Shiloh Bates:
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 Alex Navin, Managing Director and CLO trader at Performance Trust. Alex and his firm are specialists in trading CLO equity tranches. We discuss what’s become a challenging year for CLO equity on multiple fronts: leveraged loan defaults are elevated and we’re seeing spread compression on the CLO’s assets. And CLO equity market rates of return are still wide. That has resulted in CLO equity trading at discounts, while other markets like the S&P 500 hit all time highs. We discuss the potential for Fed Rate cuts to improve the outlook for CLO equity as well as growth in CLO debt ETFs leading to more favorable CLO financing costs and higher CLO equity distributions.
If you’re enjoying the podcast, please remember to share, like and follow. And now my conversation with Alex Navin.
Shiloh Bates:
Alex, thank you so much for coming on the podcast.
Alex Navin:
Hey Shiloh, thank you so much for having me.
Shiloh Bates:
So why don’t you start off by telling our listeners how you ended up being a CLO trader.
Alex Navin:
I guess it’s really interesting. I was actually a mechanical engineer in school, and I think that generally as the Wall Street firms are doing some recruiting, they found themselves looking at folks with engineering and math backgrounds, particularly as it came to some of the more complex products. So, I ended up finding myself in the Citi rotational program for sales and trading, and the first desk that I ended up on was for CMBS.
Shiloh Bates:
So CMBS is the commercial mortgage backed securities.
Alex Navin:
Yeah, thanks for jumping in with the acronyms. We’ll probably have a bunch of acronyms as we go through the conversation today, and hopefully we can break them down. And then the second rotation that it did through that program was on the CLO trading desk, so that was the quick transition into that part of the career.
Shiloh Bates:
Okay, and how long have you been in CLOs?
Alex Navin:
So, basically in the CLO market for the last 15 years, and the Citi program was pretty amazing because it obviously gave me opportunity to find that part of the trading market that I felt most comfortable in or where I felt like I had something to add in terms of an edge or a market that really started to appeal to me. And, of course, after 15 years, I think that I consider myself incredibly lucky that I still love what I do and the market still finds its way to bring interesting challenges and interesting areas for growth. And I think the CLO market’s one of those things where we’ve seen it now, I think the market’s finally topped $1 trillion in size, and that’s basically tripled in size from when I started, and probably even bigger from when you started. And I think that that growth is a demonstration of the product. At the end of the day, I’m pretty much a true believer in the quality of the product, and I think that it’s just been a really amazing, really interesting asset class.
Shiloh Bates:
So how long have you been at Performance Trust?
Alex Navin:
Well, why don’t I go back a little bit because I think that the path to Performance Trust was interesting enough to talk about. I started at Citi and I was there on the trading desk for a better part of a decade. I ended up in London for a couple of years trading the European CLO book as well. But I spent a little bit of time on the buy side, an asset manager called Blue Bay, that was during [the] COVID crisis. And on the follow of that, one of my friends at the time and my current business partner now, Jared Gogek, he actually brought me a very interesting idea based on a couple of insights that he found during the COVID market sell off and all the complexity that came with that. But the really first big insight was that we should start our own broker dealer, and we should go out on our own and try to do something independent.
This came from a couple of observations that he made during COVID, which is one – that the dealer community had largely moved away from providing liquidity for CLO equity tranches. That was for a couple of reasons. One – that it was a lot more capital efficient for the broker-dealers to focus on trading debt. Two – it’s a lot easier for them to do it because it’s a lot easier to run CLO debt than it is to run CLO equity. So, what he saw was there was a real need for us to basically fill a gap in the marketplace, which is a couple of things. Jared’s strong suit was relationships. And I think that he has an amazing ability to connect clients with one another and give that type of high-touch client experience that I think most people in the CLO market were starting to miss as the market started to grow a lot bigger. And if you called a big bank, maybe you were getting a junior analyst or a junior salesperson who’s doing their best, but they don’t know the answers right away, and they have to get you on the phone with somebody else. And two, I think that you would have them being oftentimes very distracted, especially during COVID where there are so many bonds trading on any given day, you don’t get that high-touch customer service that you would’ve come to expect from when the market, when it was a lot smaller and a little bit more boutiquey 10 years ago. So we had this need, I think, to fill a gap in client service and making sure that clients felt like they were really being taken care of. And then two, there was my area of expertise, which is essentially providing accurate pricing, deep insights into structure, modeling of equity cash flows, and helping clients navigate a market where pricing is uncertain.
There’s not a lot of visibility, perhaps there’s a perception of illiquidity. So, this combination of being able to give clients the level of service that I think that they deserve, and I think that they’re all looking for, plus the ability to give them really accurate pricing insights and pricing guidance, was this, I think , gap in the marketplace that Jared identified and brought to me. And we ultimately ended up forming our team and starting a broker-dealer called Crosspoint that ultimately got merged into Performance Trust. Well, Performance Trust found our team and the little pod that we’d built, and ultimately brought us on and added us to their platform.
Shiloh Bates:
So, is it just CLO equity that you’re doing, or do you guys ever trade in BBs or up the stack?
Alex Navin:
Yeah, we’ll trade all across the stack. So, just because we have focus on CLO equity doesn’t mean that we don’t spend time on other parts of the capital structure. I think the business model, the focus on equity, again, came from our identification of this need in the market, but as you look through different market cycles and different market participants, there are folks who certainly on our client list who trade the whole cap stack. So, if they are investing in equity and they’re investing equally in AAAs for some of the other funds that they might manage, then it’s quite natural for them to come to us and for them to use our access to the markets and also our insights and again, our relationships to trade any particular part of the capital structure. It just so happens to be that we have, I think, a competitive advantage on equity.
And equally, I think that some of the dealers have a competitive advantage on, for example, trading AAAs. If you’re one of the really large money-center banks, you are going to have access to really cheap capital, really cheap financing, and you’re going to have simply more balance sheet resources in order to have whatever it is, $100 million, $200 million, $500 million of AAAs on your book that you’re willing to make 2-way markets on. We’re not in that position. That’s not our competitive advantage. And listen, I think that the market benefits from having those players there, and we’re certainly happy that those folks exist.
Shiloh Bates:
So when you guys are trading equity, how often are the trades directly with an asset manager versus the bids wanted in competition or auction processes that are common in the market?
Alex Navin:
So the bid wanted, we have this acronym, BWIC – Bids Wanted In Comp. It’s a really big part of the market now, and I think that there’s a really good reason for it, and I can just walk through the mechanism for a minute and I think it’s, for most people, the easiest way to think about it is essentially throwing something on an auction like eBay. And you want to get as many people to bid on it as possible. And ultimately you’re going to have, ideally, one buyer who is more motivated than all the others that are out there. And the only way to maybe identify that one buyer who’s got the highest motivation or the highest conviction to buy that bond is to put it out in competition and have everybody bidding on it. So, this is a mechanism that’s become incredibly popular. I would say that at least half or maybe three quarters of the volume for the CLO market now is being done on this auction mechanism.
I think that as the market grows, we’re starting to have some growing pains with that mechanism. And I think that those growing pains have been felt most acutely over really just [the] last couple of months, especially as it relates to CLO equity. And we can talk about that a little bit more, but one problem with having these auctions out there is that if there are so many of them that it feels a bit cumbersome to run all the bonds that are coming to market or coming to auction, then you tend to get less people focused on it. So, if you’re looking for that one motivated buyer, but there’s a hundred auctions out there, well clearly they can be a little bit more selective about what they’re actually going to try to buy. So, now we have this situation where there are so many auctions that are occurring at any given time that some of the focus is starting to be lost on who’s going to be actually providing liquidity for those auctions.
Shiloh Bates:
When somebody like us decides who they’re going to bid with in the auction processes. So, we bid with an Investment Bank or we bid with a Bank, and then one of the services you offer in advance of that is you put out price talk. So can you talk about how that process works?
Alex Navin:
Yeah, definitely. So we take pride in our price talk. I think that one of the things that we do is really unique is that we put out exact dollar price talk on CLO equity, and that was a calling card that I created back in Crosspoint. And I think that there’s, again, I’ve talked about this for a minute, but there’s this perception of illiquidity, or there’s this perception that CLO equity is harder to value than other tranches. And I think that there’s a lot to that. Of course, I think that there’s reasons why it can be harder to model, there’s reasons why it can be harder to analyze and why the price might seem harder to determine. But, one of the things that we think is really valuable to the market is to give people the views that we have about where some of these things should trade. And I think that the determination of those prices, it’s not necessarily rocket science, but there is a ton that goes into it, and there’s a ton of both art and science that I think goes into determining those prices. And I’m not sure if you want me to go a little bit into methodology or how we look at it.
Shiloh Bates:
Yeah, I think that’d be really interesting. I mean, one of the reasons I may have mentioned this to you before, that I wanted to have you on a podcast, is that we find your price talk to be very accurate. So yeah, I would love to hear more about how you do it.
Alex Navin:
Yeah, sure. There’s no simple answer, but I’ll go through two different, I suppose, angles of attack on this question while we’re on a podcasts – getting one of my favorite podcasts that’s out there is How I Built This, which is this podcast where Guy Raz interviews founders who’ve built companies, and I think the one theme that they always have is everybody feels like they have a bit of a component of luck that went into the way that they built their business. I think that my component of luck was cutting my teeth at Citi, and I talked briefly about my career there, but I think one of the big takeaways is that throughout the 2010s and into even current day, Citi was one of the biggest issuers of CLOs, and the consequences of that are severalfold. One: a lot of the investors demand, or ask nicely, or ask because they don’t have accurate pricing services from third party marks, they ask Citi for marks on all the equity that they’ve purchased from Citi.
So, as an analyst and as an associate going through my early years at Citi, one of my roles and responsibilities was providing month-end marks for all these equity tranches. And so every single month I would have to put a valuation on anywhere from 200 to 500 individual CUSIPs. And so, I would have to, let’s call it luck or let’s call it lack of luck, but I would have to clear up my weekends once a month in order to sit down and price out 200 to 500 equity CUSIPs. And, in the early days, that wasn’t really that trivial. I think that the software is getting a lot better, and this is going to be the second part of my conversation here, which is that the software has improved dramatically. But, back in the day, there was a lot of running these things manually and double checking the cash flows and making sure that the collateral was pulling in properly, everything was updated.
So, it was a lot of hard work. And I think that there’s no way to shortcut that hard work. So, I’m calling it luck, but my luck was starting in a place that gave me the opportunity to do that work. So, as I projected that forward, one of the things that I had to do was get faster at valuing all of these CLO equity securities and coming up with different methodologies in order to help triangulate prices very quickly. And I think that that basically pulled forward to today gave me this, let’s call it competitive advantage in the fact that I’ve probably run more CLO equity tranches than the vast majority of people in the market just because of the fact that I was sat in that unenviable role of running bonds every single month. So that’s the luck that goes into it, and I think that there’s just no real way to shortcut that kind of hard work.
But as we pull forward into today, I think that the software is advanced dramatically, and I think that now we have a lot of tools at our disposal that we probably didn’t in the prior generation. So, we’ll talk briefly about Intex. Intex is the dominant cashflow modeling software that is used in not only the CLO market, but also other structured credit markets, mortgage market, consumer, ABS, etc., (asset backed securities). But what Intex has now is a little bit of more advanced cash flow modeling, and now there’s wrappers on top of Intex. So there’s new software providers. The one that we use is called Valitana, and I’ll give a shout out to them because they’re relatively new in the marketplace, but they’ve developed a piece of software which I think is really, really incredible and enables us to shortcut a lot of the analysis that again, used to be done a little bit by hand.
And now we have the ability to do a lot of automated runs and a lot of the automated analysis that we might not have been able to do back in the day. Where back in the day, I was essentially doing [the analysis] by hand. So, what we’ve been able to do is we’ve been able to take a lot of the different inputs that we get from all the data sources we have available to us now, a lot of loan market data, and then again modeling of the cash flows. And we’ve developed a bunch of different scenarios that are dynamic in nature. So, when I’m looking at CLO equity, I’m looking at probably, just because I’m a human, I’m not a robot yet, I’m looking at probably 5 to 10 scenarios. I know there are certain people in the marketplace who take pride in the fact that they have 50 or a hundred scenarios that they look at. I think that maybe that’s a bit dilutive in terms of your ability to digest that type of output. So, what I try to look at is 5 to 10 scenarios that I think are most illustrative of both reality and future possible scenarios.
Shiloh Bates:
When you buy CLO equity in the primary from a bank, one of the services that you mentioned was that once a month they’ll provide you a mark, they’ll tell you what indicative price for it, but a lot of times, in my experience, the secondary CLO market is trading wider or at lower prices than the primary market. So, if you buy CLO equity in the primary and then have a trader like yourself market to secondary levels a month later, you might find a pretty significant depreciation in what you bought. So, how do you think about that dynamic?
Alex Navin:
That’s a good question. Basically, I think what you’re illustrating is there are two types of buyers for CLO equity. There is broad strokes. There are going to be funds who buy third party equity and then broad strokes that are going to be funds who only buy captive equity. So, what I mean by that is, the manager will buy their own equity in primary or they’ll come to the new issue market with an equity check already in hand. So, I think if you are a manager and you’re taking your own equity check, that’s not to say that the price of the equity and primary doesn’t matter, but in a way it’s not being determined by market forces. I think you’re creating this deal to create a fee stream and ultimately, the price of CLO equity will be determined by the secondary market at some point in the future. But, it’s not the reason these things are being created.
The reason that they’re being created is to take advantage of an arbitrage between the asset spread and the liability spread to generate cashflow to the equity. But ultimately, if you’re the CLO manager retaining your own equity, you’re more concerned about both assets under management, growing the size of your funds, and the fee stream that’s also being created. So, again, this determination of what is the price at primary for a deal like that. The price at primary might not really be that important or determined by market forces. Now, if you are somebody else who has the ability to buy equity in primary from any manager of your own choosing, of course you’re going to care about what the price is. And I think that determining the price in those types of CLO equity sale processes during the primary is going to be really important. And I think you’re going to find that those deals where there’s a bit of price discovery or syndication where the equity is getting sold to multiple investors is going to align more closely with what the secondary market price is than a deal where it doesn’t go through a price discovery process.
Shiloh Bates:
When I started investing in CLO equity, one of my biggest surprises was just that if you’re working with one bank, you can buy CLO equity in the primary and they’ll send you a bunch of modeling runs with projected IRRs in the mid-teens area and they’re assuming a low default rate and a good loan recovery rate and favorable reinvestments. And there’s 10 of these variables that determine the CLO equity return. Every variable is skewed to the most favorable way. So, it shakes out mid-teens again, call it. And then if you asked a trader at the same bank on the same day what their targeted IRR would be for the same exact security, they’d call it 9% or 10%. And they’d take all those variables, all the 10 variables, and they’d skew them on the conservative side and that’s what they’d be willing to pay. So I just thought that was a pretty comical dynamic.
Alex Navin:
There is a joke that goes amongst CLO investors, it’s if you don’t see a yield of 12-14%, you need to change your scenarios.
Shiloh Bates:
So, you mentioned you had a bunch of scenarios, but do you have one in particular that rises above all else like a 2% default rate and a 70 cent recovery, which I think is probably the most common?
Alex Navin:
So, I mentioned the software. I think that the models now are all a bit dynamic and I think that creates something that’s a bit more interesting. 2% CDR with a 70 recovery, so a 2% default rat.
Shiloh Bates:
The CDR is the constant default rate.
Alex Navin:
Yeah, so 2% default rate per year and a 70% recovery rate upon default is probably not the right way to look at it. It’s the standard runs for how you would look at CLO debt, but with CLO debt, it doesn’t really matter that much. You could dial that default rate up to 5% or you could dial that recovery rate down to 50% and you’re even still going to get the same, essentially cash flows. So your debt tranches are all going to look the same no matter how you run those scenarios. But for equity, it’s going to make quite a big difference. CLO equity, generally, if you have a $400 million CLO deal, the equity tranche is going to be 10% of the deal, so it’ll be $40 million. And this gives us what we refer to in the marketplace as 10 times leverage. So, if you have 1% of your CLO go bad and one credit goes bad, and that credit happens to be 1% of the deal, while it’s 1% of your $400 million deal, it ends up being 10% of your CLO equity tranche.
So, you have this 10 times leveraged effect for all of these assumptions. One of the cool things about the software that we have now, and it’s something that we had to do manually back in the day, is we can take the market data that we already know, which is where loans are trading, loan prices, and we can use that to essentially project forward what our default rate or expected default rate is going to be. So you’re going to have different CLOs with different collateral quality. You might have a CLO that has 5% trading below some type of price that you might determine to be distressed. And I think those price levels vary over time. But right now I think that everybody would say if you’re trading below 70, which is, again the recovery that you might assume in a basic scenario, if you have 5% of your portfolio trading below 70, then you’re pretty much going to anticipate that 5% of your portfolio is going to default at some point, or at least that’s what the loan market is telling you.
So, this now is one of the biggest inputs to running CLO equity, is you can actually use the market data that we already have, loan prices. You can plug that into the model to determine what your default rate forward is going to be. So, if I’m running two CLOs under the same, let’s call it automated scenario where one CLO has 2% below 70 and one CLO has 5% below 70. For the first one, I’m going to be running essentially a 2% default rate, and for the second one, I’m going to be running a 5% default rate. And what that does is it does a risk adjustment. So, I’m still, again, the joke is solving for 12 to 14% IRR, but with one deal I’m defaulting a lot more of the collateral and with the other deal, I’m defaulting a lot less. So that’s one of the ways that some of this automation of the software allows us to take market data in to make a dynamic model.
Shiloh Bates:
So, the idea there is that maybe it’s a 2% default rate on the loans overall, but those are really for par loans. And if a loan is already traded into the 80s or 70s, then you need to make an adjustment there. Obviously, that’s accredited higher risk, and I would assume that a loan trading at 70 would just, by your modeling, default at some point and recover 70. That’s how you would think about it.
Alex Navin:
Yeah, that’s definitely one way to think about it. These are things that I like to change over market scenarios and over different cycles as well, which is why one of the things that I try to do is I always try to have a scenario that I maintain relatively constant over the last, let’s call it, two years or three years. So I can go back and look at something how I ran it two years ago without having changed the assumptions or the model too much. And then I can create another scenario now that might more accurately represent what my view of the world is going forward. And I think what you were saying there was if a loan is trading at 70, it is distressed and it is likely to default. Is it likely to recover 70 or is it likely to recover something less, like 50 or is it likely to recover something more, like 80?
Obviously that’s not something that we can know. That’s something that even distressed traders who are trading these loans, they don’t know. But clearly there’s this assumption that there’s market efficiency and that the prices of these loans are telling market participants something about what that anticipated recovery is. But where I’m going with this is essentially that’s something that can be stressed and that is something that I actually like to stress often, which is ultimate recovery. And I think that we’ve seen recoveries drifting lower as liability management exercises are becoming more popular. I think that you’ve probably talked about these with other guests in the past.
Shiloh Bates:
I have. Those are the out of court restructurings that lenders are doing now.
Alex Navin:
Yeah, certainly. And I think that there’s going to be variable recovery on some of these loans. So, that loan might be trading at 70; one lender might get 80 recovery and one lender might get a 50 recovery. So these are things that can be stressed and these are things that I do like to stress in my models in order to determine the sensitivity really to that type of input.
Shiloh Bates:
So, let’s say somebody participating in BWICs recently that you’ve been involved with, they’re buying equity. What’s the targeted IRR they should expect in your opinion?
Alex Navin:
So, the CLO market, especially equity has had a bit of a tough year. And I think maybe we can just go back and talk a little bit about why, and maybe that helps frame some of this conversation now. But, I looked at the lev’d (leveraged) loan index, the Morningstar Lev Loan index, which is pretty widely tracked index of where levered loan prices, but also the underlying features of the loans. So, if I looked 12 months ago, in August of 2024, the average spread on the loans in that index was around 350. If we go to January of this year, the average spread on those loans was 340. And, if you go all the way to today, the average spread on those loans is 325. So all things equal, again, the loan index is trading roughly in the high-90s dollars price, but you’ve lost 25 basis points of spread on the universe in general.
And, these are what refer to as assets. These are the assets that go into CLOs that generate the return that CLO equity investors expect to receive. And the other side of the equation hasn’t really moved. So AAAs right now are roughly SOFR plus 130-135. They had a brief moment of glory in January this year where they’re trading inside of 120, but if you rewind to the same timeframe as what I was quoting on the lev loan index of August of last year, generally CLO AAAs were still SOFR plus 130-135. So ,you have this equation, there’s inputs and outputs, and so the input into CLO is the spread from loans, the spread from the assets, it was 350 going in and now it’s 325 going in. And, what’s going out is your 130-135 on CLO AAAs. So, basically you have less money coming in and the same amount of money going out and it’s 10 times levered.
So, the way that this works is if you have 25 basis points less spread on your portfolio, that works out to about 2.5 points less equity payment that you’re getting as an equity holder right now. And, it’s not just for one year, it’s for every year you’re projecting going forward. So, if you have a CLO equity tranche that has five year reinvestment period and two or three years of amortization, you’re getting two and a half points less cashflow this year and for every year out to seven years. Take a present value of that, it’s roughly 10 to 12 points. So if you started this year or you started 12 months ago with an equity tranche that traded at 75, for example, 75 cents on the dollar, you’ve lost 12 points present value of future cashflow. So, your equity should trade at 63 if you were wanted to keep the same IRR.
So, if you were running this thing at 15% IRR a year ago and you’re running it at 15% IRR today, you have lost 12 points of anticipated cashflow and spread. Now, there’s been a bit of a mitigating factor, which is that you’ve already received a bunch of cashflow in that period of time, so you’ve probably received 12 to 15 points of cashflow ideally through that period of time. And so, net-net, your IRR from a year ago to today should be zero. And I think that broadly that’s what people are looking at right now is saying, well, I’ve been taking all this risk in CLO equity, but over the last 12 months, my return has been close to zero, or maybe flat, or maybe phenomenally higher in certain situations, or maybe a decent amount lower in other situations. So, as we look at that, let’s call it the problem, the problem is that that’s not something that’s going to reverse.
This is not a scenario where, oh, prices have come down and therefore now the value is better. This is just a math problem. There is less money coming in and going to investors. So there isn’t really a case for the prices to return to a higher level unless you have the opportunity for CLO managers to add spread or to build par. Add spread, meaning buy loans with wider spread or build par, meaning buying loans with lower dollar prices, or you have a world where CLO AAAs end up going a lot tighter. So, you have to have pretty rose colored glasses in order to see why CLO equity at this stage has corrected to a point where everything is going to be different there where it was 12 months ago. I think in general, my view is that the worst of it is probably done, but that doesn’t really change the fact that we have less cash flows as equity investors right now.
Shiloh Bates:
Okay, but in this math problem, we have CLOs today are buying three quarters or so of leveraged loans out there, and if the CLO equity isn’t making good money, then this is like a closed system, then the CLO financing costs have to come down to make it profitable for the equity going forward or loan spreads, there won’t be demand for loans and loan spreads move wider. But, there isn’t a long run setup where the equity is putting in at-risk dollars and not making a healthy return.
Alex Navin:
I agree with that, and I think that maybe I have a couple questions for you in terms of where the fundraising landscape looks like for third party investing versus dedicated manager fund investing, because I think as much as I agree with you that this should be a self-correcting mechanism in the sense that if equity returns don’t look good, then people will not create CLO equity anymore. But do you see something different in terms of, in the private credit space, where you have maybe more rationality in terms of creation of these vehicles because you just won’t do it if the arbitrage doesn’t make sense or it’s a bit more opportunistic in terms of the assets they’re able to source versus the liabilities that they’re pricing in CLOs? Maybe they have different funding mechanisms other than just the CLO market?
Shiloh Bates:
Well, one of the real attractions of private credit CLOs is just the natural profitability is greater. So you might pick up 175 BPS in spread on the total loan portfolio, comparing private credit to broadly syndicated. But at the AAA, for example, which is the biggest financing cost, the delta there is probably today 25-30 BPS. So, just the private credit, just the cash flows you get from the CLOs is going to be much higher.
But coming back, so the problem for, and I guess you’re asking about private credit highlights , that it’s more of a broadly syndicated CLO equity math problem. But, if borrowers are refinancing tighter, how I would’ve thought of that in the past is that okay, so that’s negative for CLO equity cash flows, but at the same time, the economy is presumably doing well at a market where loans are repricing tighter, the capital markets are open. I should expect less defaults than my base case. But would you say that’s true today or no?
Alex Navin:
That’s interesting because this maybe pulls to a bigger question about the U.S. economy as a whole and the idea of how healthy are capital markets in general. And I think if you look at even just equity indices, maybe the S&P 500, all the money is being generated by the Mag 7 and Artificial Intelligence and all the various plays that come with that – infrastructure, energy, etc. But, if you look at a broader index like maybe the Russell with small caps, I think you’re seeing a lot of these companies treading water to some extent. They’re certainly not growing as fast and inflation is still here to some extent. So, I think it’s a question of are these companies growing fast enough to keep pace with inflation and therefore, are their stock prices going to be going up? Are they going to be mostly flat?
And the reason I bring this up is that a lot of these smaller borrowers are maybe much more representative of what you’d get in the Russell Index from a stock equivalency standpoint than what you would get in the S&P 500 from a Mag 7 standpoint. So, you have this universe where capital markets are wide open. There’s still this maybe hangover of a ton of liquidity that came from COVID and all of the programs that both were fiscal and monetary in terms of money that came into the system. So, yeah, there’s the ability for a lot of these borrowers to refinance at much cheaper rates. And of course the growth of the CLO market is one of the reasons why a lot of these borrowers are able to get such amazing, cheap financing. And again, from a fundamental standpoint, I think this is amazing.
I think that this is the ability for the US capital markets to be incredibly efficient and to allocate money to folks who are trying to grow the economy and folks who are employing Americans. And, let’s call it, the problem at this stage is that it’s not going to be a tide that lifts all boats. And I think you’re going to have different sectors where there’s going to be problems. And I think that the first thing that we saw when there was a little bit of a tariff tantrum today, everybody was going through their CLO portfolios and trying to decide which sectors are going to be exposed. Is it agriculture? Is it going to be the equipment? Manufacturing? Where is it that there’s going to actually be economic sensitivities? Because in general, financing costs are cheap and money is cheap, and it feels like it’s really easy to refinance your loans tighter and tighter and tighter. But I don’t think that’s going to solve the problems for everybody in the universe. And I don’t think we’re going to have this 0% default rate. I think that in general, if you look 12 months ago and 12 months forward, you’re probably closer to 4 or 5% defaults, including LMEs because you’re going to have credits that are still running into growth problems.
Shiloh Bates:
Well, it’s one of the key issues because people, I think look at CLO equity as potentially an alternative to the S&P 500 or to other equity exposures. And the reality is the S&P 500 is driven by seven stocks. So, in our asset class, we care about the health of every loan. And if a loan does really well, well that’s not great either. They just refinance out of your market, so you have to care about everybody. And the economy has become a little bit of a, it’s not this rising tide lifting all boats. Some companies are doing really, really well.
Alex Navin:
Yeah, CLO equity is for sure a trade for Goldilocks scenarios, and if the market is too hot or doing too well, you’re going to get this negative convexity effect with so much loan repricing. We’ve just seen that over the last 12 months. But there’s certainly times when you’re able to clip this steady arbitrage and you’re able to have this advantage where you’re getting tons of cash flows that you can reinvest that makes CLO equity an incredibly attractive asset class. It’s not every year. You wouldn’t ever expect it to be, you think you’d expect prices to go up, prices to go down, but this last year has obviously been challenging. But this doesn’t mean that the asset class doesn’t make sense.
Shiloh Bates:
But in your, back to the math problem again, so if you lost 25 BPS on your assets and you don’t have any cost savings, CLO financing rates are the same. This is year over year, August to August, and we’re recording this August 22nd, by the way. So then, going forward, should somebody assume that we’ll lose 25 BPS on the assets again and not have tighter CLO or better CLO financing rates?
Alex Navin:
Well, I wish I had a crystal ball, but here’s a couple of things that I’m thinking about as we’re heading into the fall here and as we’re heading into the potential for maybe a rate cut, which obviously President Trump’s pushing for pretty hard. I think that there’s this real possibility that if and when rate cuts come, the floating rate assets and CLOs float against three months SOFR and so do the liabilities. So we have both liabilities and the assets floating against three months SOFR. And three months SOFR, for all intents and purposes, is going to track pretty closely with fed funds. So if we have some interest rate cuts, you’re basically going to have pretty direct impact on the interest income for both CLO assets, loans, and liability, CLO tranches. So, I think if you are maybe an insurance company or maybe just an asset manager, a mutual fund, or maybe you’re buying the loan mutual fund because you like floating rate assets, which certainly makes sense in an inflationary environment, you like to have some floating rate assets that are going to protect you to some extent against inflation.
And in the fall you have that floating rate come down and start to float down. Maybe you’re going to start to rethink about buying that floating rate loan at SOFR plus 250. And I think maybe you’re going to think about allocating towards fixed rate assets that aren’t going to be having that compression and income, especially if you’re a longer term investor. If you are an endowment or a mutual fund or you have the ability to take duration risk and you’re happy with 10 year, 20 or 30 year duration risk. You might be more inclined to go buy something that’s not floating than something that’s fixed. So, that’s one, let’s call it potential mitigant of continued spread compression on the loan side.
Shiloh Bates:
Well, again, so if I’m losing 25 BPS on the assets and not saving anything on the CLO financing costs, isn’t it true that the CLO begins its life, it goes two years, it gets through the non-call period, and let’s say CLO financing rates haven’t declined. Isn’t it the case that still we could do in the money refinancing if we’re not looking to extend the life of the deal, if we do a refinancing the CLO AAA and all the debt securities will be shorter, CLO debt investors like short CLOs and we’ll give you a lower rate there. So, isn’t that an option versus this math problem that you’ve described?
Alex Navin:
Yeah, it is. And these options that CLO equity have are at times incredibly valuable. And I think that the one that you’re talking about right now is let’s fast forward two years in the future. The whole deal is a bit shorter. What you would expect there is a bit of a term curve. So, that means that if you’re buying a brand new CLO AAA for a primary deal, you might have a seven or eight year weighted average life. But, if you’re buying a refinancing AAA or refinanced AAA, you might have something like a three to five year weighted average life for your AAA. And because you have a shorter number of cash flows or shorted effective spread duration, you would theoretically buy that at a tighter spread. So, I think that we see that a little bit right now in [the] secondary, I think that primary spreads are generally 130, but if you were to buy secondary AAAs, you’re probably paying, well, you are almost certainly paying a premium dollar price.
So, it was a question of exactly where your spread is, but all things equal, I think that you’re buying shorter AAAs anywhere from 10 to 25 basis points tighter than you’re buying longer AAAs. So yeah, you have that ability to refinance, but it’s going to be incredibly sensitive to what’s happening at the market in any given time. Post this, let’s call it tariff tantrum that we had this year, this mini tariff tantrum, that term curve was pretty flat, short AAAs and long AAAs were trading at the same spread. So, I think that some of the most skilled CLO equity investors understand that this market dynamic can occur at different times and will know when to pull the trigger on different options. So, should I pull the trigger on a refinancing? Should I pull the trigger on a reset, which basically takes your whole deal and makes it like a brand new deal again with a five year reinvestment period. Or, in the option that I think some people are actually taking right now, you’re just going to collapse the deal, you’re going to call it, you’re going to sell all the loans to the market and you’re going to get your money back.
And I think that that option that people are starting to pull the trigger on right now makes a lot of sense when the arbitrage is bad and loan prices are high.
Shiloh Bates:
Yeah. But when loans are repricing tighter, so the loan owner is going to make do with less income. But isn’t that from the perspective of somebody investing in CLO equity, isn’t it that the total market return and leverage finance is going down? So, in the equity, yeah, I’m losing some cash flows, but so is everybody else. So, is the loan investor, presumably the bond market, somebody investing in high yield bonds is suffering from high yield spreads coming in. So, it’s not that everybody in the debt market is losing, but you don’t have to take it on the chin in terms of the price of the security that you own in equity because, and maybe this will tie to maybe a question on SOFR coming down, but there’s a lot of money in our asset class, and I think the money has come in because the asset class has offered favorable risk-adjusted returns.
And it seems like we’re giving some of that up at the moment. We’re coming back to the math problem again, when a loan reprices from SOFR plus 350 to 325, the loan probably still trades at par. So, you are losing income, but the price is the same. So, for CLO equity, how I think it should work is that yes, I am losing income when loans reprice tighter; however, the overall market rate of return is tighter for all asset classes and the value of what I own should hold up. I think actually what’s happening though is that’s not the case. People are looking at CLO equity and saying, I want a 15% return regardless of how many of these loans have repriced tighter. So, that results in a negative move.
Alex Navin:
Yeah, and certainly, I mean to talk a little bit about that call mechanism that I was mentioning, I think we are already seeing that call mechanism be used because you’re having these vehicles that simply are no longer efficient. If you have a vehicle that maybe it’s on the really bad side of all the loan repricing and the loan index might be at 325, but say this CLO happened to own tons of really, really clean credits, good on the manager, of course, pat them on the back for choosing good credits. But, the problem with that is now maybe their portfolio actually has a 290 spread, 290 weighted average spread. And if you have a portfolio that has a 290 weighted average spread, you’re simply not going to generate enough income for the CLO equity investor to get the cash flows that they need to take the risk that they want to get the 15% IRR that they want.
So again, your CLO equity investor who’s sophisticated and can look at the portfolio and understand, hey, all these loans are really clean, I’ll probably get better than bid side execution. When I liquidate this portfolio, I might get an extra three or four or five points above what I currently think my equity tranches marked at or the NAV is. Now it’s just a good time to just get my money back. I’ll take my money back and I’ll take advantage of this strong loan market and I’ll put it somewhere else. Maybe I’ll put it in debt because debt is actually pretty cheap. BB tranches are probably pretty cheap, all things equal. I think there’s plenty of investors who say, BBs offer really compelling relative value compared to equity as a result.
Shiloh Bates:
But if I come into this year with a return expectation for CLO equity of again, just let’s call it 15% and loans are repricing tighter on me, would I have expected or should I expect that in August offered rates of return across leveraged finance have come down. Should I still expect to be making the 15%? Why isn’t the market rate of return 13% or some other number?
Alex Navin:
So, this part of the market, this is where it becomes non-linear, and this is where it becomes a scenario of investors get to determine what the market price is in the secondary market in a competitive environment. And I think right now that’s certainly what we’re seeing is that CLO equity investors in third party who are willing to participate in the secondary and provide bids when tranches are available for sale, I think they are taking the time right now to say, Hey, market prices are not reflective of the 15% that I want to earn, or 12% to 15% that I want to earn at the market prices where they were trading two months ago or three months ago. So now, I want to buy these equity tranches at, call it 5 points, 6 points, 7 points lower than where they were trading in June or July. And if I can buy them there, I want to. And there’s plenty of people who want to buy CLO equity 5, 6, 7 points lower than where they’re trading in July because you do get that, now advantage of, okay, maybe your cash flows are a little bit lower, but you’ve adjusted for that in terms of your purchase price and now you’re able to purchase something at a lower price and self-correct to that IRR that you’re trying to achieve.
Shiloh Bates:
The other part of the math problem that we’ve talked about, which I find fascinating by the way, because it’s really just with this simple math, it sums up the whole year, but there’s been a lot of money raised in these ETFs for CLO securities, AAA and down. So, why aren’t CLO financing rates moving down as quickly as the loan financing rates?
Alex Navin:
Great question. I can barely keep up with the pace of growth of some of these CLO AAA ETFs. I do think that it’s great that retail investors finally have the ability to get access to this asset class. And again, with CLO AAAs trading at 135 now, it’s such a compelling security to buy for almost any type of investor that’s out there. You’re obviously getting far better than you would ever get in a money market fund or a savings account. So, as an individual investor, I do think that it’s amazing that they now have access to this asset class. As much as they have grown, I think we’re in the tens of billions. I think we’re probably 40, 50, 60 billion in terms of AUM and CLO AAA ETFs. It’s still a pretty small size compared to the size of the market. So, I think I quoted earlier, CLOs in general, roughly $1 trillion in size.
The AAA tranche is around 60%. So you have 600 billion of CLO AAAs outstanding. That means that the dominant investor base is not these ETFs. They’re still pretty small in the grand scheme of things, and so they’re not going to determine where AAA is priced or don’t price. And this asset class has really been dominated by banks. And it’s obviously an incredibly attractive asset class for banks as well. They’re floating rates, so you get to have a lower portfolio duration, the AAA rating, plus the high amount of subordination, plus the fact that there’s basically been, I think the number is 0% losses on CLOs going back 20 years. So, if you have a bank portfolio that wants to take really low capital charges and get really attractive interest income, I don’t really think there’s that many better assets than CLO AAAs. That being said, if you’re a big bank, whether it’s U.S. or foreign, Japanese, other big players as well, you have a significant amount of pricing power and negotiating power.
I think that if you come in to take the entire tranche, $350 million AAA tranche, you are doing that with a view that you are going to box out any other investor and not have to compete on price. And so, I think that that’s one of the dynamics that’s kept AAAs very cheap, is that there is perhaps less competition during the syndication process for some of these deals than you would get in any other fixed income asset class where you run a really competitive sale process and it’s multiple times oversubscribed and there’s investors clamoring all over each other to gain access to the collateral, etc. I think we do have a unique dynamic here that keeps AAAs a bit wide.
Shiloh Bates:
So, with the Fed potentially cutting here maybe once or twice this year, is the expectation, is that going to be positive or negative for CLO equity?
Alex Navin:
I talked a little bit already about the fact that floating rate assets may become a little bit less attractive if you are losing some of that interest income. And you might have investors pivot from floating to fixed in that particular scenario. But, there’s another way to look at this as well, which is that I think in a world where you have easier money from the Fed, you have rate cuts coming in, I think we’re going to start to see capital markets go a bit gangbusters again. And I think that some of that’s already starting to occur. We’re seeing the resurgence of SPACs, Special Purpose Acquisition Companies. There’s some of these vehicles that are blank check companies that essentially can do whatever, but investors throw money at them anyway, not knowing exactly what it is that they’re going to do. We’re seeing the resurgent in crypto.
We’re seeing these crypto treasury companies, like MicroStrategy, and tons of retail investors throwing money that way. So that’s essentially what happened post-COVID, 2021, we had easy money, we had helicopter money. You had a lot of retail investors starting to chase those returns. But it’s not just retail, it’s institutional as well. You have folks saying, okay, well now my discount rate’s lower. I want to go further out the risk spectrum. I want to take more risk. I want to allocate towards other things. And so, all of a sudden this can be really incrementally good for the CLO market because you would have a big resurgence in capital markets activity. What I mean by that is mergers and acquisitions, LBOs, new companies coming public. When you have that resurgence, that could be the source of collateral that the CLO market has been dying for, for a long time.
And I think that if you have that dynamic come to the market where you have a real true boom in capital markets activity and you have new collateral coming to the market, then all of a sudden you don’t have this dynamic of CLOs competing all over each other to buy the same collateral again and again, tighter and tighter in refinancings and resets, and you have de-novo collateral coming to market where you can actually take advantage of wider spreads. So, I think that that’s the optimistic case here, which is that rate cuts could drive a boom in capital markets and could drive M&A, in which case you have a bit of a Goldilocks scenario, again, which I was talking about for CLO equity, which is loan prices will stay high, there will be more collateral to buy, and your arbitrage will be relatively constant in that world. It’s possible for CLO AAAs to come in because you’ll have more people trying to buy the widest spread AAA asset that you can and you’ll have a better arbitrage. What do you think?
Shiloh Bates:
Well, I think it’s definitely true that if we took our cashflow modeling and we left SOFR where it is today, which is roughly four and a quarter, CLO equity would be more profitable if that’s the only variable that you moved. But I think the second order effects, in my view, are going to be very favorable for CLO equity. So, the lower base rate will mean less bankruptcies, less restructurings, less interest burden on companies. I think that’ll be favorable. And then my thoughts on just the market rate of return is that, let’s say again hypothetically, if CLO equity is doing some mid-teen return, as the base rate comes in, that mid-teen return should look all the more compelling to folks. So, I think both of those factors could result in CLO equity trading up.
Alex Navin:
Do you also see a potential for some type of downside in the next, maybe it’s not 12 months, but maybe it’s 24 months because it’s been a long time since we’ve had a credit cycle.
Shiloh Bates:
So, that’s a good question. And I think though that again, as you’re running defaults in your modeling, and we’re doing the same here, we are looking at the trading prices of loans and factoring into our default rate, anything that’s showing stress now. So, I think that really captures the risk on the year look forward. But, at the end of the day, these loans were initially made with a 50% loan to value. Private equity firm owns a company. If the loan’s not paying off at par, presumably the private equity firm is getting totally wiped on their investment. Where senior secured recoveries have been in the mid 60s area, so there’s still a recovery, a decent one, even in a default. So, yeah, there’s downside risk, but it’s also across our three funds, it’s basically exposure to first lien assets and we consider these assets to be all-weather.
So, they can certainly underperform. We’ve talked about CLO equity doing that this year, but when first lien loans are underperforming, then you probably have some pretty substantial problems in any other asset class that you might’ve favored as well. That’s how I think about it. And then one thing I should point out in this conversation, CLO equity returns have been what they are, so that’s a little disappointing. But for BBs, which we also manage at Flat Rock, actually pretty much everything that we’ve talked about really isn’t an issue for the BB. So, I pulled up the Palmer Square has an index that tracks the return for BBs. It’s up 6% and change this year. So, if default rates are elevated, it’s not enough to impair BB. If the loans are repricing tighter, it’s less income for the CLO equity, but the BB’s still getting paid its interest presumably. So, investors in that part of the CLO capital structure are doing quite well, and I think that’s actually true as you go up the stack, which we don’t manage the other portions.
Alex Navin:
Yeah, I think BBs are really pretty compelling value proposition here, just in general. I think that if you’re looking at the primary market for BSL, you’re getting anywhere between SOFR plus five and SOFR plus six, but if you’re looking at some of the stuff that you guys invest in at Flat Rock in the private credit space, you’re going to get even wider than that. And SOFR right now is still around 4%. So your all-in yield is already at that double digits level, and you don’t have to make any rosy assumptions in terms of your modeling like you might have to do for CLO equity. So, you’re getting true fixed income, 10 to 12% yield by simply buying the BB tranche and not having to be too creative about the accounting.
Shiloh Bates:
Alex, my new closing question for the podcast is, what’s a CLO if you only have 30 seconds to give the answer?
Alex Navin:
Sure. The CLO in 30 seconds. Ultimately, A CLO is a financing facility and it’s a financing facility for levered loans. Couple different markets, both the private credit market, what we used to call the middle market, but also the broadly syndicated market, which is much bigger. And, what it provides is the ability to, this vehicle will finance all these credits in an incredibly diversified way by creating an arbitrage. So the assets inside the facility will generate a higher amount of interest income, then you’re going to have to pay on the liabilities. And what that creates is a structure where you have advantages for every single part of the investor. Both you have subordination for the senior making, the senior really attractive investment for folks who are risk averse. And then you have really attractive risk adjusted returns for investors in the junior tranches, both the junior rated tranches as well as the equity tranche, which really takes advantage of this arbitrage and this diversified financing facility.
Shiloh Bates:
Thanks, Alex. Really appreciate it.
Alex Navin:
And Shiloh, I wanted to thank you very much for obviously having me on the podcast, and thank you for your time. And I just remember when I started in the market, there were so few resources for folks to get out there and learn about CLOs and get up to speed. It always felt like things were behind paywalls or behind bank research desks, so really grateful for you to be doing a podcast like this and putting some education out into the market for everybody to receive.
Shiloh Bates:
Great. Thanks, Alex. I really enjoyed our conversation.
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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.
Definition Section:
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 the 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 in 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 a D, depending on the agency, 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 among market participants.
Middle market loans are usually underwritten by several lenders, with the intention of holding the instrument 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.
LIBOR, the London Interbank Offer Rate, was replaced by SOFR on June 30th, 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 pool 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 the underlying floating rate index.
RMBS are residential mortgage-backed securities.
Loan to value is a ratio that compares the loan amount to the enterprise value of a company.
GLG is a firm that sets up calls between investors and industry experts.
Payment In Kind, or PIK, refers to a type of loan or financial instrument where interest or dividends are paid in a form other than cash, such as additional debt or equity, rather than in cash.
A covenant refers to a legally binding promise, or lender protection, written into a loan agreement.
Net Asset Value (NAV) – The value of a fund’s assets minus its liabilities, typically used to determine the per-share value of an interval fund or investment vehicle.
Dividend Recapitalization (Dividend Recap) – A refinancing strategy where a company borrows to pay a dividend to its shareholders, often used by private equity sponsors.
Continuation Vehicle – A fund structure that allows investors to roll their interest in an existing portfolio company into a new vehicle, while offering liquidity to those who want to exit.
Equity Cure – A provision that allows private equity sponsors to inject equity into a company to fix a financial covenant breach.
Risks:
CLOs are subject to market fluctuations. Every investment has specific risks, which can significantly increase under unusual market conditions.
The structure and guidelines of CLOs can vary deal to deal, so factors such as leverage, portfolio testing, callability, and subordination can all influence risks associated with a particular deal.
Third-party risk is counterparties involved: the manager, trustees, custodians, lawyers, accountants and rating agencies.
There may be limited liquidity in the secondary market.
CLOs have average lives that are typically shorter than the stated maturity. Tranches can be called early after the non-call period has lapsed.
General disclaimer section:
Flat Rock may invest in CLOs managed by podcast guests. However, the views expressed in this podcast are those of the guest and do not necessarily reflect the views of Flat Rock or its affiliates. Any return projections discussed by podcast guests do not reflect Flat Rock’s views or expectations. This is not a recommendation for any action and all listeners should consider these projections as hypothetical and subject to significant risks.
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 U.S. markets and U.S. monetary and fiscal policies. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. The views and opinions expressed by the Flat Rock Global Speaker are those of the speaker as of the date of the broadcast, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions, and flat Rock global disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research or investment advice.
It is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Neither Flat Rock Global nor the Flat Rock Global speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered. None of the information provided should be regarded as a suggestion to engage in, or refrain from any investment-related course of action, as neither Flat Rock Global nor its affiliates are undertaking to provide impartial investment advice. Act as an impartial adviser or give advice in a fiduciary capacity. Additional information about this podcast, along with an edited transcript, may be obtained by visiting flatrockglobal.com.
