CLOs: Finding Attractive Value Today

Greg Campion: Collateralized loan obligations, or CLOs, have gone mainstream in recent years, continuing to gain acceptance as an institutional quality asset class. But with a potential recession on the horizon and expectations that corporate defaults may be on the rise, do CLOs still offer the potential for attractive risk- adjusted returns?

Melissa Ricco: There's no question that we still face a lot of uncertainty around the macro situation, but at current levels, we're finding really attractive opportunities, especially at the top of the CLO capital structure, where senior tranches are offering a powerful combination of historically high yields alongside structural protections.

Greg Campion: That was Melissa Ricco, Co- Head of Structured Credit Investing at Barings, and this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on today's show, finding attractive value in collateralized loan obligations. All right, Melissa, welcome back to Streaming Income.

Melissa Ricco: Thanks for having me.

Greg Campion: I'm excited to have you back here on the show. It's been a little while since we've talked about CLOs, and there's obviously so much going on in this market right now. I thought it would be an opportune time to talk about it. And so maybe we can start high level. I'm hoping you can talk a little bit about how the asset class has been fairing against a macro backdrop that's obviously been pretty uncertain with rising rates and still persistent inflation out there. How have CLOs been faring so far?

Melissa Ricco: Yeah, sure. I would say resilience is the best word to describe the CLO market, and I mean that from both a performance and liquidity standpoint. I think anyone that's been in the market as long as we have, it's just been remarkable to see the CLO asset class grow the way it has. We're over a trillion dollar market. Just the wider acceptance of the asset class overall, I think we've dispelled a lot of the myths that the three letter acronym comes with.

Greg Campion: Yeah.

Melissa Ricco: We've certainly seen just strength in overall liquidity. One interesting point is that there's over seven ETFs for the product now, speaking to the broader investor base that we've seen.

Greg Campion: Interesting, interesting. Yeah. And in terms of some of these more, I guess, cyclical forces, so you think about higher rates for instance, has that been a tailwind for the asset class? And I'm curious how you and the team are thinking about that because there's a lot of conversation right now of, " Are we getting near the end of this rate cycle?" How are you thinking about just that impact on rates on the asset class?

Melissa Ricco: Yeah, it's certainly been a very large factor, significant factor, in our market, I would say. Looking at year- to- date returns for our asset class, they've been quite strong. AAA is down through BBs, and a lot of that has to do with the fact that base rates are in the low 5%. So CLOs are offering very attractive carry, high coupons right now. For example, AAAs offer a 7% coupon to investors, and that's for an asset that has experienced a 0% default rate, can handle the entire CLO portfolio defaulting with a 65% recovery. So some real attractive features there, I would say, overall. Obviously you have the other side of the coin, which is the impact on the underlying loans and from a rising rate perspective. So that certainly has to be considered, and I know we'll talk a lot about some of those fundamental features as well, but it's certainly very topical.

Greg Campion: Yeah, so let's get into that. Let's talk about the fundamental outlook. So I'm curious as you start to think about the broad health of the underlying loan market and, of course, the CLO structures themselves, how you're assessing that right now, and then also how you and the team are starting to think about what the default picture could look like, assuming that we head into a recession eventually, although it seems to continue to get pushed further and further into the future. But just curious how you and the team are sizing up that fundamental outlook today.

Melissa Ricco: Yeah, maybe we'll start with the positives first. And the first would be the fact that I think we're starting from a pretty solid place and the point of companies have pretty strong balance sheets. They've pushed out maturity walls. Capital markets have been open. Interest coverage ratios are starting from a high place as well. And the second positive I would say is from a CLO perspective, CLOs have less risk, I would say, than the overall loan index. So if you look at defaults, for example, currently CLOs have less than a 1% default rate, whereas the index is more like two to 2. 5%, depending on how you quantify that. And a lot of the reason for that is the fact that CLOs are actively managed. So managers are going out thinking about all of these risks when they're constructing portfolios, but then they're also trading. So they're able to get ahead of some of these things that we've been talking about for so long. A lot of this stuff is not a surprise. It's been on the forefront for quite some time.

Greg Campion: And then if you think about what rating agencies may do. So you think about, okay, let's assume that the economy slows down, some of these underlying issuers start to run into trouble, maybe we see defaults start to rise for the underlying loans. Curious how that will translate, I guess, both in terms of rating agency actions and then what that could mean for the space. And I guess I'm curious where that default picture may go, both for underlying loans and for the CLO's structures themselves.

Melissa Ricco: We're certainly anticipating that there's really only one way to go from the current picture. So defaults will pick up. I would say expectations are somewhere in the three to 5% range over the next year. I think they'll potentially be on the higher side of that range if you consider distressed exchanges, which has been the majority or at least 50% of the credit events that have occurred year to date. I would also say that those are levels that we think are manageable within the CLO structure, and that range has been pretty consistent with all of the managers that we talk to and the managers that we cover overall. From a CCC, or downgrade, perspective within the underlying CLOs, yes, we are seeing that come through. On average, CLOs have about a 5% exposure to CCCs. I could see this going to maybe 10 to 12%. Of course, it's always hard to predict. And there will be a lot of bifurcation across deals, across managers. We'll see a lot of difference in performance. So I think that's an important aspect of all of this. But, again, these aren't levels that we think are going to cause an issue for the CLO structure. CLO structures are set to withstand this type of thing. We've seen this before. I think what will be a bit different this time around, and we're having a lot of discussions around, is just recoveries. So I think we're seeing a pretty wide dispersion in the recoveries from defaults year to date. And for context, historical loan recoveries have been around 70%. We have to manage that down, I think, overall. So that's just something that we're considering as well.

Greg Campion: So if you're an investor in this asset class or you're thinking about making an allocation to the asset class and you're doing your due diligence and thinking about, " Okay, what's my real potential downside?" Let's assume the economy hits a real rough patch, we start to see more underlying defaults, and you start to see that CCC bucket rise. At what point do you start to get worried about that? At what point does cash flows need to be diverted away from CLO equity holders? How does all that work out and do you think of that as a pretty remote scenario as we sit here today?

Melissa Ricco: I would say we'll definitely see some deals hitting their triggers, if you will, their over collateralization tests, which will potentially cut off equity. There's no question that there are, and in particular, there's some deals that were from 2017, 2018 vintage that were not able to reset that may have already had some tail risk in their portfolio. So going into the cycle and approaching the end of their reinvestment period, the managers are going to have less flexibility to trade. And so those deals, we think, could look worse for the equity or more of the single B double B type tranches. So I think where there is potential areas of concern, that would be it. So I think from a cashflow cutoff standpoint, I think the important thing to remember there is that those are temporary shutoffs, if you will, and they're meant to occur to protect debt holders. So I think there's some equity that would be potentially at risk, but it's going to vary just depending on the deal, depending on the portfolio profile and what the tail risks are there. But overall, I don't view any of those things, just broadly speaking, as a major issue for the asset class in terms of receiving your principal back. It could cause some volatility in mark to market, things like that. So I think being more patient in this asset class is important. These are longer term vehicles.

Greg Campion: And we're making a leap here, looking at worst case scenarios, especially when you just mentioned that defaults in CLO portfolios are around 1% today. But in the past, so if you've gone through cycles including the GFC back in 2008, 2009, when some of those deals had cash flows diverted away from equity, how did that ultimately work out for some of those deals?

Melissa Ricco: Yeah, I would say the interesting point about that is that when cash flows are diverted, and if they're diverted to buy additional collateral during volatile times, that actually allows the manager to buy discounted assets, which ultimately is accretive to equity. And so if we look at the equity performance from deals that were issued around the great financial crisis, they've had some of the best returns. So you're looking at 20% plus IRR. So I think that is an interesting point. Obviously it depends on where your cost of liabilities are within the structure and a lot of other factors. So I wouldn't necessarily say that every situation and every market's going to react the same way, but I do think that is an important aspect of the CLO structure in that managers are able to reinvest and the structure can work to protect the debt.

Greg Campion: Yeah, okay. That makes sense. That makes sense. I'm probably being way too overly dire in my line of questioning here, but I think that it's no secret that everybody has just been expecting this economic downturn that keeps getting pushed off and pushed off and pushed off. But you assume that at some point, it gets here and we may face some of these headwinds, but it sounds like you're pretty comfortable in terms of the structural protections that are in place and the starting point from which you're coming from in terms of the underlying credit exposure.

Melissa Ricco: I think the other important point too to make that we haven't yet is the fact that CLOs are extremely diversified pools. And so if we're thinking about defaults, it seems like it's going to be idiosyncratic in nature, and that's what we've seen year to date. It's been pretty evenly distributed across sectors. So within a CLO, it's very diversified from both a position as well as an industry standpoint. So I think that's also a significant benefit in this market.

Greg Campion: Out of interest, did CLOs tend to have much or any commercial real estate exposure? That's obviously a sector that's really in focus right now.

Melissa Ricco: Yeah, no, definitely not from a direct standpoint. There's some loans that may have some more indirect exposure, but we're not finding that to be very significant right now.

Greg Campion: Okay. We've talked a little bit about the fundamentals. Wouldn't mind shifting and talking a little bit about technicals as well. So technicals can be a big driver in terms of both the underlying loan market and the CLO loan market as well. So if you think about the supply and demand dynamics that you're seeing in the space right now, how would you characterize those?

Melissa Ricco: Yeah, it's been pretty consistent for our market for quite some time now that we've all been complaining about the challenged arbitrage in our market. And really what that comes down to is just this imbalance between where CLO liabilities are priced versus where loans are priced. And so CLO liabilities have not kept up with loans. Loans have been moving up more recently, which has made it more difficult for managers to issue CLOs. And so we've seen a bit more muted supply, especially over this last quarter. That being said, it's been interesting to see that there still has been pretty significant volume year to date. I think we're down maybe about 25%, but so even with that, there's ways that deals are getting done. And I think that really does speak to the fact that there is demand out there. U. S. banks, I know we've talked about in the past, have been largely out of the market and that's been a significant impact to the demand for AAAs. And so that's also made it tougher. There have been other buyers that have come in and consistently bought. Japanese banks are still very active. Insurance. Some U. S. banks are still playing, just maybe not to the degree that we've seen in the past. So you're seeing discipline in the market. Some patience. I would say the market's more open to tier one managers, so it's much easier to get a deal done. There's a pretty wide basis between where you can get your AAAs done if you are in tier one versus not, which we can talk about that, but I think that is an attractive opportunity as an investor. So, yeah, I would say we're expecting going forward not to have the similar issuance that we've had in the past. Still stay fairly steady and just overall more discipline.

Greg Campion: Okay. Okay. So you've had less issuance overall. You've had some historical buyers like U. S. banks maybe take a step back. Is that related, by the way, to the regional banking crisis or is that other factors that are driving that?

Melissa Ricco: No, that's really other factors and that's occurred quite some time back. I would say the recent banking crisis, interesting that I feel like our market has gone somewhat unscathed to a large degree in that CLOs didn't hold any regional banks and we really saw very little forced selling. I certainly don't think that's helpful right now for U. S. banks to come in, but I wouldn't say that that was definitely the cause because this has been the case for quite some time. I would say, I think, generally the expectation is they come back. I won't try to predict when that could be, and there's been some talks about maybe mid next year. We certainly think there's a lot of reasons they should be back in the market, but it's not something that I'd want to predict.

Greg Campion: Now on the manager tiering point that you made, so that's really interesting and I'd like to understand that a little bit more. So, of course, at Barings here, we have two different parts of our CLO business. We have the part that you and your colleague Taran Leonard manage, where you're investing in third- party CLOs and putting together portfolios of those for our clients. And then you have the part of the business that is run by Adrienne Butler and her team that is issuing CLOs and I think Barings as a CLO issuer, correct me if I'm wrong, I think we would be considered one of those tier one managers where the deals that we're pricing tend to be at the tighter end relative to competitors. But tell me a little bit just more about that differentiation between managers and how that impacts whether or not you can issue or not in an environment like this.

Melissa Ricco: I think it largely comes down to that AAA tranche, in that it's just such a large part of the capital structure, and the buyers of AAAs typically may have a more limited list of managers that they're willing to invest with. I would categorize them mostly, but maybe not all, as the larger scale managers that they're... But I would argue, and I think there's case to be made, that there are other managers that have track records where they maybe came from another platform. So there's a lot of the story that you need to understand and due diligence that you need to do, but if you can pick up an additional 50 basis points on AAA, for example, and be comfortable with that manager and they have a historical proven track record and have the right resources and all of that commitment to the asset class that we think that could be fairly attractive and has been sort of a gap in the market that we'd like to look at. I think manager is one of the most important criteria, we think, when investing in a CLO. And I think if we're looking at a BB, for example, we're going to have a much more refined list of managers that we're willing to invest with. But I think there's a case to be made further up the stack if you can pick up additional spread and it makes sense.

Greg Campion: Got it. Got it. Now at one point, I think we were seeing lots of new shops popping up issuing CLOs. Are we still seeing that, or has the slower issuance environment, has that kind of slowed that down? Curious if you're still seeing consolidation in this space or any big movement there?

Melissa Ricco: I think that's actually really interesting because I think we often talk about manager consolidation and we do see it. We continue to see it, but it's never really to the degree that I think we're all expecting. We have seen some additional new managers come to space where maybe they're part of a larger insurance company and they've built up a team to issue CLOs. Now one could argue maybe this wasn't the best time, considering it's just much harder to do that, but I think many of them I'm sure have the patience and all of that. So I don't think that it's necessarily going to result in some quick manager consolidation on that front. But things are always changing. It's always interesting to see the dynamics between those acquisitions and oftentimes they'll happen for different reasons. So it's very case by case, I would say.

Greg Campion: Yeah. Yeah. It seems like the long- term trend, as you mentioned upfront, is growth of the asset class, continued acceptance of CLOs as an institutional asset class. So you would expect that as part of that you would continue to see growth, and then we're seeing growth in other areas like private credit CLOs is another growth area as well, which again is probably not surprising given the massive growth that we've seen in that market as well.

Melissa Ricco: Yeah, absolutely.

Greg Campion: Okay. So we talked a little bit about the fundamental outlook, we talked about the technical outlook, a little bit about the competitive environment out there and the picture. Let's talk a little bit about just opportunities. So I know you mentioned AAAs as being attractive right now, given the yield on offer. Tell me a little bit about, as you and the team survey this landscape right now and look to put capital to work, where are you seeing some of the best opportunities today?

Melissa Ricco: Yeah, I would just start off by saying I think it's important to note that CLOs, I think, you can almost look at any part of the capital structure, other than new issue equity, I will put that aside, and say that it offers a pretty attractive relative value, especially when comparing it to like rated corporates. I could say that almost about every part of the stack. I think the thing is the relative value within the stack moves around from time to time. And so, yeah, we've talked about AAAs. There's no doubt that there incredibly attractive in the market today just from a risk return standpoint and just the carry that's there. I would also add AAs, you can pick up an additional 80 basis points on top of AAAs for what is still an incredibly risk- remote tranche that has never defaulted. So all those things, I think, ring true for the AAs as well. I would add further down the stack, BBBs and BBs, I think, if you're looking for more yield. BBs, we think, look more interesting than equity. So there, you're able to earn risk- adjusted returns. I would say low to mid- teens, which is actually higher than where we see new issue equity today. And, again, this can change and move around, but I think that's typically the case. And there, you're just going to need to be mindful of what the tail risks are in portfolios. Does the manager have the proven track record? Things like that. If you buy in the secondary market, you do have some upside. If you're buying it at a discount in the new issue market, we really like the clean, high- quality profiles from tier one managers there. So there's a lot. It depends a little bit about each individual's client's risk return type profiles and what they're looking for.

Greg Campion: Yeah. So would you say, and I know that you and the team are always monitoring different parts of the capital structure, looking at everything from AAA down through equity, and as you mentioned, things change and relative value shifts around. Would you say it's true today that given the higher base rates, given the fairly wide credit spreads that you're able to achieve in the debt tranches, would you say that that makes equity look relatively unattractive today?

Melissa Ricco: Yes. I would say that generally speaking, especially I would caveat that with new issue equity. There is some secondary equity that trades that it's more difficult to make that widespread conclusion because there's a lot of different nuances that come with what vintage is the equity from, what does the portfolio look like, what dollar price are you buying it at, what do you see as the overall return, what do you think the takeout is? So there's those type of things when you're looking at secondary, but I definitely think that's the case with new issue equity.

Greg Campion: Got it. Got it. Okay. All right. Well, Melissa, this has been a really great tour through the CLO asset class and a great update on some of the big dynamics that are shaping the space right now. As we bring this conversation to a conclusion, I just wanted to give you the chance to offer any parting thoughts to investors who may already have an allocation in this space or may be considering one. Any parting thoughts to share?

Melissa Ricco: Yeah, I would say given the backdrop of some of the risks we've talked about, I think CLOs offer a lot of attractive features, whether it's the diversification of the portfolio, the structural protections, and not to mention the active management, which we think is really key. All those things together, the fact that CLOs offer very attractive yields as well with high carry, we think that makes a ton of sense in this market environment.

Greg Campion: Yeah, such an interesting time right now, such an interesting space. An asset class that's really stood the test of time as we've seen cycle through cycle, and as you point out, some really attractive value on offer in different parts of the capital structure today. So really appreciate you sharing your thoughts, Melissa. This has been awesome and hope to have you back on the show again soon.

Melissa Ricco: Thanks for having me.

Greg Campion: Thanks for listening to episode number nine of season eight of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate and emerging markets, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. We publish a new episode every other week. And if you have specific feedback, you can email us podcast @ barings. com. That's podcast at B- A- R- I- N- G- S. com. Thanks again for listening, and see you next time.