Day: July 18, 2024

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 titiers, 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 rate, 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 abov3 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 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 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.

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.

JAAA Fact Card

JBBB Fact Card