I have a love-hate relationship with Twitter. 95% of what I see is a waste of time, but figuratively speaking, 5% of what I see is highly valuable. Especially in the context of being a solo punter without a large team, budget, etc. The other day I came across someone mentioning ticker BRW as an interesting publicly traded closed-end fund and was surprised to discover that it is a Saba managed (Boaz Weinstein) fund. I wanted to write about it because the CEF world is rife with garbage management and unoriginal portfolio positioning. While I don’t own BRW (at time of writing), I believe it is one of the few CEFs that is actually original in its thinking and positioning.
Boaz
Weinstein is a well-known CDS trader/investor and has been banging the drum of late on tail risk opportunities via shorting B/BB cyclical credits funded by being long deeply investment grade names (and SPACs pre-merger). He also kept the lights on through a deeply boring credit period in the 2010s by running a closed-end fund activist strategy, buying CEFs at a discount. He agitates for change and aims to provide a return to investors via both dividends from the CEFs and closing the NAV gap. From what I see, Saba is the main player in this niche.
Making Your Mark
Enter Voya Prime Rate Trust, a CEF that Saba won over. Instead of forcing a liquidation, buyback, or other NAV closing event, Saba took over the investment management of the fund. In 2021, Weinstein outlined:
The ticker changed from PPR to BRW, and the name changed to Saba Capital Income and Opportunities Fund. It was a head-scratcher to understand how BRW relates to the fund name, and then I realized BRW is likely Boaz’s initials. Some people like monogramed shirts; others like CEFs.
Alas, Weinstein went on to make major changes to the fund immediately (emphasis is mine):
In connection with becoming investment advisor on June 4, 2021, Saba Capital broadened the Fund’s investment strategy from solely owning high‐yield loans to investing in high‐yield and investment grade bonds, SPACs, closed‐end funds and other investments…
…Saba Capital slashed the Fund’s 75% exposure to high‐yield loans rated single B or below because we believed a yield of 3 to 4% was insufficient reward for taking risks to companies with ‘junk’ ratings from Moody’s and S&P. In our view, the sales were also compelling because the Fund simultaneously bought a diversified pool of SPACs yielding 2 to 4%. As SPACs are only permitted to hold AAA rated U.S. Treasury Bills until they consummate a merger, the switch resulted in an increase in credit quality from junk to AAA with no loss of yield, while adding optionality for capital appreciation from successful SPAC acquisitions…
…the Fund lowered its leverage ratio from 28% to zero as of October 31, 2021. Saba Capital aims to utilize leverage in a more opportunistic manner…
So the fund upgraded credit quality from B to AAA, lowered leverage to zero, and diversified the fund’s strategy set. Pretty good! It now seems to resemble more of a multi-strategy alternative fund versus a focused CEF. Furthermore, by reducing leverage to zero, it loosens the straitjacket most CEFs sit in. Namely, they are fully leveraged at all times, forcing them to sell at the worst of times and buy at the best of times. As such, it can increase leverage opportunistically when spreads widen and capital is short.
BRW Early Results
By April of 2022, it showed good returns versus most standard benchmarks:
Weinstein had a very short note in BRW’s April 2022 shareholder letter, but he indicated:
Consistent with the Fund’s goals of delivering a high level of current income and capital appreciation, shareholders should expect to see increased portfolio exposure to high‐yield bonds/loans and equities, and decreased exposure to SPACs, now that valuations have become more balanced.
Leverage has gone up from zero (Oct-21) to ~38% (Sep-22) as the market has deteriorated, principally from adding exposure in corporate bonds and equities, along with more SPACs and CEFs.
I think it’s fairly clear why BRW is a bit different than most others in the sleepy backwaters of CEFs. But to return to the title of this post, the dividend is where this gets more interesting intellectually.
That ‘Phat Divvy
In Boaz’s first letter, he outlines:
…the annualized distribution rate was 4.5%. In July, the Fund implemented a managed distribution plan of 8% per annum, which was increased to 12% per annum on December 20, 2021.
Whoa. That is quite a change in payout. Is this fund invested in CLO equity with leverage as a cherry on top?
Boaz explained the reasoning for the high dividend:
In an effort to reduce the discount between the Fund’s share price and its NAV, the Fund’s Board of Trustees recently announced an increase in the managed distribution from an annual fixed rate of 8% to an annual fixed rate of 12%. This significant increase will position the Fund amongst the highest yielding CEFs. Our internal study of premiums/discounts and NAV yields displayed a strong correlation. Of 33 CEFs with NAV yields of 10% or greater, the median premium to NAV was 5% or more, with only two trading at discounts greater than one percent.
As I indicated above, CEFs don’t offer a ton of degrees of freedom, especially if one is fully leveraged. REITs and BDCs share some similarities in that respect. CEFs, REITs, and BDCs have great access to capital when markets are liquid and the public loves the entity (read: pushes it above NAV or reasonable fair value). If a CEF trades below NAV, it effectively is capital constrained if it is maxed out on leverage.
As such, Boaz, ever the self-described puzzle aficionado (listen to any podcast with him), is playing a game of luring high dividend-seeking investors to enable access to capital at NAV or above. Why pay a dividend in line with earnings if it results in below NAV trading performance?
Look no further than CLO equity CEFs to see how high dividends, irrespective of whether they are a return of capital or income, can trade vs NAV. Eagle Point Credit is a leveraged CLO equity CEF with a distribution yield in the mid-teens:
CEF Connect
As such, Boaz is intentionally looking to return capital to investors (in addition to the income) with the hope that BRW trades at a premium and that the pipeline to issue more equity semi-permanently opens. Alas, success has not been found as BRW trades at a discount to NAV:
CEF Connect
Time will tell whether this strategy of piecing together the retail “bees to honey” gravitational pull to high dividends counters some of the limitations of publicly traded closed-end funds. At the very least, it is an interesting way to approach the game.
Amid what appears to be a fairly volatile market environment, it’s worth checking in on some of the data to understand where we are.
Here are a few headline indicators that I looked up this morning:
High Yield Option Adj. Spread: 547bps
BBB-B ETF CLO % of Par: 88.8 (Janus BBB-B ETF)
Leveraged Loan 100 Index (% of Par): 91.7
S&P YTD: -23.6%
US Dollar Index: +17.3%
On the credit side, it seems the market is headed back to the July lows. The market is pricing in a solid amount of stress in the form of future defaults. I previously wrote about the high yield spread, utilizing Verdad Capital’s research to note a guidepost of when the HY spread is north of 600, things tend to get worse but it’s a good time to be investing.
Apollo commented on BBB CLO tranches in early August:
…we believe BBB-rated tranches issued today can withstand an annualized default of the underlying loan portfolio of approximately 11% for each of the 5 years without being impaired.
APO 2Q-22 Earnings Transcript
Barings also outlined the opportunity in BBB CLOs:
But with opportunities emerging to buy bonds at a discount, there is a potentially significant pull-to-par opportunity, which we saw with U.S. BBs late in the second quarter. More recently, the spread differential between BBs and BBBs has compressed, and as a result, we believe higher-quality BBBs have, somewhat unconventionally, started to look attractive as well.
On leveraged loans, Barings outlined the following:
Credit spreads have accordingly remained wide relative to the fundamental risks of the asset class. In fact, with current spreads in the range of 550-650 bps in the U.S. and Europe, and in the context of historical recovery rates, it would take a default rate of over 10% in order to fully erase the excess credit spread that is being offered today. Yields also remain attractive, at around 9% in both the U.S. and Europe, or roughly 400 bps higher versus a year ago. As such, absent an unprecedented increase in default rates-which is not our base case scenario and given the continued tailwind from rising rates, we believe the asset class is in a position to generate healthy returns over the next 12 months, as has historically been the case when spreads have experienced similar widening.
Leveraged loan BDCs are trading at healthy discounts to NAV – an already somewhat market price adjusted figure, providing substantial buffer for future defaults.
While prices in the short / medium term are often a function of flows versus fundamentals, in the long run fundamentals tend to win. Across the spectrum of credit and equity, there are opportunities abound. Of course, if one believes that we are headed into a structural depression, there’s more permanent impairment to come.
But in an environment today in which negativity is high, it generally pays to be dollar cost averaging into cheap assets.
If one looks back 50 years, the return profile of stocks was much different. The expectation of an investor was that a material portion of their return would come in the form of dividends. Today, the combination of a much more greased pathway to scaling businesses, the advent of tax-efficient stock buybacks, and cultural acceptance of returns coming in the form of increased share prices over time versus more certain coupon payments has made stocks paying fat dividends a thing of the past.
If one looks at a low cost dividend stock ETF, Vanguard Dividend Appreciation Index, one will only find a paltry 1.9% dividend yield. It is mostly made up of the largest and most durable businesses – that have above average growth, but that pay out a minority of their earnings in the form of dividends.
To be sure, they also buy back stock, so the total shareholder yield is higher than 1.9%, but one can’t eat dinner on buybacks today.
If one looks at a more aggressive dividend fund, GQG Global Quality Dividend Fund, it sports a 5% dividend yield. More than tasty to satisfy a dividend focused equity investor. But under the hood, one sees that a number of highly cyclical businesses drive the distributions to shareholders:
Personally, I don’t feel strong conviction owning these sorts of businesses. That’s personal psychology versus data driven comparisons of what is most optimal for long term returns. But ignoring one’s psychology is recipe for freezing / making bad decisions when markets go south.
So can you have your cake and eat it? Do stocks exist that are high quality businesses, have a diversified set of products, and pay out the vast majority of earnings to investors? And that can grow organically despite paying out those earnings?
To date, private asset managers are the only group of stocks I have found that fit the bill. They tend to have the following characteristics:
Low debt or net cash positions
Highly scalable business models with little incremental capital needed
Locked-in revenue for years via long duration fund lives with no LP withdrawal rights
Pay out somewhere between 30-100% of cash flow
Run by management that tends to excel at efficient capital allocation
Generally speaking, I would expect companies with the above characteristics to trade at above average multiples. Alas, today for the most part they do not. My best guess as to why is:
They generally invest in smaller / non-investment grade companies
They generally utilize healthy amounts of leverage
It’s a people business, and your advantage can walk out the door
Private asset managers can indeed fail as businesses. But the key thing to note is that given their revenue is locked in, if one pays a low enough multiple, one doesn’t really have to pay for future success.
Furthermore, certain private asset managers have captive funds that won’t leave if performance falters. Private asset managers have locked in captive funds via public BDCs, owned insurance vehicles, holding company assets, and more. This places a soft floor under which revenues can be underpinned.
As such, in my own personal decision making fork in whether to invest incremental public equity allocations to aggressive dividend funds versus additional private asset managers, I continue to lean towards the latter until something changes.
Note: This is not investment advice, do your own work.
While repackaging, chopping up, and distributing pieces of financial engineering have developed a reputation for devilish alchemy – I on the other hand find it all quite fascinating. I’ll spare you the details on the basics, as I’ve put together a repository of primers in the Resources section of this website. If you don’t understand the mechanics of CLOs, this won’t make much sense. If you’re looking for a multi-bagger or something that outperforms the S&P, close the tab and move on, it isn’t here. Last, if you’re looking for commentary from a structured credit expert, I am far from that. In this post, I’ll focus on what my personal conclusions are with respect to how a retail investor can interact with CLOs.
The CLO capital stack allows an institutional investor to target a risk / return profile with some level of precision. An investor can purchase diversified AAA debt slices with no prior defaults (never say never) or CLO equity, the most risky slice with theoretical returns in the low teens.
Source: PineBridge Investments
While some investors will scream of tax inefficiency, as the majority of the return comes in the form of ordinary income, I will ignore that relevant fact for the sake of this discussion.
But why do CLOs offer potentially higher returns for similar “risk?” Here are ideas, albeit unoriginal, but in my words.
Relative Age of Market
The CLO market is “new” versus the bond market. CLOs came to light in the 90s and accelerated as a feature of the financial system over the past 20 years:
Source: Athene
After the financial crisis of 2008, the industry underwent a change in standardized structure and terms.
CLOs allow banks to pass on (and collect fees on) loans they originate to willing buyers that don’t have the front end infrastructure to originate loans themselves. It allows banks to earn higher returns on their equity versus being weighed down by the capital drag of originated loans, especially in light of post-financial crisis regulation that increased capital requirements for riskier holdings. Here’s an overview of the CLO buyer pool:
Retail investors are material participants in the market underpinning CLOs, leveraged loans. They participate via publicly traded BDCs, floating rate loan funds, private BDCs / interval funds, and more. Below is an overview of leveraged loan ownership in the US and EU, with retail clocking in at between 15-20% in the US:
However, retail participation in the CLO market, especially CLO debt tranches, is certainly far lower than leveraged loan participation. Only recently have ETF structures that allow access to CLO debt appeared and are currently minuscule in size. It remains to be seen whether retail interest in CLOs will increase over time.
It Rhymes with CDOs
Three letter acronyms of financial engineering were foundational components of the ’08 credit crisis. But there are important distinctions between today’s CLOs and CDOs of the 2000s.
CLOs are backed by simpler, more diversified pools of collateral than CDOs. CDOs issued in the run-up to the GFC consisted mainly of subprime MBS, and CDOs backed by other CDOs (so called CDO squared) were common.
In 2006, almost 70% of the collateral of newly issued CDOs corresponded to subprime MBS, and a further 15% was backed by other CDOs. Furthermore, more than 40% of the collateral gathered by the CDOs issued that year was not cash MBS, but CDS written on such securities. When conditions in the housing market turned, the complexity and opacity of CDOs amplified financial stress. Their collateral is diversified across firms and sectors, and the known incidence of synthetic collateral or resecuritisations is minimal.
While it sounds somewhat silly to think that institutional investors may shun CLOs do to a misplaced association, I believe that the perceived complexity and similarities to the CDO trash fire of the past make this asset class the opposite of something in which the old adage “can’t get fired for buying X” applies.
Volatility is High
Once you look lower than the A tranche of the CLO structure, you find that the BBB and BB debt tranches have relatively elevated standard deviation.
One can presume that CLO equity is step-wise more volatile than the BB tranches, likely far exceeding S&P500 volatility. Excess volatility demands excess return, and thus it makes sense that BB and lower rated tranches may offer higher returns with “higher risk.” Why that elevated return spills over into BBB and higher rated debt which doesn’t appear to have the same level of elevated standard deviation, I’m not exactly sure, and may attributable in entirety to the prior factors I outlined.
The Little Guy
While assessing whether CLOs fit your own investment goals is your own responsibility, I will outline what my own opinion is of the various publicly traded retail CLO offerings that exist on today’s marketplace.
Until only a few years ago, there were no options to invest in the debt tranches of CLOs via an ETF wrapper. One could access debt tranches via publicly traded closed end funds (CEFs), but their equity-like fee structures and leverage appear to be a mismatch for the underlying assets.
Recently, Janus Henderson and Van Eck both came to market with their own ETF offerings focused on CLO debt. Between the three ETFs, investors can effectively access the AAA tranche, the AA tranche, and the BBB tranche – at fee rates far lower than the CEF structures.
JAAA
CLOI
JBBB
Fund Size
$1.6B
$25M
$80M
AAA
96%
29%
–
AA
3%
47%
–
A
1%
9%
–
BBB
–
–
90%
BB
–
–
7%
B
–
–
3%
Not Rated
–
15%
–
# of Holdings
114
18
66
Fee rate
0.26%
0.4%
0.5%
Source: Janus Henderson, Van Eck
Through these ETFs, an investor can attain reasonable CLO manager and vintage diversification, not to mention dramatic underlying loan diversification. However the overall fund sizes are relatively small, especially JBBB and CLOI. I would personally like to see more diversification within CLOI, as its largest holding is roughly 10% of AUM. However it is important to note that the Janus offerings’ feature documented mandates of issuer and single CLO concentration limits (15% issuer, 5% single CLO), whereas the Van Eck fund is classified as non-diversified. In fact CLOI’s largest investment is roughly 10% of the fund. Thus CLOI may be better viewed as a discretionary fund versus JAAA/JBBB being more systematic exposure to specific portions of the ratings stack.
An investor will have a harder time understanding what the yield of each fund is, especially while rates are moving so quickly. Each CLO debt tranche has a floating rate based on LIBOR / SOFR plus a spread. Today, base rates (LIBOR / SOFR) are moving rapidly with Federal Reserve action and there are limitations on the forward projections that ETF managers can provide (versus a private fund).
I downloaded the daily holdings data (self reported) of each ETF and was able to calculate the market price of the underlying CLO debt (vs par), the weighted average coupon at the time (given it is moving along with rates), and the implied current yield based on the market price.
JAAA
CLOI
JBBB
% of Par
98.6%
97.9%
92.2%
Wtd. Avg. Coupon
3.2%
4.0%
5.6%
Gross Current Yield
3.2%
4.1%
6.1%
Net Current Yield
3.0%
3.6%
5.6%
8/31 30D SEC Yield
3.7%
4.2%
6.2%
Source: Red Deer’s Analysis, Janus, Van Eck; Data as of 9/22/2022
Note in the above, there may be delays in the reporting of latest coupons adjusted for higher base rates versus reported distributions, resulting in higher reported SEC yield based on prior distributions vs calculating it off of the coupons reported in holdings downloads.
Given the discount to par in the overall market and within these funds, it is important to have a baseline view on what default rates and ultimate recovery rates will be in the leveraged loan market (along with a host of CLO specific assumptions). That may help inform whether the discounts to par represent an opportunity as loans “pull to par” or further price degradation will ensue. As this is entirely personal, I will leave that to the reader to decide.
While defaults have been low within the CLO space across most debt tranches, one has to consider that future performance is a function of the underlying collateral, not historical data. One may have more cause to worry given recent trends of ratings quality underlying leveraged loans:
It’s clear that there has been migration towards lower rated collateral with B- representing the largest share of leveraged loans, even considering the tighter credit environment in 2022. If one considers ratings reflective of future credit performance, one might expect greater frequency and severity of defaults during a credit cycle.
However the credit losses that one must incur to pierce the principal of the BBB layer, for example, is deep in the capital stack. Per the below representative CLO, the BBB layer has ~25% in credit enhancement or first loss capital above it.
Source: Athene
CLO Debt ETF Risks
The principal risk I see in the ETF structure as it pertains to accessing CLO debt is a liquidity vacuum. Specifically, in times of stress, one can presume an ETF will see outflows of funds as retail investors retreat to cash and / or reallocate. The result is that the ETF manager has to sell a corresponding amount of assets.
While that works just fine when an ETF owns deeply liquid securities, it starts to break down when the opposite is true. The ETF manager of assets with greater illiquidity than say, large cap equity ETFs, will often have to sell the most liquid assets first as there may not be a bid for the least liquid assets. Selling one’s most liquid assets leaves an ETF in a shaky position, and not one that the resulting ETF client would like to have.
Alas, I’m fairly certain these fund managers would argue that the AAA –> BBB tranches are indeed liquid enough for an ETF to function normally. And that may indeed be the case given the small fund sizes within these ETF offerings today. However it would be prudent for a holder of CLOs via ETF to consider this a risk in excess of the same risk in a large cap equity ETF (or similar deeply liquid collateral base).
Additionally and obviously, given these are actively managed ETFs, one has to consider the risk that the manager makes poor decisions that cause underperformance vs. the benchmark.
CLO Equity
Separate from owning rated CLO debt tranches, the ability for an investor to own CLO equity has been available for the past ~5 years. And distinct from CLO debt tranches, the equity tranches almost exclusively reside within CEF structures, interval funds, or private funds.
I believe PIMCO most aptly described the case for CLO equity:
Although CLOs are complex instruments, CLO equity can be boiled down into two key return drivers: a call on credit spreads and a call on the assets of the transaction. Each of these options needs to be valued within a unified risk framework that considers bottom-up credit factors as well as the top-down macroeconomic environment. While the mark-to-market risk of CLO equity is acute, hold-to-maturity investors can benefit from a robust and stable return profile. Unlike most alternative investments, CLO equity cash flows tend to be front-loaded, typically providing investors with current cash and reducing cost basis early in an investment life cycle.
For this reason, an opportunistic CLO strategy can serve as a complement alongside other longer-lockup investments. Many long lock-up investments, such as private equity or venture capital funds, generate back-end return profiles, so an allocation to CLO equity can smooth return profiles within broader alternatives buckets by providing front-end-loaded returns. A CLO-driven approach can also serve as an offset for higher-credit-beta investments, since it can potentially capitalize on a widening spread environment.
Again, while up to the investor to decide suitability, CLO equity is a unique product that doesn’t have many analogues. Perhaps the most appropriate analogue for retail public market investors is leveraged loan BDCs (LLBDC). Often times the LLBDC manager is also a prolific CLO manager. LLBDCs typically hold about 40-60% of their capital structure in debt, with LLBDC equity (the publicly traded equity stub) comprising the rest. By contrast, CLOs typically utilize debt for 90% of their asset base, leaving the last 10% for the CLO equity investor, a much more leveraged approach to capturing the earnings in excess of debt service (and expenses).
Regardless, the punch line on the retail investor’s options when it comes to CLO equity, is they are…not great. This is for a number of reasons.
For one, each individual CLO has a CLO manager who typically owns a portion of the CLO equity. That manager often takes a 0.40% management fee, along with an incentive fee of 20% over a 12% hurdle. The publicly traded CLO equity security often comprises of a bundle of many CLO equity securities, giving an investor diversification across CLO vehicles / managers. The publicly traded security will also take another more hefty fee layer – often a management fee north of 1.5% and an incentive fee of ~20% over an 8% hurdle with an aggressive catch-up clause. While there are often fee rebates / waivers that occur across CLO equity deals one can presume that the worst case is a large chunk of potential upside outperformance is mowed down by layers of incentive and management fees while downside scenarios are fully borne by the retail investor.
Last, the publicly traded CLO securities often employ substantial leverage. Remember, I outlined that CLO equity already has implied ~10x leverage. These CLO CEFs and interval funds often employ an additional 30% of debt to total assets, raising the total leverage of a CLO CEF / interval fund to ~14x. Yikes. Why do they do this? Fees seem to be the most realistic answer. One can charge the biggest fee structures when the return profile is leveraged up to be accordingly high.
When you put together high leverage and a historically low default environment over the past 5 years, these CLO equity vehicles give the appearance of a high return proposition. So much so that they often trade materially above their self-published NAV. Eye watering dividend yields pull in a certain kind of retail investor that cannot resist the squeeze despite the disadvantaged setup. While I believe that CLO equity may make for an interesting allocation without aggressive fee layers, that is not readily available to a retail investor today.
Conclusions
While I don’t believe that CLOs are any sort of holy grail of investing, I do believe they remain an under-appreciated tool to create outcomes that align with certain investors’ goals, especially in an environment with increased interest rate focus.
CLO debt ETFs, a new kid on the block, have opened a new asset class that doesn’t appear to be a collective grift that robs the retail investor, a good thing! Targeted ETFs now exist that enable surgical fine tuning to different risk profiles / ratings classes. Furthermore the underlying loan diversification allows the retail investor to get exposure to the overall credit performance of a certain tranche versus being heavily biased to manager asset selection.
Retail CLO equity vehicles appear to be a way to play the CLO structure with one’s shoes tied together. In time, one can hope that more investor-aligned vehicles come to market. Today, one can access a similar product (but far from the same) via LLBDCs, which effectively incorporate a sandwich of the equity layer plus the A, BBB, and BB layers of a CLO, without the more conservative and lower fee CLO structure.
Until there is a change in the winds in which banks have an incentive to hold more loans on their books, vehicles like CLOs will continue to be a mainstay of the credit landscape, and at the very least, it is worthwhile for investors to understand how CLOs among other floating rate credit products can be tool in the overall tool-belt.
Disclosure: Author does not own any of securities mentioned at time of writing. This is not investment advice, do your own work.
When economies and markets go bad, most people including myself, tend to get tunnel vision or some form of psychological paralysis. In part, it is because the sheer volume of information inputs that indicate dire outcomes goes up dramatically and the mark to market value of a portfolio is dropping at an abnormally fast rate.
With respect to investments, I like to think about what the “chaos factor” of an investment is. Is it negatively affected by chaos, defined by flight of capital, slowing economic growth, and negative sentiment? Or does it thrive in these times?
Chaos Factor in Practice
Consider a publicly traded closed end fund as an example. The basic construct is the fund raises a defined amount of capital at IPO, and invests capital similar to a mutual fund or any other investment fund for a long period. It uses material amounts of leverage, say 30% of its total asset base. And it has collateral requirements against the leverage, meaning if the value of its assets drop below a certain level, the fund must sell assets to pay back the debt providers. A margin call, if you will.
In a deep drawdown, similar to March 2020, or the ’08/’09 credit crisis, this sort of fund (if packed with volatile assets) ends up having to puke its assets at the market bottom regardless of whether the assets are good long term investments or not. It is capped by the upper bound of return that the assets provide, meaning perhaps a group of equity investments may return 15% annually over a long period of time as a best case, but can permanently lose 50-75% due to a leverage unwind in a drawdown that isn’t recoverable and permanently ruins the capture of underlying portfolio performance.
Natural Negative Chaos Bias
Most investments are forced to run in a way that is negatively biased to chaos. If a corporation doesn’t run with an optimized capital structure, an activist often gets involved to force its return on equity higher (e.g., use more debt to juice returns). Closed end fund structures are compensated on total assets, so they are implicitly incentivized to use leverage to maximize fees.
Few corporations or investment structures have the authority to run in an un-optimized manner that skews them positively towards chaos. It sacrifices near or medium term returns, and we humans are impatient. A legendary P&C figure is known to run with an abundance of excess capital to take advantage of low priced assets in times of chaos. That strategy has in part made him who he is today (hint: this is Buffett). But examples like this are few and far between as these examples must often sit through an incredible amount of criticism during the good times.
Negative Bias Is Not Bad
That isn’t to say that negatively biased investments to chaos are bad investments. People spend fewer advertising dollars in a deep recession than in a boom time. Does that negative bias to chaos make Google’s search engine product an unattractive asset to own? I don’t think so. Most investable items are indeed negatively biased to chaos. Vanguard equity ETFs offer an incredible product to capture benchmark performance, but are undoubtedly negatively biased to chaos. However, it’s clearly okay to have that negative bias, so long as the investment does not have to unravel itself during the hard times.
Positive Bias As A Ballast
There are business models that are modestly positively biased to chaos. In a recent Capital Allocators podcast, Greg Lippmann of The Big Short fame (see resources tab for link) outlined how he actively built a drawdown fund business in parallel to his hedge fund, as during the worst of times his investors have the right to pull capital from the hedge fund whereas with a drawdown vehicle, he owns the right to call capital at any time.
The reason why I like to a handful of positively biased investments to chaos, is it helps my psychological stability during times of duress. It is comforting to know that while the stock price or NAV of an investment may be down substantially, it is a period that the investment can use to build value that is realized after the ensuing recovery. Ultimately, it provides a ballast to one’s mind when the tunnel vision sets in during the worst of times. And that’s just one thing that someone may do to help make the right decisions when the noise is the loudest.
One of our holdings is going through an M&A process – of which I sold 75% of our position to reallocate. I put a good chunk in BXSL, as continuing to increase our allocation to credit related investments makes sense for our personal desired outcomes.
Blackstone runs a premier credit platform. It is the most prolific CLO originator, has the one of, if not the biggest private debt platforms, and culturally prioritizes losing money over stretching (read Schwartzmann’s book, What it Takes).
A quick overview of BXSL – it is a publicly traded BDC that one can consider a sister fund to Blackstone’s private BDC, BCRED. It invests exclusively in first-lien loans, with the vast majority privately originated, in the non-investment grade space. Average issuer EBITDA is large, north of $150M /year.
But there are many choices for 100% first lien BDCs, why BXSL?
Here are my simple reasons:
Rates. It is highly sensitive to rising rates versus similar BDCs, by virtue of 50%+ of its liabilities being fixed rate debt. So as rates have gone up, its earnings benefit more than similar products that have a higher share of floating rate liabilities. While we purchased at a ~9% yield on cost (excluding special dividends, which push it to 11%), the base dividend has already increased to land it at a 10% yield on cost, and management is guiding towards a roughly 30% increase to earnings from 2Q-22 based on where rates are projected to go by the end of September.
Scale. Blackstone’s massive size allows it to bear costs that others can’t. They can have teams of people plug in to reduce costs, intro to new customers, etc – a cost that others can’t justify. There’s a 5 person team doing nothing but calling its debtors to help them on top and bottom line initiatives. It’s not something typical of a credit provider, more an equity provider. For me, that ideally means fewer defaults or better recoveries when defaults occur.
Culture. I care that the sponsors we invest in are more focused on downside vs upside. The management team explicitly uses incremental cost savings to get better credit risk at the same spread versus capturing greater spread for the same credit risk.
Discount. Shares were at $23.5/share when we purchased, almost a 10% discount to NAV. Whereas BCRED trades at NAV – a 10% discount is a nice way to mitigate the likely defaults coming down the pipeline in 2023. Especially when similar BDCs include 2nd lien debt, equity, etc. My guess is this is because the BDC recently went public and the last share unlock happened in July.
There is plenty more information out there on the credit portfolio – both in absolute metrics and sensitivities, but keeping this one short and sweet.
Disclosure: We own BXSL, this is not investment advice. Do your own work.
Currently, leveraged loan defaults are near zero. I believe 2022 cumulative defaults have totaled about 0.6% as of this week. The long term average is around 3%.
The big question is as rates rise, what will happen to defaults? Blackstone’s publicly traded leveraged lending BDC gave a very specific answer as to how interest coverage will trend at different levels of interest rates:
…if LIBOR gets to 4.3%. So today, we’re at, what, 2.92%. And let’s just say we go past the [current futures] curve which is 3.9%. And we’re at 4.3%. And we stay there for a 12-month period.
The percentage of our companies that have less than one-time interest coverage is 4.3%. And if you go up [sic] from 4.3% and you go north of 5% that ticks up a little bit, but not much more from there.
BXSL 2Q22 Earnings Transcript
One has to make their own assumptions on interest rates, default rates, and recovery rates (as well as timing, etc.) – but these numbers help think about it. If all of those names below 1x interest coverage default, and higher rates shake out more weak links, perhaps the BX portfolio gets a default rate of ~5%. Typical recovery rates are around 65% for first lien leveraged loans – but to make it simple and assume 50% – you would get to a 3.25% loss rate if it all happened in one year (not reality). This leveraged lending vehicle is about 43% equity – so a 3.25% loss on total assets is about an 8% loss to the equity (3.25/43). Not ideal, but would consume near one year of interest income. Also not a draconian scenario.
As always, the elephant in the room is what may happen on top of expectations, which is not envisioned today. And that we will likely never know until it happens.
Disclosure: My family owns shares in BXSL, this is not investment advice. Do your own work.
A few days ago I had another chat with my unofficial mentor. They are just another person on the internet, never assumed any such role, and I don’t talk to them regularly. I just watch what they say closely to learn from them and very occasionally reach out with questions (my thoughts on a prior discussion here).
I’m writing this to remind myself of the conversation and to be able to refer back to it from time to time. The topic of conversation was politics, not investing, but the lines blurred. They outlined that within any assertion, there’s signal and then there’s noise. That’s obvious. But the practice of separating signal from noise is not an easy one both psychologically and tangibly. People are lazy. At times (perhaps too often) I am lazy. It’s incrementally more work to read an article and then follow up with the source content to validate whether the claim is true or not or whether it has been presented in a way that skews the actual data. Politics, they outlined, has more noise than almost anything else out there.
The more poignant part of the conversation was when they outlined that they often ask people “tell me why” with respect to politics related frustrations. What often follows, they outlined, is hate related buzzwords followed by frustration that they were put in that position to have to explain themselves.
To be clear, I myself struggle with this as in my past I was mostly concerned with fitting in by repeating things other people I admired (at least at the time) said. It’s newer to me within the context of my lifespan to think about what my own brain knows about something, what it doesn’t, and what I believe after trying to figure out the truth myself. Covid has ironically helped me with this, as I was deeply interested in what core truths existed amidst massive amounts of noise and derangement across the intelligence spectrum.
We went on to talk about investing in this same vein and they outlined that good investing is simple as “tell me why something will go up or down?” It’s smart because it isolates a rambling explanation of fundamentals at the exclusion of why something may go up or down. There was a nice podcast at Capital Allocators where a former Viking Global manager outlined how people overweight fundamental analysis and often don’t give thought to why that will actually change the price people pay in the medium term. It runs in similar vein to the above.
For me, I don’t plan to be much of a single name stock picker. I know myself, and I’m really just a huge fan of finance. Great investors to me are like great baseball players to baseball fans. My goal is durable income so I can spend time with my wife and kids. I don’t much care to get rich beyond the independence we have today. So I’m happy to outsource to others in a diversified manner. But that isn’t a free pass on knowing core truths based on data. Without asking why and understanding core truths, my actions inside and outside the investment world are less meaningful, and less satisfying. So, to that end, here’s to “tell me why.”
I’ve noticed a number of things happening across the credit ecosystem of late. Namely, the syndicated loan market being largely muted versus its 2021 self, the reasons for it, and implications.
To start, Oaktree outlined why the AAA tranches of CLOs have lost their bid.
As the Fed added over $4.6 trillion in assets to its balance sheet in 2020–21, it also accrued liabilities representing the same amount. This meant banks were flooded with excess reserves (i.e., capital above the amount that regulators require private banks to hold on deposit at the central bank). These reserves earned almost no interest, so banks dealt with this glut by using that capital to buy safe assets that earned slightly higher interest rates, such as AAA-rated CLO tranches. This is one of the main reasons why CLO primary market activity soared to record-breaking heights in recent years.10
In March, the Fed ended its quantitative easing program, meaning it is no longer seeking to be a net buyer of assets. Banks therefore aren’t regularly accumulating reserves and thus no longer need to buy assets like AAA CLOs. Moreover, the Fed is now also paying a higher interest rate on reserves, and Treasurys are offering higher yields, so CLOs look less attractive by comparison.
Oaktree
And the conclusion:
Consequently, demand has declined for low-risk CLO tranches, which make up roughly 65% of each CLO, and CLO primary market activity slowed accordingly in the first quarter.11CLO managers have therefore been forced to offer wider yield spreads on AAA tranches in order to complete deals, even though the underlying credit fundamentals of CLOs remain strong.
Oaktree
So overall, Oaktree is saying that the AAA market for CLOs doesn’t have the bid that it had prior because of Fed tightening, and the banks don’t have to reach for safe yield anymore (because the Fed has stopped buying up the safest assets from them, like treasuries or agency MBS). This is compounded by the fact that banks have loans on their balance sheet that were meant to be syndicated, in large part via CLOs, that they are hung on. Moelis and Company outlined:
The banks are strong. The nonbank market is strong. But right now, the nonbank market is focused on transactional loans that the banks have and they’re being offered at the clearance aisle, 10%, 20% off. And I just think that’s just a natural, yes, I think that those are going to get cleared out because they’re onetime, and then we will reset and the banks will be in business. By the way, they’ll be in the new federal funds rate, I get it, there’ll be higher interest rates. There might be lower leverage, but they’ll be back in business. Right now, there’s a fundamental almost not working transactional market as the clearance sale happens.
2Q22 MC Earnings Call
It looks like the large cap direct origination market is widening out on a spread basis as a result. Remember, CLOs are filled with non-investment grade loans so if banks are choking on their inventory, and there are fewer buyers for 65% of each CLO (the AAA tranche), not many non-IG loans can get done through this pathway.
As a result, Apollo’s large cap lending strategy (disc: we are allocated to this) has seen its spread over LIBOR / SOFR on new origination expand meaningfully over the past months:
1Q22: 530 bps (ADS commentary)
2Q22: 591 bps (ADS commentary)
Mid 3Q22: 650 bps (APO earnings call)
This is material widening in the context of what Apollo’s middle market vehicle (MFIC) has experienced:
1Q22: 612 bps
2Q22: 622 bps
On the MidCap earnings call, I asked about this contrast in movement between large and middle market lending, as one would think that smaller companies on average should be less creditworthy. Thus more spread widening than large cap lending.
The answer (no transcript yet) effectively said that because the broadly syndicated market is muted, in part due to the above lack of buyers, competition has lessened for large cap direct lending versus middle market direct lending, which did not depend on the CLO market in the same magnitude.
So where is the opportunity? It seems like clearly large cap lending is a target rich environment within credit. Apollo went on to say:
As a result of the lack of capital availability in these markets, private credit continues to experience strong demand from financial sponsors and companies.
For context, the weighted average yield at amortized cost of directly originated large cap loans in our portfolio was 8.0% as of July 31, 2022, and the yield at amortized cost of opportunities our near-term pipeline ranges from approximately 8.5% to 10.5%. Aside from the tailwind of rising interest rates, we believe that our ability to build a new portfolio of directly originated large cap loans in this environment enhances the pace at which we are able to increase our overall portfolio yields.
Based on our current pipeline and portfolio activities, we expect liquid loans to become a minor portion of our portfolio [as direct origination is increased] in the fourth quarter.
Moreover, my mind is thinking about whether this stoppage in the broadly syndicated loan market is more weighted toward being the result of Fed actions or oversupply of hung inventory. If it is the former, perhaps we see permanent spread widening that starts to make its way to the middle market as well. If the latter, the large cap lending opportunity may be a short window.
I’ve previously wrote about how I’ve looked at Apollo’s middle market BDC (also here, here, and here) and how I’ve been looking at CLOs. Linking to these posts forced me to look at them again and virtually all of them made me feel a bit embarrassed as I wrote them no more than two months ago. I’ll chalk it up to learning a good amount in the interim.
I realized the other day that I have been essentially looking at similar assets that have been packaged up in three different wrappers, of which I actually have decent data access to (I don’t have Bloomberg, S&P, etc.). First is the public BDC. The BDC sources virtually all of its new loans from MidCap. While it’s in transition to be a near 100% MidCap portfolio, roughly 90% of its portfolio is aligned with what MidCap does today (and I believe 85% of that portfolio was already MidCap sourced). Second, MidCap releases information for bond investors which one can ask the company for. Third, I found an S&P research report that slipped through the paywall cracks which outlined the basics of a CLO originated and arranged by MidCap.
While all three aren’t exactly apples to apples, they aren’t far from being so. In any case, I lined up their capital structures to compare them:
Note: MFIC BBB- rated debt and MidCap B rated debt are in the form of unsecured fixed rate bonds.
The major takeaway is the leverage of each structure, with MFIC running at 60% debt / total assets, MidCap at 80% and the CLO at 88% (or 1.5x, 4x, and 7.5x debt/equity). Note that typical broadly syndicated loan (BSL) / large cap CLOs run at 90% / 10x leverage. In any case, if you look at MFIC versus the CLO, you see that the MFIC equity essentially represents a strip of the CLO from AA down to the equity. It should be materially more safe than the MidCap equity let alone the CLO equity. In fact, the co-founder of MidCap essentially confirmed that on the prior earnings call (my first earnings call appearance!) when I asked in too many words if a BDC was the right wrapper for MFIC (BDCs have 2.0x leverage limits and generally trade poorly vs NAV) given how comfortable he was running MidCap at much higher leverage:
Well, so the first question with regard to leverage is that our discussion with regard to risk related to leverage is that 1.5x, 1.6x, 1.4x, it is all splitting hairs. It’s all based on leverage within the AAA or AA of the CLO of this pool of loans if we CLO’d it. And right on MidCap is leveraged higher. And so from a risk perspective, we always felt like that’s very safe.
MFIC 2Q22 Earnings Call Transcript
While I didn’t know hardly anything (in retrospect) about CLOs, one can see in the chart above how the MFIC leverage sits cleanly against the AAA layer of the CLO.
Moving on. Overall one would expect, if you step into a hypothetical that the assets backing each are the exact same, that the return on equity should rise as leverage rises. In reality, they are not the same as the CLO has only leveraged loans I presume (I have no access to the loan tape), where as MFIC and MidCap have a material amount of other ABS loan types in their portfolios. In any case, here is my best guess as to the target ROE for each structure:
MFIC
MidCap
MidCap CLO
Est. Return to Equity
9%
12%
14%
As to what each equity slice trades for – I don’t have all of that data, specifically the CLO equity (Woodmont 2022-9). But I do know what MFIC’s equity and MidCap’s equity is trading for.
MFIC
MidCap
MidCap CLO
Trading Price as % of NAV
85%
100%
100% (?)
Adj. Est. Return to Equity
10.5%
12%
14%
Note: MFIC trades at ~$13.25 at time of writing. MidCap has traded at NAV each quarter per Apollo.
All is to say, this isn’t a recommendation on what to do about MFIC stock. It is just interesting how these different equity slices match up, particularly how an AA down to equity strip (MFIC) can trade at a material discount to NAV (it traded as low as the $10s / 70% of NAV in recent months) while a BBB down to equity strip (MidCap) can trade at NAV at the same time.
Disclosure: My family owns shares in MFIC, this isn’t investment advice. Do your own work.
