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 Stephen Anderberg, the sector lead for US CLOs at Standard and Poor’s Global Ratings. We discuss how CLOs are rated, and trends in upgrades, downgrades and defaults. The Federal Reserve cut interest rates by 50 bps on September 18th, so we discuss how that is expected to move the CLO market. We also discuss how CLO ratings have performed relative to the more well-known corporate rating system. Many of the securities we discuss are rated speculative grade or “spec grade” by S & P, which means not investment grade, or more specifically, that’s when a borrower has the ability to repay but faces significant uncertainties, such as adverse business or financial circumstances that could affect credit risk. That’s according to the S & P website. If you enjoy the podcast, please remember to share, like, and follow. And now my conversation with Steve Anderberg. Steve, thanks so much for coming on the podcast.
Steve: Shiloh. Thank you very much. Really appreciate the invite and I’m looking forward to the conversation.
Shiloh: Likewise. Why don’t we start off by just going through your background and how you ended up as a CLO ratings analyst at S & P?
Steve: So my current role at S & P is Sector Lead. I’ve been with S & P now for 25 years and before that worked with the city of New York in the Office of Management and Budget. Within S & P, I’ve always been with structured finance. I started in ABS surveillance back in August of ’99 looking after the ratings of collateralized bond obligations. And from there pretty quickly started working on CLOs, which at that point I think literally had six transactions outstanding, something like that. From that I’ve seen the CLO market evolve and grow through the 1.0 era, before the financial crisis, and the 2.0 era that followed. And obviously today it’s a trillion-dollar asset class and the core part of most investor portfolios, and structured finance investor portfolios.
Shiloh: You were rating CLOs in 1999, is that right?
Steve: I was in the surveillance group, so doing the monitoring and rating changes on collateralized bond obligations, which actually did see a lot of rating changes. And then the CLOs, which really didn’t.
Shiloh: I was just curious because I started on the buy side working for CLO managers in 2000. So like you, I’ve been around since the very beginning and seen this and experienced this huge growth.
Steve: It’s been amazing to see it evolve from a bank loan market and then to grow into a trillion dollar market that we have today. It’s really astonishing.
Shiloh: Agreed. So Steve, how are CLOs rated?
Steve: The CLO ratings at S & P are built on a foundation of the corporate ratings, and by corporate ratings, I mean both the fundamental credit rating assigned to the company, a single B minus, double B minus, whatever it is, and then also a recovery rating that’s assigned to each loan in the collateral pool. And in BSL CLOs, something like 98% of the collateral carries a public rating and the company rating is used to infer a likelihood of default in the modeling. And the recovery rating obviously is used to infer the recovery assumptions in the cashflow modeling. So when we look at a CLO, when we rate a CLO, we put the portfolio into our credit model CDO evaluator, which simulates default rates for portfolios that are commensurate with our different rating levels. And then it provides something called a scenario default rate at each CLO tranche rating level. And you can think of these as the scenario default rates as our hurdle rate at each rating level. So for example, within a typical BSL CLO collateral pool, if you run that through the model, you might get a scenario default rate of say 68% at the AAA rating level, which just means that for a tranche from a CLO to be rated AAA, that’s collateralized by that pool of assets, the tranche is going to have to be able to withstand 68% of the collateral defaulting over the life of the CLO without the tranche missing any interest or principle.
Shiloh: So each loan has its own probability of default and also the loans have some correlation with each other. So they’re in different industries or similar industries. So you’re running simulations through the loan pool and just trying to figure out what the AAA and AA survive, and then that ties back to the actual ratings that you give. Is that how to think about it?
Steve: That’s exactly how to think about it. With the one caveat that we’re not looking at the debt rating, we’re looking at the company rating. And the reason for that is that the debt ratings get notched up and down based on the recovery prospects. So a senior secured loan is typically going to be one or two notches higher than the company rating, and we already capture recovery elsewhere. So we look at the company rating across our CLO analysis.
Shiloh: So when a CLO is coming to life and it’s not maybe getting the ratings that it is targeting, the solution to that is either to have more equity or to have a more diversified pool of loans, or a higher rated pool of loans. Are those the options?
Steve: You could either rejigger the collateral pool and maybe put some higher rated assets in, or you could change the capital structure on the CLO to make it work under the methodology. One thing that’s nice as an asset class is that the models are available externally, including to the arrangers. So for the most part, when they’re submitting a transaction to us, they have an idea of what’s going to work and what’s not going to work, so we don’t have to go back and forth as much.
Shiloh: And then one of the things I’ve noticed that maybe wasn’t intuitive to me right away was just when something’s rated AAA and sold as such through banks, a lot of times it seems like the rating agencies would actually be willing to provide more leverage at the AAA or AA in that it’s actually the cap on how deep the attachment point is, actually comes from end investors, not the rating agency.
Steve: That is true up and down the capital stack that sometimes you end up with a tranche that could pass at a higher rating level that’s going out at a different rating level. And then it could be based on investor preference. There’s also you need a cushion in place. You’re not going to want a AAA that goes out and has a very tight rating cushion, both for just downgrade prospects of the tranche itself or tranche rating, but also because the manager does not want to get cut off from trading if they fail their CDO monitor test, which affects reinvestment. So they want some cushion in place there.
Shiloh: So nobody wants to have ratings that are close to where they would be potentially downgraded if the CLO has some missteps. And then at Flat Rock, we’re an investor both in broadly syndicated CLOs and middle market CLOs. How does the rating approach differ between the two?
Steve: It’s a really good question. Middle market CLOs are an area that’s seen tremendous growth over the past several years. In the aftermath of the GFC, it was typically, if you look at the overall issuance, it was in the maybe high single digits and then after 2016 it bumped up a little bit. Now it’s more like 20% of total CLO issuance. We use the same criteria for both BSL CLOs and middle market CLOs. There are a lot of structural and collateral differences between the two that get captured in the quantitative modeling. There are two key differences though from a rating approach, even under the same criteria, both having to do with the assets. So if you look at BSL CLOs, probably 98% of the assets carry a public rating. In middle market CLOs, that’s not the case. The majority of the assets are not rated and yet to run CDO evaluator, you’re going to need a rating on for each company in the portfolio. And so for those, we do credit estimates, which are basically, for the CLO manager’s purposes, just an estimate of what a rating would be if the company had a rating, and they could use that in their management of the CLO, and we could use it in our analysis. So credit estimates instead of ratings. And then the second difference is recovery assumptions. The spec grade public loans have a recovery rating tied to them that guides the recovery assumption, the CLO modeling, but the credit estimates don’t come with that. So there we have a standard table for recovery assumptions. So you have one set of assumptions, senior secured, non cov-light loans, and other set of assumptions for senior secured cov-light loans and so on down the stack.
Shiloh: So for middle market loans and for broadly syndicated loans that are going into CLOs, either way they get rated, just the question is whether or not it’s a public rating available to all market participants or it’s a less formal process, the credit estimate that S & P also does.
Steve: In order to do the analysis, you need a rating or estimated rating, implied rating on every company in the portfolio. It doesn’t work without that.
Shiloh: So how has your ratings framework changed over time?
Steve: The criteria does not change that often. It changes when our view of the fundamentals changes. So we did a really big update in September of 2009, which affected almost all the assumptions within the criteria, the assumed default rates, recovery rates, correlation, and a host of other things. If you look at the 1.0 CLOs, you could get to a AAA rating with maybe a 26% par subordination. But then coming out of the GFC, in part because of rating agency changes, in part because of market changes, it was more like mid- thirties now. So the criteria change of September of 2009 was part of that. Just required more par subordination to get to a AAA. And then after that there was a smaller update in June of 2019, which is to take into account the totality of data from the last of the 1.0 transactions, which were paying down at that point.
Shiloh: So it sounds like, since the GFC, that to get the ratings that CLO investors want, there has to be more par subordination, or really equity, really at each level. So the AAA has more equity supporting it and the double A same all the way down the stack. So that’s beneficial. Obviously, you know we’re an investor in double Bs, so double Bs get more equity, that’s great for them, it means lower probability of default. But given how CLO securities performed through the GFC and beyond, why was it necessary to make your modeling assumptions or your framework more conservative from the perspective of the debt investors?
Steve: Given what we were going through at that point and the data we’re looking at during the GFC, we were rethinking how correlated pools of credit might perform under different stressors. So we revisited the criteria based on that, and there was a lot that came out of it. The modeling assumptions became more punitive, especially at the higher rating levels, especially for AAA. Should point out, by the way, CLO AAA has performed really well in the history of the market. There’s never been a AAA default, but the criteria change did require more subordination for those. And there are other changes as well in terms of what we expect to see in the CLO transaction documents and other things. All just making sure the ratings produced and the criteria would be commensurate with the economic environments we thought they should be able to survive.
Shiloh: The Fed has been in a hiking cycle. How has that affected CLO ratings?
Steve: Given the 50 basis point rate cut on September 18th, this is obviously a timely topic. The key issues looking forward are going to be the path of interest rate cuts, but also what happens with earnings growth in the spec rate corporate space. The rate cuts this week provided a tailwind for leveraged loan issuers since they’ll be devoting less cash interest payments and able to use it for other things, including investing in future growth. And if we were to end up in a situation where EBITDA growth turned negative, the rate cuts will provide some cushion there. So definitely at least a modest credit positive for CLO collateral. In terms of CLO issuance outlook, I think the impact of the rate cuts is a little bit more opaque. I’d be interested in your perspective as well here, but resets and refis are just going to continue to dominate issuance this year and maybe next year just given the overhang of transactions that are out there, that are outside the non-call period with spreads that are wider than current market spreads. For CLO new issuance, we think that insurance demand for floating rate product is going to remain very strong and that will have a benefit for CLOs in general. And anecdotally, we’ve heard that insurance companies have raised a trillion dollars in annuities, and that’s a lot of dry powder to deploy into the CLO market. And Japanese banks, the ones we’ve spoken to, remain well positioned to continue to buy CLOs. So between those two things we think that would be supportive for CLO issuance next year.
Shiloh: One of the things that has surprised me about interest rates and the market reaction is just that if you would’ve asked me in 2021, and broadly these syndicated CLOs were printing at, call it, there’s a LIBOR back then, but 115 basis points over was where some AAAs were getting done. And as the Fed started hiking, actually the spreads on AAAs went wider. And I would’ve thought people would be clamoring for AAAs because the higher base rate the return offered was higher. But actually the market reaction I think was twofold. It was banks sensing, potentially, the beginning of a recessionary period just were putting the brakes on buying new AAAs, one, but also because the base rate was higher, a lot of investors just didn’t want to take the extra risk and earn the AAA spread over LIBOR or SOFR for example. They were happy just earning the base rate. So now I think what’ll happen is, as the Fed lowers rates, I think what’s going to happen is people are going to be very interested more in the spread than they were in the past because the base rate isn’t going to be as high. And I think that’ll continue to put downward pressure on spreads, up and down the stack from AAA to double B. That’s how I think this is going to play out.
Steve: I think you make an interesting point, Shiloh. So I fully agree that to some extent at least investors look at the all-in yield on a tranche so that as the base rate becomes less a driver of that, they’re going to focus more on the credit spread. So that could push for wider credit spreads going forward or at least put a damper on further credit tightening. Spread tightening. It is interesting, there are other factors that drive all this as well. And you look back at 2021, which was, so far, the all-time record for new issuance, 185 billion of CLO new issuance. And in that case the banks were just flush with deposits from COVID stimulus checks and needed a place to deploy. The cash rates were very tight. So CLOs just offered an attractive spread above the base rate, and that’s just where a lot of the money went, and that’s just drove issuance for that year.
Shiloh: But I think I see it may be slightly different though. I think as the Fed cuts that actually spreads are going to continue to decline. And the reason is I think it’s maybe opposite of the theory. You’d be like, okay, well if the Fed’s cutting, I care about all in yield, so the spreads needs to be higher. But actually that’s definitely not what happened on the way up. On the way up, the Fed was hiking and investors were acquiring, at least for a while, more spread. So here I think what’s going to happen is AAA is going to be all the more interesting now because they’re going to need to earn it. They’re not going to be able to just take the base rate. So that’ll be more competition for AAAs and down the stack.
Steve: I think that’s true if you look at 2022 and 2023, which showed very wide spreads on AAAs and other tranches of CLOs, economic growth or lack thereof and fear of a recession just drives a lot of this. So maybe that would be the dominant factor in driving credit spreads going forward.
Shiloh: Prospects for recession definitely would be a big factor in there as well. So changing topics: The CLOs do have bond buckets, usually it’s 5%, the typical cap on bonds that can be put into a CLO, I think that’s the number. And a lot of times these are floating rate secured bonds, so they look a lot like loans anyways. But what are you seeing in terms of manager usage of bond buckets today?
Steve: Interesting question. So we thought with the rate cut, it was a good time to take a look and to see where we were. So obviously the addition of bonds to CLO portfolios is a phenomenon we’ve seen over the past couple of years as higher interest rates took hold. And there was really a way for managers to pick up part the cost of giving up some spread. And there was also a pretty substantial weighted average rating factor, a WARF benefit, since a lot of the bonds came from slightly higher rated issuers, in some cases a lot higher rated issuers, than the typical leverage loan issuer. So I think we’re at like 2% of total collateral. So still modest in terms of actual usage of the bond buckets, but if you look, the median WARF or SP WARF of the bonds is 2165 against a median WARF of the CLO collateral overall of 2,700. So that’s a pretty significant difference.
Shiloh: So the WARF is the weighted average rating factor, and that ties into probability of default for each underlying loan.
Steve: That’s exactly right for each of the underlying issuers. So a lower WARF indicates, at least from a rating perspective, a higher quality collateral pool. And if you look at the bond holdings, I think we just did a quick snapshot yesterday, 82% of them are from spec grade issuers, so it’s as expected, but 14% were from triple B issuers and then 4% actually came from single A minus or higher, which you don’t usually see those higher rated obligors within C collateral pools. It was just a phenomenon for the bonds.COVID stimulus checks and needed a place to deploy. The cash rates were very tight. So CLOs just offered an attractive spread above the base rate, and that’s just where a lot of the money went, and that’s just drove issuance for that year.
Shiloh: But I think I see it maybe slightly different though. I think as the Fed cuts that actually spreads are going to continue to decline. And the reason is I think it’s maybe opposite of the theory. You’d be like, okay, well if the Fed’s cutting, I care about all in yield, so the spreads needs to be higher. But actually that’s definitely not what happened on the way up. On the way up, the Fed was hiking and investors were acquiring, at least for a while, more spread. So here I think what’s going to happen is AAA is going to be all the more interesting now because they’re going to need to earn it. They’re not going to be able to just take the base rate. So that’ll be more competition for AAAs and down the stack.
Steve: I think that’s true if you look at 2022 and 2023, which showed very wide spreads on AAAs and other tranches of CLOs, economic growth or lack thereof and fear of a recession just drives a lot of this. So maybe that would be the dominant factor in driving credit spreads going forward.
Shiloh: Prospects for recession definitely would be a big factor in there as well. So changing topics: The CLOs do have bond buckets, usually it’s 5%, the typical cap on bonds that can be put into a CLO, I think that’s the number. And a lot of times these are floating rate secured bonds, so they look a lot like loans anyways. But what are you seeing in terms of manager usage of bond buckets today?
Steve: Interesting question. So we thought with the rate cut, it was a good time to take a look and to see where we were. So obviously the addition of bonds to CLO portfolios is a phenomenon we’ve seen over the past couple of years as higher interest rates took hold. And there was really a way for managers to pick up part the cost of giving up some spread. And there was also a pretty substantial weighted average rating factor, a WARF benefit, since a lot of the bonds came from slightly higher rated issuers, in some cases a lot higher rated issuers, than the typical leverage loan issuer. So I think we’re at like 2% of total collateral. So still modest in terms of actual usage of the bond buckets, but if you look, the median WARF or SP WARF of the bonds is 2165 against a median WARF of the CLO collateral overall of 2,700. So that’s a pretty significant difference.
Shiloh: So the WARF is the weighted average rating factor, and that ties into probability of default for each underlying loan.
Steve: That’s exactly right for each of the underlying issuers. So a lower WARF indicates, at least from a rating perspective, a higher quality collateral pool. And if you look at the bond holdings, I think we just did a quick snapshot yesterday, 82% of them are from spec grade issuers, so it’s as expected, but 14% were from triple B issuers and then 4% actually came from single A minus or higher, which you don’t usually see those higher rated obligors within C collateral pools. It was just a phenomenon for the bonds.
Shiloh: So it sounds like some CLO managers have bought high quality bonds, probably low coupon, but bought them at a discount to par. And that helps with the CLOs over collateralization tests
Steve: And just generally offset par losses that might’ve come from elsewhere.
Shiloh: And then one of the trends we’ve seen in the market really over the last two years is the rise of the liability management exercise. So I did a podcast recently with Drew Sweeney of TCW on this, but the LME is the out of court restructuring where the private equity investor that owns the firm and the first lien debt agree to some restructuring, which probably entails a haircut, the first lien lenders taking a haircut on their debt. How has the rise of the LME affected your business and your ratings?
Steve: So you’re right in pointing out that most of the LMEs have come from private equity owned or sponsored companies. There have been a couple with publicly owned companies as well, but one point I would make is that CLO portfolios are very diverse. The median portfolio has something like 300 obligors in it. So the impact of any one obligor in a collateral pool going through a liability management exercise is fairly muted. And we have noted, by the way, a difference in approach between the bigger scale managers, the higher AUM managers and the smaller managers, where the larger managers are more likely to leverage their scale and engage in the LME process and try to come through with a more positive outcome, something that’s more accretive to the recoveries. The smaller managers would be much more likely to sell and just get out of the situation because they may not have to scale to ensure they get our seat at the table.
Shiloh: And then what’s the trends in loan upgrades and downgrades, for example, today?
Steve: So the higher interest rates and slowing growth we’ve seen over the past couple of years have definitely put pressure on lower rated corporate borrowers, and, some of them at least, have been straining under the burden of higher debt service costs. And by late 2023, the downgrade rate for spec grade companies had risen considerably and peaked at three and a half downgrades for each corporate rating upgrade as of October of last year. And then it’s moderated a bit since, although it’s been choppy month over month. I think at this point most corporate loan issuers have adjusted to higher rates by cutting costs, deferring CapEx expenditures and doing other things. And then another benefit of the current market is that spec grade companies have been able to refinance or reprice their outstanding loans, in some cases cutting their interest expenses by 50 basis points or more. So they’ve got the benefit of two rate cuts just by refinancing their outstanding debt. So we’re definitely in better shape than we were, say, a year ago,
Shiloh: The Fed beginning to cut: Should we infer from that, that maybe more upgrades than downgrades are on the come here?
Steve: So you are absolutely right that the decrease in rates is going to create a tailwind for highly leveraged borrowers. And it will free them up, at least to some extent, from the burden of interest payments and allow them to redeploy that money into other things, including CapEx, which could benefit growth going forward. In terms of the ratings, it’s already largely baked in, and when the analysts look at a company rating, they’re taking into account the forward rates and taking it into account when it’s not in the ratings. So the very fact of seeing the rate decrease, unless something is to change in the path going forward that makes us change our assumptions, I don’t think you would see a large number of upgrades based solely on that.
Shiloh: So that was upgrades and downgrades for the underlying loans and CLOs, but what about upgrades and downgrades for CLO securities?
Steve: So we haven’t downgraded a AAA CLO tranche rating probably since 2012. It’s been a long time. It really takes a considerable amount of economic stress before that happens. And I took a quick look at the past four years, going back to the beginning of 2020, at what the CLO tranche ratings were doing. And obviously 2020, given the pandemic, the shutdowns, the impact on spec rated corporate issuers was pretty significant. And there were a lot of downgrades in the CLO collateral pools and the liability ratings follow. So something like 13% of BSL CLO ratings from S & P got lowered in 2020 and a lot fewer middle market ones, 1% middle market ratings got lowered that year, but every year since from 2021 onward, there’ve actually been more CLO tranche upgrades rather than downgrades. So I think it’s a pretty good record, especially given the level of corporate downgrades in 2022 and 2023. The CLO managers were able to reposition the portfolios in most cases and go out against the downside and just the structural mechanics protected the transactions and they’ve done pretty well in the course of a stressed economic period.
Shiloh: So transitioning from CLO upgrades and downgrades, the more important thing to me would just be defaults. So have we seen an uptick in CLO security defaults since the COVID period?
Steve: The short answer is not really. We’re just about to update a piece and show that we’ve had 61 CLO tranche defaults through both the 1.0 and the 2.0 era. But the asset class is large enough now that every year you’re going to see a small handful of double B tranches that might default. Usually these are, right now, what we’re seeing is transactions that originated before the pandemic and then suffered again in 2022 and 2023 and just weren’t able to cover, at least on a projected basis, the debt outstanding at the double B level. But 61 tranche defaults out of 18,000 or so rated tranches over the past 30 years is a pretty good record.
Shiloh: Agreed. So the default statistics that you just mentioned, how did those compare to the loan ratings? Does a double B CLO, is it comparable to a double B corporate, or how should we think about the ratings between the two?
Steve: The short answer is CLO ratings have done very well, and in every case, performed with fewer defaults against comparably-rated corporates. You have to be a little bit careful on how you do it, because fundamentally, if you’re looking at CLO ratings, they’re originated and then seven or eight years later, or maybe sooner if it gets reset or whatever, they’re not there anymore. With corporates, you have ratings outstanding for a long time, but Meredith Coffey from the LSTA published a piece back in July of 2022, actually using some S & P data and comparing the default rates for CLO tranches against the default rates for like-rated corporates. And if you take a look, for example, at double B, for CLO 1.0 transactions, the double B default rate for CLO tranches rated double B, it was something like 4%. For CLO 2.0, so far the double B tranche default rate has been well under 1%. And then if you look at corporate ratings over the same period, it’s more like 9%. So there’s a pretty significant difference between those two.
Shiloh: But you’re quoting there the cumulative default rates. How I would think about it is like an annual default rate. So if the cumulative, you said it’s 4% for the 1.0s, so maybe if they were outstanding for seven or eight years, call it eight years, then it’s a 50 bps default rate per year. And then for say the 2.0s, you said 1% cumulative. Well, how many years do you think those double Bs were outstanding for maybe five, something like that? So it’s 20 bps per year would be the default rate there.
Steve: Yeah, for an individual transaction, of course it’s going to be extraordinary, unlikely you’d see a default in year one. But if you want to look across the universe of tranches, you could look at it that way. Any way you stack it up, CLO tranche ratings come in pretty well below the comparable corporate ratings.
Shiloh: So one of the questions I’m frequently asked, I tell them, Hey, the double B default rate has been quite low, and their response is, well, are we on the precipice of a massive default wave? Is the future going be very different from the past and maybe embedded in that is the question about higher base rates. But I think your answer on upgrades and downgrades answers that question. If the CLO securities are, as you said, for the most part, upgrades is the trend, not downgrades.
Steve: That’s true. I mean, even during a stressed economic period, if you want to get a sense of how the CLO ratings might respond under different levels of economic stress, we actually publish a series annually, a series of stress tests, and the BSL iteration of that should be out this month or maybe early next month. We take all of the CLO tranche ratings and run them through basically four sets of stressors with successively more later defaults and successively bigger triple C baskets. And then we look at the impact for our rated universe of these stresses. So if you want to see what would happen to the double Bs, for example, under a scenario where 20% of loans default and the triple C baskets blow out to 40%, as unlikely as either of those things would be, you could do that.
So Shiloh, if I could ask you a couple of questions and turn the tables, how do you use ratings into your investment process or processes at Flat Rock?
Shiloh: We’re not really ratings constrained. So we own CLO equity. Obviously CLO equity is non-rated, so we’d like the CLO debt securities in the CLO to be rated well, but we don’t have a regulator, or a capital charge regime. Well, our regulator is FINRA and the SEC, but we’re not an insurance company or a bank where we need to maintain an overall rating or portfolio quality. So for equity, you’re not rating those securities, so we make our own judgements. And then for double B, your opinion on the credit quality of the note is certainly important, but we’re doing our own scenarios and work ourselves. So you said you’re for stress cases, we’ve got a bunch of stress cases as well, but at the end of the day, sometimes we would buy double Bs. That would be the weaker end of maybe where you guys would rate, and we would do that because they’re cheaper in the market and we think they offer good returns, and maybe they’re later in their life and they don’t need all the equity subordination that they might’ve had originally. If a double B is upgraded, which I don’t think we’ve seen too many of those, I don’t think it really matters that much in terms of trading level because… it’s funny. One difference in CLOs from other markets is that when a CLO security is issued as double B, I think the industry nomenclature just keeps it as double B. That’s where it was initially rated. That’s the part of the capital stack that it is. And if you guys upgrade it to triple B, I think people would continue to call it the double B. And if it was downgraded to single B, maybe somebody would still call it a double B, but acknowledge that there’s been some losses on the loan. Rating is a very important part of the market, but it’s really affecting, I think, especially the guys who are playing in the investment grade parts of the stack. So the AAA investor needs that rating for the bank, wants to make sure that rating is maintained through the life of the CLO. But some of the debt’s downgraded in one of our deals definitely means there’s been some par losses on the loans. But for us, that could just mean we bought the equity cheap in the past. It wouldn’t necessarily correlate to how we’re doing down the stack.
Steve: Interesting. And how constructive are you on CLOs just as an asset class, say going into next year, how do you see the combined impacts of rate cuts and either economic growth or lack of economic growth impact in the asset class?
Shiloh: So I think one of the things that will change now with the Fed beginning what we think is going to be this cutting cycle here is just that the relative attractiveness of double Bs has really been pronounced over the last two years. So the Fed hiked a lot, and you could get at least in, let’s talk about middle market CLOs for example, the yields on those securities, CLO middle market double Bs, have been in a 13% area. So a lot of people looked at that and said, Hey, that’s a great return. Why would I want to take first loss risk and be in the equity? So some of them made that rotation or that new allocation, and then now as the Fed cuts, the yields, the double Bs are going to be going down, one, and then two for CLO equity, the projected returns there are not going to look that different even though the Fed is cutting. And the reason is that I think most people who sit in my seat, they’re running an IRR calculation through the cash flows that the CLO equity is supposed to produce or is expected to produce. So there’s already baked into that a declining SOFR curve. So there’s already a budget there. If you’re buying equity today and you’re targeting mid to high teen returns, you’re budgeting for that decline in SOFR over time. Whereas for the double B, those payments are made quarterly and they reset quarterly and they’re going to be resetting lower, and that’s going to result in less cashflow to the double B. So my point in that is just I think you’re going to see a rotation out of double B; CLO equity is going to become relatively more interesting. And I think the two things that may benefit CLO equity here are that one, the lower interest expense burden for a lot of companies, it’s not going to matter. The loan’s money good, and maybe you’d rather have the higher base rate there, but some weaker borrowers in the market will actually benefit and have more cash, more liquidity, better interest coverage. And for CLO equity, that could mean a marginal difference in terms of default rate, more favorable to us. So I think that’s a potential benefit. And then the other part of that is, again, if you’re targeting mid to high teen returns for CLO equity, as the Fed cuts, other competing asset classes are going to offer lower comparative returns and CLO equity, the rates, we don’t see them coming down. So on a relative value basis, I think it’s going to make equity look more appealing than maybe it has over the last year and change.
Steve: Interesting.
Shiloh: Well, Steve, thanks so much for coming on the podcast. Really enjoyed the conversation.
Disclosure: 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 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. A reset is a refinancing and extension of a CLO investment period. EBITDA is earnings before interest taxes, depreciation, and amortization. An add back would attempt to adjust EBITDA for non-recurring items ETFs are exchange traded funds. LIBOR, or London Interbank Offered Rate, was repolaced by SOFR (Secured Overnight Financing Rate) on June 30, 2024
Delever means reducing the amount of debt financing High yield bonds are corporate borrowings rated below investment grade that are usually fixed rate and unsecured. Default refers to missing a contractual interest or principal payment Debt has contractual interest, principal, and interest payments, whereas equity represents ownership in a company. Senior secured corporate loans are borrowings from a company that are backed by collateral. Junior debt ranks behind senior secured debt in its payment priority. Collateral refers to the sum of collateral pledged to a lender to support its repayment. A non-call period refers to the time in which a debt instrument cannot be optionally repaid. A floating-rate investment has an interest rate that varies with an underlying floating rate index.
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