Talk Your Book: CLOs – The Providers of Leverage

0:00Today's Animal Spirits Talk Your Book is brought to you by Eagle Point Credit Credit Management. Go to eaglepointcredit.com to learn more about their collateralized loan obligation strategies. That's eaglepointcredit.com.

0:34investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:44Welcome to Animal Spirits with Michael and Ben. One of the themes of this year, unbelievably so I guess, is the rush into money market funds and the yields on cash that's available. On today's show, we went almost to the other end of the world in terms of income strategies. We spoke with Tom from Eagle Point Credit Management about what they do with their portfolio of collateralized loan obligations. This might be the longest one we've ever done. Yeah, we went pretty deep on this one because frankly, we're learning a lot about this too, right along with the listener. Yeah. So I don't want to step on too much of this because we went deep and this is good.

1:19And I think you'll enjoy learning about CLOs. So here is our conversation with Tom Majewski.

1:27Welcome to Animal Spirits with Michael and Ben. We are excited today to be joined by Tom Majewski. Tom is a managing partner at Eagle Point Credit Company. Tom, welcome to the show. Great. Thanks very much for having me, Michael. All right. This is going to be new to our audience and candidly newer to us. We're talking about the loan market. We're talking about collateralized loan obligations, which is something that it's a market that's grown over the years, but it hasn't really been in the lexicon since the bad times. So where should we begin? How about just a quick introduction? Who is Eagle Point Credit Company?

1:59Sure. Eagle Point Credit Company is a publicly traded fund that invests in the equity tranches of CLOs, or collateralized loan obligations. I'm the CEO of the company and the managing partner of the external advisor, Eagle Point Credit Management. ECC's assets total about$750 million, plus or minus. And our advisor, Eagle Plug Credit Management, manages about$8 billion of assets on behalf of principally institutional clients and some retail clients. So I guess the first place that I would start is if somebody is trying to get access to this, because this looks a little bit different than the typical investment, whether it's a mutual fund or an SMA or an ETF.

2:39If somebody is trying to purchase, let's just say ECC is the ticker of the parent company, or maybe you can correct me if I'm wrong, What is in that portfolio? What are they getting? Are they getting access to the loans inside of the portfolio? Are they getting access to the parent company and how investors are viewing that? What are they getting from that investment? Sure. An investor buying ECC stock today buys into the current portfolio within ECC, which is substantially all CLO equity. There's a small amount of CLO debt and a few other small securities in there, but the vast majority of its portfolio is CLO equity.

3:09We believe it's one of the largest and most diverse portfolios of CLO equity in the world. And it's something that's available to investors. They can buy the stock at trades on the New York Stock Exchange under ticker ECC. Obviously, intraday liquidity, whatever folks want to get in or out, it's as easy as hitting buy or sell on your phone. The stock pays a monthly distribution of a pretty handsome distribution, which is something that's been well received by shareholders. A long time ago, we paid it quarterly, and enough folks said, why don't you just pay it monthly if your portfolio generates so much cash, which it does.

3:44So we were happy to oblige a bunch of years ago. Before we get into the CLO stuff, maybe you can just give us a little bit of background on why this is a BDC and for people who are unaware, what that structure is and how it works and why you guys chose to go that route with this fund. Sure. The ECC is actually not a BDC. It's a 40-act investment company that has not made the BDC election. It's basically a closed-end mutual fund. BDCs are the same thing, except they make a special election to be treated as a BDC. And then they get certain additional things, some additional leverage they can take on.

4:20And it also changes some of the things they can do. Like they can issue stock below NAV and things like that upon shareholder vote. We don't have any of those provisions in ECC. But it looks and feels a lot like a BDC, and frankly, research analysts who cover it are often the same research analysts that cover BDCs. At the end of the day, the strategies at the core are fairly similar to a typical BDC in that we're generating high current cash flow for our shareholders coming from loans to American companies, very similar to what BDCs do. Many BDCs often lend more in the middle market space and on a direct lending basis, where they might be the lender of record.

5:03And if you look in their portfolio, you might see a loan to company XYZ or company ABC, which is probably a middle market company you've never even heard of in the United States. ECC invests principally in the equity tranche of CLOs. These CLOs are U.S. CLOs, so again, lending to American companies on a secured basis. but ours are typically larger cap and called broadly syndicated loans. The underlying loans that make up a typical CLO are going to be a wide variety of the market basket of the American economy. Companies like American Airlines, Cablevision in New York City, Hilton Hotels has been a loan borrower.

5:46Lots of different companies like that that are household names that you do business with every single day. So maybe we should take a step back and just describe what is a collateralized, is it collateralized? Yeah, collateralized. I was saying it's a collateral or collateralized. Okay, it's the I's. What is a collateralized loan obligation? A collateralized loan obligation is basically a securitization of a pool of corporate loans. These are small pieces of big loans to big American companies. The loans are typically floating rate and typically senior and secured, meaning they have a first priority in a company's capital structure.

6:22Now, many of the borrowers in the CLO market or the loans that we lend money to through our CLOs are typically below investment grade companies. So they're often rated double B or single B, which is below investment grade from the rating agencies. Despite that, in theory, higher risk, the loan index has performed exceptionally well over the last 31 years, the Credit Suisse Leverage Loan Index has had positive returns in 28 of the last 31 years. And I'm unaware of any other risk asset class that's had such consistent positive total returns. And that's the raw material that feeds the income into our CLOs that we're then able to generate the strong cash flows out to our investors.

7:08So this is something like a high yield sort of credit rating. What is the sort of default rate that people could expect for something like this? Sure. So indeed, it's the same ratings as high yield bonds. Unlike high yield bonds, there's two big differences between loans and bonds. Loans are floating rate versus bonds are fixed rate. So certainly being in fixed rate paper has been very painful for many investors in that sector. the things we invest in are principally floating rate. And we're also senior and secured. So when companies do get into trouble, and we'll get to the default rate in just a minute, companies will get in trouble when you're lending in below investment grade land.

7:49The recovery rates are typically much higher on loans than unsecured bonds, simply because you have a collateral package and you're first in line for repayment. Now, in terms of defaults, there's very rarely an average default year. The average default rate over the last 30 years for loans is between 2 % and 3%, according to most measures. Some different people measure it slightly differently. But sometimes defaults are very, very low. Last year, we saw several months in a row with no corporate loans defaulting. And other times, the default rate has gone up. The highest default rate we saw was back in somewhere around 2009, when the trailing 12-month default rate hit about 11 % for the loan market.

8:33On the surface, that sounds pretty bad. High-yield bonds sometimes have had default rates even higher than that, first off. But what's made CLOs work and what originally attracted me to the asset class 20, 25 years ago is something that's very unique in securitizations. If you compare to, you might have heard of mortgage-backed securities or auto loan securitizations, most of those securitizations are static pools. And what that means is you get the loans that you get at the beginning. You hope they all pay off at par. A few of them won't, but assuming most do, it's all going to be okay. In a CLO, there's typically a five-year reinvestment period.

9:16And what this means is that any time a loan pays off, has an amortization payment, partial pay down. These loans have some degree of typically quarterly amortization to the extent a loan defaults and you get a recovery or to the extent the collateral manager or servicer of the CLO sells a loan. For the first five years, the principle from any of those sources can be used to reinvest in new loans. Now, sometimes it's better to reinvest in loans in the primary market, newly issued brand new loans. And sometimes it's better to invest in the secondary market when loans are on sale. And sometimes they're trading very, very cheap.

9:57And a lot of people ask us or everyone asks us about the default rate. A very interesting statistic about the syndicated loan market is the prepayment rate. And these are essential and they go together coupled with the price of loans in the secondary market. The long-term average prepayment rate for loans is about 30 to 35 percent per year. So if you start with a pool of 100 loans, on an average year, you're going to get about a third of your money back at par that you can go reinvest in the market. Now, in choppier times like these, the prepayment rate slows for sure. And right now, we're running between 12 and 15 percent on an annualized basis, so much slower than the long-term average.

10:41Sorry to break in. Why is the prepayment rate so high? Is that because companies are borrowing at such high rates that they want to pay it down quicker? What is the reason for that? So the L in CLO is the L in LBO. We're typically the financiers of Blackstone and KKR and Apollo and folks doing leveraged buyouts. While there are public company borrowers, companies like American Airlines that I cited and maybe 10 or 20 % of the market is actually public, Look, quite a few companies in CLOs that we lend money to are levered buyouts and we're the providers of that leverage. And what typically happens if a sponsor like one of those firms buys a company, they're typically going to hold it for between two and five years.

11:25They're going to reduce some costs. They're going to streamline operations, hopefully get some new contracts and then try and sell the company. Typically, when they sell the company, they have to repay the old debt. And so that triggers repayment coming back into the loan market, which is great news in many cases, not all the time. But when things are in the choppier waters like they are now, the loan index is around 93 cents on the dollar right now. So if you're getting par dollars back for the first five years of your CLO, you can go take those par dollars and reinvest at 93. Roll the clock back to April of 2020, certainly a dark and uncertain day in the economic world.

12:05in all the world, up 2 % of the loan market paid off at par in April of 2020. Think about that. Loans were 80 cents on the dollar in the secondary market. And simply by opening the mail, if you were running a portfolio of loans, you got 2 % of your money back at 100 cents on the dollar. You could go reinvest that at 80. And you made up, frankly, for a handful of COVID mistakes that you might have made. So the default rate is very interesting. The prepayment rate is misunderstood. and I have a theory that's held up my entire career, I hope it continues to and I believe it will, is that in credit, the rumor is always worse than the news.

12:46If default rates go to 10%, and that's not a prediction, but if they were, loans are probably not trading at 95 cents on the dollar. Where are they, like 65? Probably. That's where they were last time. Maybe they were 75, something like that. But every loan that doesn't default pays off at par. It's a binary outcome for every credit investment in the world. And to your point, if we see a situation where there's 10 % defaults, we hope loans are trading at 65. Right. That would be great. And every loan that doesn't default continues to make par paydowns. And when stuff, if the market traded down to 65 at a broad level, some loans are going to be at 70, some are going to be 60.

13:28It's not a standardized market in those days. and the ability to sell a loan at 70 and buy a loan you like more at 60 within a CLO, as long as you're in the reinvestment period, is very, very valuable. Tom, sorry to jump in with a tangent question because I have so many more things to ask you on the matter at hand. But what are the differences between a CLO and a boogeyman acronym, the CDO that we heard about in 08? Because I'm sure you get investors that are like, I don't want to touch that. So what are some of the differences? I get that question every single day, and I suspect I will every single day until I retire.

14:01Garbage in, garbage out. Quality in, high cash flows out. It's really as simple as that. While the acronym sounds the same, what the CDOs of the mid-2000s invested in were very junior pieces of securitizations of mortgages to subprime borrowers. Now, 20 years ago, 30 years ago, in the 1990s, subprime mortgages were at 18%. They were 50 LTV. They were very, very conservative loans. You could make a lot of mistakes as a lender and still have a positive return. By the time we got to 2006 or 2007, those rates were 2.5%. There were no-doc loans and 90 LTV. Not a lot of margin for error in that case.

14:44Overlay a recession, overlay some fraud in the mortgage market with people who get a W-2 somehow needing a no-doc loan. Why that happens doesn't make a lot of sense. Those things all turned out very, very poorly. So if you put investments in that all go to zero, it doesn't matter what the structure is, there's nothing really we can do to help you. The loan market, while 2008 was a negative year for the loan market, had you invested in loans just on an unlevered basis on January 1 of 2008, by the end of 2009, you had a positive total return. It wasn't the most fun ride for sure, but when all is said and done, even with 11 % of corporate America defaulting, you ended up with more money than you started with.

15:29And that's just in loans. In CLOs, you did exceptionally well because CLOs could keep reinvesting their paydowns in deeply distressed loan and good loans trading at distressed prices. Those loans paid off at par. All right. So getting back to ECC, I'm looking at a chart and we'll listen to the show notes. You've got a great quarterly update with a lot of information that shows accumulative distributions per share by year. And I need to know how you went from$2.35 a share in 2015 to$10.40 in 2018 to$18 in 2022. this seems a little bit worrisome just from the skeptic's point of view. Like, tell me what I'm missing.

16:12How is this going up until the right in such a steady fashion? How are you doing this? Oh, so, and that chart you're looking at in our investor deck is a cumulative distribution. Oh. I wish it was an annual distribution. Oh, my bad. No such luck there. No such luck there. Oh, boy. All right. If it was annual, I think our stock would be trading at a higher price. See, I knew it was too good to be true. But look at that chart. It's incredible. The consistent high cash flow that these investments generate let us pay very high cash distributions to our shareholders. And the one thing that's never too good to be true is cash in your bank account.

16:51That's the number one best return on an investment. and shareholders who own ECC, who don't take advantage of our discounted reinvestment option, get a lot of cash in their bank every single month. And that's the chart that shows, had you invested it, our IPO was$20 a share. You've gotten 18 and change back in distributions. You know, we're on pace to get to$20 a share really soon and you still own the company. But wait, this is, I'm glad you mentioned this because this, this, the, the stock price is not the thing, right? If you only look at the stock price without the total return, you're completely missing what's happening.

17:23It's like looking at junk bonds, just the price without the total return. Correct. This is very much about the current cash flow. And I would imagine since you gave that anecdote about if there's a 10 % default rate and loans trade at 60 or 70 cents on the dollar, it actually makes sense to me that people in this space would have those sort of overreactions because they're looking to protect the downside and there's probably going to be some overreactions. So that would mean if you're just looking at the price, it's probably going to be more volatile than you would assume when you look at the income.

17:51That's very, very fair. A couple of things to share around that. To talk about the market in general, the best vintage for CLOs prior to the financial crisis was 2007. You would think that's odd. Think the credit standards in 2006 and 2007 were very weak. Every bad credit that was done into that bubble, Tribune and TXU and some of the greatest defaults are all in there. However, that batch of CLOs generated a median return to the equity investors between 18 % and 19%. Not because they had great credits, but because they could reinvest when loans were at 65 cents on the dollar for everything else.

18:30They had the 10 % default rate, 11 % default rate that we talked about. Yeah, but you had to go through hell to get that. I mean, it wasn't a straight line, that's for sure. But compared to investing in bank stocks, for example, CLO equity did much, much better than had your own banks over that same period. And that's really what we think of a CLO as a better bank. Let me posit this to you. We do what every bank, we CLOs do what every bank does. We borrow from people at a low rate. In our case, it's the CLO debt. And we lend out at a higher rate. And we have a positive net investment margin, the difference between what we lend at and what we borrow at.

19:07So that's great. That's what banks have done since the beginning of time. and it works out a lot of the time. What a CLO has that no other bank has has ever figured out is we borrow long and lend short. So I'm sure you've had a number of podcasts recently about bank failures and all the terrible things going on in the banking world. Hopefully, the worst is behind us. We'll see. First Republic is down 43 % today. I saw that, yes. It's selling$100 billion of fixed rate assets. That's a toughie. Frankly, had these banks own CLO AAAs, which are floating rate instead of fixed rate mortgages, they'd probably have a, they might be in better shape today.

19:44All right, so you borrow long to lend short. That's the opposite of what I've heard. That's the mistake. So no bank ever does that. Banks take deposits from you and me or checking account, your savings account, maybe a one-year CD, and they lend 30-year mortgages. We do the opposite. A CLO borrows for 12 years and makes five to seven-year loans. Those loans typically pay off in three or four years, because we talked about that prepayment rate. And then for the first five years, any of those paydowns can go by new loans. Every loan in a CLO has to mature before the maturity date of the CLO debt.

20:17And I can promise you every credit will do one of two things. It will default or pay off at par. And as long as those maturity dates are all before our CLO debt is due, we can see every loan through to its ultimate outcome. And along the way, there's no mark-to-market triggers. And that financing is locked in place. So if loans are 65 cents on the dollar, it's not good news, but it actually probably is good news because we're reinvesting cheap. But the lenders into a CLO, the people who buy the CLO debt, can't make us put in more money. They can't force us to sell loans based on the price of performing collateral.

20:50So who are you borrowing from? So we actually borrow. So our CLOs issue tranches of CLO debt. There's AAA, AA, all the way down to double B. It's floating rate, which is nice. It's 12-year legal final. It has a two-year non-call period. And the people who buy that at the top of the capital structure, kind of AAA, AA, and single A, it's often banks and insurance companies are some of the largest investors. Some of the largest banks in the United States, not all of them, but several of them have between one and 3 % of their gross assets in CLO AAA, several large Japanese banks, several large insurance companies.

21:31Further down the capital structure, kind of between BBB and BBB, is often mutual funds and some insurance companies and hedge funds and folks looking for a little more of a return. You can kind of get a high single-digit, low-double-digit return still in a nice floating rate asset. You mentioned the floating rate thing a few times. How often do those rates reset for you? Every 90 days. So our assets and liabilities all float off of LIBOR converting to SOFR and everything resets. And what what are those changes looked like in the last, I don't know, 18 or 24 months as rates have changed considerably in the rest of the economy?

22:07So radically rates, you know, three, three month LIBOR was below half a percent not too long ago. It was below half a percent for a long time that went up. Then COVID brought it right back down to, you know, close to zero. And now we're back up to, if I look on the screen right now, three-month LIBOR is five and a quarter percent. For us, it almost doesn't matter in that our loans earn LIBOR, but we pay LIBOR or SOFR to our CLO debt. So it's kind of a wash between the two. While we don't increase our distribution, we don't get a lot of extra money when rates are going up. Importantly, we're not underwater when rates are going up, which fixed rate investments would be.

22:45So Tom, in 2022, there was this weird paradox where investment grade bonds, at least the index, so I'm thinking about LQD, underperformed high yield dramatically because there was so much interest rate risk and there was really no corporate spreads. I mean, corporations were fine. So there was no stress really in 2022. So how did that impact your performance in 2022? So LQD and the underlying index there is typically fixed rate, unsecured bonds issued by investment-grade corporates. Our CLOs invest in floating rate secured loans to below investment-grade companies. The loan index was down modestly last year, down about a percent, give or take, compared to investment-grade down, depending on which index, 15%, something like that.

23:40One of the only large asset classes to be positive last year, other than cash, frankly, was CLAAs, which had a positive return due to the high current coupon. And their coupon just kept going up throughout the year. All right. A few questions from the investor point of view. This might be ridiculous, but just maybe level set or give people like this versus that. What's the difference between investing in something like ECC versus a floating rate ETF, bank loan, or senior loan, or whatever, something like that? Sure. So the underlying investments, kind of the raw most underlying investment in those funds is actually the same thing as in CLOs.

24:17So if we were to look at BKLN or SRLN, funds like that, the vast majority, if not all of those loans are going to be some of the same loans underlying a CLO. A CLO, we list our top 10 obligors in the materials you see, and you can see we have well over 1 ,000 different companies. So one difference is our portfolios, underlying portfolios, are going to be much more granular. It's just impossible to have 1 ,000 different loans in a loan ETF like that. And then those funds are typically open-ended funds with daily ups and downs where investors either redeem in, buy in, buy out. the bid-ask spread on loans is non-trivial.