spread or pricing, we’ll probably be more inclined to buy the debt
friendly. And people might ask, well, why is that? Why are these two type of
managers exist? And quite frankly, if you are private equity-sponsored, their
equity or their return target or hurdles are probably higher. It’s probably
mid-teens, right? If you’re more of an insurance company, maybe out of your
equity you only need eight or 9%. So different sponsors have kind of different
return hurdles and that’s just how the market is fragmented right now.
Shiloh:
So in the primary market, I think top tier AAA and actually maybe
better than me, but I think it’s like three months. SOFR plus, is it like high
130? Is that what you’d say?
John:
Yeah, that’s about right. 135 to 140 is kind of the range right
now.
Shiloh:
Does it ever make sense for you
guys to not be in the top tier if you’re not in the top tier for AAA? I mean
you might pick up another 10 or 15 basis points and in that case you’re in a
manager whose shelf maybe isn’t as liquid or it’s a platform where they’ve
issued the less CLOs or maybe they have a new management team. Does it in
general make sense to kind of stretch for that extra yield in the AAA or do you
guys kind of hew to the most conservative established managers?
John:
So your listeners might get frustrated on some of these answers.
Most of ’em, it depends, right? So there is a tradeoff there. I think that’s
very important. But I also think it’s important to define what we mean by top
tier. And most people divide the CLO management group into three different
tiers, one, two, and three. And a lot of people have misconception that if
you’re in tier three you’re not a very good CLO manager. And that’s just not
true. It really stemmed from the fact that the Japanese CLO investors, these
large banks, including Norinchukin, has been in the news recently have an
approved list of about 40 or 50. No one knows for sure CLO managers. And if you
made that approved list, you’re kind of automatically top tier. These are
usually the bigger managers. The ones that have the most deals outstanding,
have the longest track record.
That’s what gets the Japanese investors comfortable and that’s
what makes top tier, Tier two can be a little less track record, a little
smaller things of that nature. And then tier three are usually newer managers
have been around only for a couple of years. There are very good top tier three
managers. There are less good tier one managers. So it really just depends. But
to answer the question, JAAA is about 65 to 70% tier one managers, whereas the
overall index is about 50 to 55%. So we are definitely overweight top tier
managers, and you’re right that you get maybe less spread, but you get a lot
more liquidity. So we are overweight top tier, but we do look for those
opportunities in tier two or tier three where we really love the manager and
then we’re getting a wider spread. So we take that trade off very seriously and
it’s a way to add value to the portfolio.
Shiloh:
So you mentioned preferences in the docs or the CLOs governing
document, the indenture from the perspective of somebody who invests in CLO
equity, things I would care about would be flexibility to reinvest after the
reinvestment period ends. We’d also like favorable language around the par
flush
Disclosure AI:
Note. A par flush can occur when the CLO begins its life with more
loans than required by the indenture. The excess loans can be distributed to
the CLO equity early in the CLO life.
Shiloh:
And I assume that you would be on the exact opposite side of both
of those debates, but what are some preferences that you guys have?
John:
Yeah, I mean those are both very important and this really gets in
the weeds, but I think one of the big topics that have been out there is these
liability management exercises. Instead of firms just going bankrupt, a lot of
times they try to work with their, and these are firms that are using the
leveraged loan market. So if they get into difficulty, oftentimes they to
manage out of that instead of just declaring bankruptcy. And there are
different things they can do as far as priming the current investor group. That
just means issuing new loans that are senior to the current loans. And
oftentimes CLO managers have a hard time just based on the CLO docs
participating in some of those exercises. So if they’re not able to, they
really have two choices. They can be in a situation where their debt actually
now is layered to new debt, which you don’t want, or they just have to sell the
loans at a very distressed price, which they don’t want to. So some of the docs
now allow for CLO managers to participate in some of these investor groups up
to a certain extent. And we think that’s actually a positive, right? Because it
allows them to kind of do what’s best for their end investors, which ultimately
are us. So that’s one very topical point right now you’re going to hear if you
haven’t already a lot more about that in the coming months and years.
Shiloh:
So you can buy bonds in the primary or the secondary. So is the
way you think about that, that an attraction of the secondary is that you can
buy bonds and they close T plus one
Disclosure AI:
Note T plus one refers to a trade settling one day after the trade
date, that’s when cash is exchanged for the security,
Shiloh:
But might be harder to source. Whereas in the primary market, a
lot of times you’re going to make a commitment and the bond’s not going to fund
for five weeks, it might be T plus 20 or something like that. Is that kind of
how you see the trade off there?
John:
Yeah, that’s exactly right. But the other part of the trade-off is
secondary bonds tend to trade tighter. Some of that is the fact that some
secondary bonds have shorter weighted average lives. And in general, if you’re
buying a bond with a shorter weighted average life, you’re lending money for a
shorter term. So it should be a tighter spread. But generally secondary bonds
because of this in the CLO market, this dynamic you just mentioned, T plus one
versus T plus 20 or 25, secondary bonds tend to trade tighter. So we’re
constantly evaluating that trade off. Is the secondary market so tight that it
makes a lot more sense to buying in the primary market or vice versa? At this
point, JAAA in particular is big enough. We’ll probably always be buying some
bonds in the primary market just to have that certainty of the pipeline of
being able to put the cash to work. But we’re also constantly looking at the
secondary market. People who don’t invest in the market on a day-to-day
wouldn’t know this, but there are bid lists, other investors, other banks,
other money managers constantly selling. We’re constantly involved in those bid lists to see if we can pick up
secondary CLO bonds at very attractive spreads. So that’s really the trade-off.
Shiloh:
So one of the things we’ve seen develop over the last year or so
is that there’s very short AAAs, like a refinance where there’s maybe a year or
so to go on the reinvestment period and those price well inside of new issue.
Is that something that’s interesting to a fund like yours or do you prefer the
wider spread and the longer reinvestment period deals?
John:
It also depends on the dollar price of the CLO. So most people
that are listening probably understand that the typical structure for a CLO is
a two year no-call five-year reinvestment period. What that means is when the
CLO is issued, it can’t be called for two years. And then if a loan matures or
is paid off, the CLO manager can reinvest that cash into a new loan after five
years. There’s a limited ability to do that. But in general, at that point, the
AAA start amortizing down and usually a deal is either called or refi or reset
pretty soon thereafter. So what you have to be very cognizant and this decision
changes a lot depending whether the market is mostly at a premium or mostly at
a discount, right when it’s at a discount. You love those kind of short
weighted average life going into or coming out of reinvestment period, starting
to amortize because you think the deal’s going to get called. And if you’re
buying it at let’s say 97, 98 cents on the dollar, you’ll get your money back
when the market’s more at a premium, you have to be very careful of that. So
it’s really an individual bond case by case basis. Right now the market’s
actually kind of right in the middle. It’s mostly right at par. So it really
just depends on the overall spread and the comparison. I would say right now
we’re more interested in the longer weighted average life, wider spread primary
market,
Shiloh:
And then in middle market CLOs, the AAAs, their price at around 30
basis points above the spread on broadly syndicated. Is that interesting to you
guys at all or do you prefer the larger broadly syndicated CLO market?
John:
We definitely prefer the BSL market. The middle market CLO market
kind of had a moment last year when issuance, which normally was five to 10% of
the BSL market, all of a sudden became 20 or 25%. This is just because there
were a lot of leveraged loans out there that were having trouble refinancing in
the BSL market and the private credit market came around to kind of help with
that. But the problem is the private credit market really hasn’t gone through a
massive dislocation covid, a lot less transparency, a lot less liquidity.
Usually it’s one lender, one borrower coming up with the docs and figuring out
the blending requirements. So you just don’t really know what’s going on under
the hood. And yes, they come with more spread and more credit enhancement and
more protections, but if we do get a large dislocation, a, you’re going to have
very little to no liquidity and you’re going to have higher defaults almost for
sure.
Leverage is higher in that market.
Debt service coverage ratios are lower, so almost for sure defaults are going
to be higher and no one really knows if the extra credit enhancement you’re
getting is going to be enough. So we have stayed away from the middle market or
private credit CLO market because for us, we think for our investors, liquidity
is paramount. Right now it’s a liquid wrapper, an ETF wrapper. We want to make
sure that our investors can get their money back if they want their money back.
We’ve had very large creates and redeems in this space. And in fact a couple of
weeks ago we had $400 million sell and we didn’t even get a redeem. So that
means somebody sold $4 million of J AAA and we didn’t see any outflow. And you
might say, well, how’s that possible? It’s because we’re constantly getting
creates at the same time.
And so the market makers were just able to offset that sell with
enough buys that we didn’t have to get a redeem. So bottom line is that’s a
great use case for our investors of how liquid this product and this market
actually is. But we know there will be a time we will have another C type
environment or GFC environment and maybe five years or maybe 10 years, but at
some point it’s going to come and we want to make sure that we have the
liquidity in the portfolio to meet any redemptions that we have and staying in
the more liquid BSL market as part of that strategy.
Shiloh:
And by the way, I would certainly agree the broadly syndicated
CLOs up and down the stack are going to be a lot more liquid than middle
market. But you did mention liability management exercises earlier. We invest a
lot in the middle market CLOs, and one of the attractions is just that there
really is not lender on lender violence there. There’s no, and so when loans
default, we’re expecting more of the kind of restructurings that we’ve seen for
the last 30 years. We’re not really expecting much to change, whereas broadly
syndicated, the loan recoveries really have been pretty poor for the last two
years or so.
John:
Yes, no, I totally agree. I don’t want your listeners to think
that I am really reigning on the parade of the private credit or middle market.
What you said is absolutely true, and there are some very good lenders there
that have done it a long time and know what they’re doing. And there’s probably
some very good credits there. I would just say again, there’s a lack of
liquidity and transparency and maybe hasn’t been proven through a more
dislocated market. But you’re right, some of these deals may be better, quite
frankly, in a dislocated market for the you just mentioned. But for the reasons
I mentioned, that’s why we’re sticking to the BSL market.
Shiloh:
So then AAA financing costs have come in really dramatically since
the spring of 2022. What do you think is driving that and should we expect the
trend to continue?
John:
There’s several things driving that. Interestingly enough, what
happened with Silicon Valley Bank just over a year ago now, and now the news
coming out of Japan with Nor Chuan is making both regulators and banks really
focus on their investment portfolio. I don’t think people necessarily know how
big some of these portfolios are, but look, banks bring in deposits and they
make loans and sometimes they can’t
make enough loans for all the
deposits they’re bringing in, so they have to buy securities to make up that
difference. And traditionally, banks have bought very high quality fixed
income, government debt, mortgage debt CLOs, but until this recent increase in
interest rates buying kind of long duration or treasuries kind of worked for
banks and then all of a sudden the thing goes, it worked until it didn’t and a
lot of banks got underwater. And so even though CLOs may seem a little more
complicated or more risky for a bank, they’re kind of the ideal asset class.
They’re floating rates, so they really don’t have to worry about
interest rate risks and they’re very high credit quality. And that’s why so
many banks are now trading out of their long dated treasuries and mortgages and
buying more CLOs. So that’s been a huge buyer. Money managers are buying more
and more. If we were talking six or seven years ago and we were talking about
who owned what money managers would be much smaller. They’re about a third of
the CLO market right now. They were much smaller back then, but the liquidity
has improved. And so money managers are using this as a tool for portfolio
management. And then quite frankly, it’s the CLO ETFs. If you look at the stats
so far, year to date, the net issuance of AAA CLOs is almost zero. That means there’s
been a lot of gross issuance, but there’s also been a lot of liquidations and
amortizations. So basically deals getting called or deals getting paid down to
offset that. And then you add on the 6 billion of AAA CLO ETF buying that’s
actually put to market in a net supply deficit. That means money managers or
other investors have to sell to make that up. And so you can never have more
supply than demand, but the demand continues to pays with money managers,
banks, and now the CLO ETFs and that is what’s driving in spreads.
Shiloh:
Let me ask you just specifically about CLO ETFs. Do you think that
there’s enough assets there that that’s a material factor in driving AAA costs
lower?
John:
I absolutely do, and I think it will continue. Now you might say,
well, where will that come from? I mean, I think supply will continue to
increase. So basically CLOs are just an arbitrage between where you can buy the
leverage loans, how much deal costs are, and then where you can buy the CLO
capital stack. And as AAA CLOs get tighter, that arbitrage gets better and more
created because the arbitrage gets better. So I do think that as spreads get
tighter, there will a be some motivated sellers at a tighter spread. But I do
think that we have only begun to tap the investor base when it comes to CLO
ETFs. I mean, we’re at 10 billion, we’re actually at 10.4 billion, but the
market’s just over 11 billion. I think this could be a 20, maybe even a 30
billion market. Like I said, there’s still 6 trillion in money market funds out
there. And so I do think it’ll be a very big market and I think the CLO
creation machine or the new issue machine will continue to ramp up and do
enough deals to feed that demand.
Shiloh:
Well from that perspective of a CLO equity investor, I’m certainly
sharing you on in terms of the raising assets and hopefully the result is lower
financing costs for the CLOs. So one other question is just around interest
rates. So does your fund pay a floating rate dividend and the expectation is
that when and if the fed cuts, the distribution yield will come down or how do
your investors think about it?
John:
I mean, in general, that’s definitely true. One thing people have
to realize is there will be a lag because CLOs are benchmarked to the three
months. SOFR rate, secured overnight financing rate, so they only reset every
three months. If the Fed cuts rates, things like repo rates will reset
immediately lower. It takes at least three to four months because the rate will
take three months to reset, and then there’s another month delay until they
actually see a lower distribution or dividend. So there is a delay. What I
would tell investors is, look, all indications the Fed has given us is they
probably will cut either later this year or early next year. It will probably
be only 25 basis points, and it will be very much a slow cut cycle. So we’re
not thinking it’s going to be 50 or a hundred basis points like we saw during
covid. So gradually your overall distribution yields will go down, but
currently you’re still about 50 basis points, higher yield than longer term
treasuries. So there’s a lot of reduction in that yield before you’re even
equivalent to what you’re getting with most corporate debt or treasury debt. So
I think the investors are still in a very good place.
Shiloh:
Okay. So are there any questions that I haven’t asked you that are
maybe topical for your fund or for the CLO industry in general?
John:
Well, I think when we’ve been out there talking to investors, we
always get the question about the GFC and CDOs, I guess because they’re both
securitized products, one letter different, both acronyms and the idea behind A
CDO isn’t that much different from a CLO, but what makes them extremely
different is the collateral that you use to build one. So a CDO is basically
subprime mortgages, most of which should have never been issued or created and
mostly given to people that probably should not have been getting those loans.
And so when the GFC hit and a lot of these people couldn’t refinance their
mortgage, and these subprime loans were a floating rate and the rates were
adjusting up and they couldn’t pay those. A lot of people we know in some prime
space, like 70% of people defaulted. So if you were creating an instrument that
was based on that subprime market, of course it didn’t perform well.
CLOs very different leverage loans have been around a very long
time, have been through all sorts of dislocations, have been through the GFC
and CLOs perform very, very well since then. A triple-A CLO has never defaulted
in the history of the market over 30 years. And a triple-B CLO even hasn’t
defaulted since the GFC. So these instruments are time tested, very safe. They
don’t have anything to do with what happened with CDOs in the subprime market
during the GFC. And if you have other questions as far as we can walk you
through the math, like you said, the recoveries have gone down over the years,
but you still need something like four to five or even six times A GFC
environment for a AAA CLO to consider defaulting. If we were in that type of
environment, any other financial asset you owned would be in a much, much worse
position.
Shiloh:
So you mentioned that low default rate at triple B. I mean, does
that imply though that people would be better off taking a little bit more risk
and moving down the cap stack rather than investing in the triple A,
which, and I know they’ve never
defaulted, so everybody feels good about that, but would it make sense for a
lot of people to take a little bit more risk and maybe get paid for it?
John:
It’s a great question. It really depends on the investor. What I
want to emphasize when looking at JAAA versus JBBB, so JBBB invest mostly in
triple B CLOs is yes, you’re getting more yield. You’re basically going from
let’s say a six and a half percent to kind of an eight and a half percent
yield, but you’re taking on a lot more risk. Whereas a triple A CLO is only
slightly riskier than cash, maybe one or 2% volatility. Triple B CLO probably
has four to five times the volatility of a triple A CLO. So you’re getting to
the point where it’s kind of like an equity type volatility. And so some people
are fine with that, particularly if you are very confident that we’re not going
into a recession or a very constructive on the overall economy and corporate
market. But that being said, you have to understand, if we go into a covid type
experience, that type of product could be down 10, 15, even 20%. Now you’re
getting an eight and a half percent yield to offset that. But we want investors
to understand what they’re signing up for because the only dissatisfied
investor should be a surprised investor and we don’t want people to be
surprised. So if that extra yield is worth it to you, by all means we think
it’s a great product. I own it myself, but if that’s too much risk for you,
then stick with JAAA.
Shiloh:
And so what’s the best way for an investor to find out more about
your funds?
John:
JanusHenderson.com or you can search on JAAA or JBBB. We have our
fact sheet on there. We have all sorts of information on either ETF, but that
is the best place.
Shiloh:
Great. Well, John, thanks so much for coming on the podcast.
Really enjoyed our chat.
John:
Yeah, same. My pleasure and great questions. Really, really
enjoyed the conversation.
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 investment or
potential investors in any Flat Rock Global fund.
AUM refers to assets under management
LMT or liability management transactions are an out of court
modification of a company’s debt.
Layering refers to placing additional debt with a priority above
the first lien term loan.
The secured overnight financing
rate (SOFR) is a broad measure of the cost of borrowing cash overnight,
collateralized by treasury securities.
The global financial crisis (GFC)
was a period of extreme stress in global financial markets and banking systems
between mid 2007 and early 2009.
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 AAA is the highest credit quality. A C or D, depending on the
agency issuing the rating, is the lowest or junk quality. 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 spread is the
percentage difference in current yields of various classes of fixed income
securities versus treasury bonds or another benchmark bond measure
ETFs are exchange traded funds.
Offset is a refinancing and extension of A CLO investment.
The Bloomberg US Ag Index is a broad-based flagship benchmark that
measures the investment grade US dollar denominated fixed rate taxable bond
market.
JAAA and JBBB are the tickers for the Janus Henderson CLO Triple A
and CLO Triple B ETF.
For the risks of investing in these funds, please see
janushenderson.com.
RMBS stands for Residential mortgage-backed securities.
Non-Agency mortgages are mortgages not owned by a government
agency
CDO or asset-backed security is a securitization backed by
collateral that is not first lien corporate loans.
General Disclaimer Section
References to interest rate moves are based on Bloomberg data. Any
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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
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subject to change without notice, projections should not be considered a
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represent the views of the firm as a whole.
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Disclaimers regarding JAAA and JBBB:
This is not an offer for any of the funds mentioned in the interview. The returns quoted for JAAA and JBBB are past performance and do not guarantee future results; current performance may be lower or higher. Investment returns and principal value will vary; there may be a gain or loss when shares are sold. For the most recent month-end performance call 800.668.0434 or visit
janushenderson.com/performance. Janus Henderson Investors US LLC is the investment adviser and ALPS Distributors, Inc. is the distributor. ALPS is not affiliated with Janus Henderson or any of its subsidiaries.