Talk Your Book: Floating Rate Income

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0:36podcast.

0:40Welcome to Animal Spurs with Michael and Ben. On today's show, we are talking about collateralized loan obligations. Wait, isn't that what almost took down the financial system in 2008? No, not exactly. Those were collateralized debt obligations. Some of them might have been inside CLOs, Ben. I don't know. It's been a long time. I haven't read Too Big to Fail in 20 years. I read a lot of very long magazine pieces about this stuff back then because there weren't really blogs and stuff to get into this. But yeah, I think anything with the word collateralized in it probably has people feeling a little nervous.

1:11Thank you for not checking my math there. Okay. A little bit off. So we talked to Fran and Bill from VanEck today, who work for their fixed income ETF portfolio management team. We talked about CLOI, which is a collateralized loan obligation ETF, which is obviously making way in the headspace of investors because this thing went from zero to a billion in the last three years, I guess. Unbelievable. So it's essentially, it's a basket of loans that invests in a basket of loans. Yes. Baskets all the way down. And there's higher, hearing about the products is interesting. It just made me think how many different ways, you think of fixed income as like this really boring asset class to invest in.

1:51Oh, you just buy government bonds and that's it. And now there's so many other ways to invest. And I think the fact that we've had so much extreme volatility in bonds in this decade has made people try to rethink, wait, maybe I need a little bit of this or some of that and try to hedge different environments. Well, guess what? The appeal to this is it's actually not fixed income. Right. Oh, because it's floating rate. Right. Right. So yeah, when rates go up and inflation goes up, this thing, the rates adjust and you don't have the interest rate. Because fixed income investors got destroyed in 2022.

2:23And investors that were exposed to floating rate that is more credit risk, which actually weirdly held up in 2022, made it out just fine. Yes. But I do think there is something to the fact that fixed income investors have woken up to the fact that I need to be way more thoughtful about this allocation and maybe have different pieces of my allocation that account for deflation and disinflation and then inflation and then financial crises and all these different things that can impact different aspects of the fixed income market in different ways. This is a good conversation with Fran and Bill. It is a highly complex subject.

2:56And so this is not the type of thing that loans itself to just one conversation. So for advisors that are listening and want to learn more, there is more to be found at vanek.com. So with no further ado, here is our conversation with Fran Rodoloso. Fran is the head of fixed income ETF portfolio management at VanEck. And Bill Sokol. Bill is the VP and director of product management.

3:22Guys, welcome to the show. Thanks for having us. Thanks. Great to be on today. Before we get into the conversation about CLOI, the ETF that we're going to be talking about, collateralized loan obligation, not exactly a corporate bond or a treasury bond. I'm assuming a lot of people that are listening to this might not have been around back in 2008 when these buzzwords were there for the wrong reason. What is a collateralized loan obligation? So a CLO or collateralized loan obligation, it's a securitized portfolio of leveraged loans. These are often referred to as bank loans or syndicated loans.

4:03And these are loans made to cash flow generating companies. The loans are secured by assets of these borrowers, and they rank senior to other debt of these companies. So senior to things like high yield bonds. And historically, they've had lower levels of losses as a result of that seniority. A CLO typically holds 150 to 300 of these individual loans. And like any securitization, what happens is that the CLO will issue debt in order to fund the purchase of those loans. So the investors in that debt earn the interest that is being generated by the underlying loans. So interest and principal actually is paid to the debt investors.

4:49But this isn't paid pro rata. It's paid sequentially. So you have different levels of subordination. You have different tranches. You have different credit ratings that reflect the seniority. So you have a AAA tranche that's going to be paid first, paid interest first. And it's the most insulated from losses in the portfolio. You have an equity tranche, which absorbs any default losses first before any of the other debt holders, and it receives all of the excess cash flows after interest payments are made to the debt holders. And between the AAA and the equity, you have AA down to BB, typically.

5:33And this structure does allow for different levels of risk and return. and they, I should also note, they pay floating rates of interest. So that reflects the same floating rate nature of the underlying loans. So you're going to get SOFR plus a fixed spread and the spread is going to reflect the level of risk you're taking. What is the reason for floating rates? Why is it floating? Well, leveraged loans are floating rate. It's the nature of the asset class. typically it's because these are made or historically these have been made by banks and banks like holding floating rate assets. And you want to match the assets of the CLO, which in this case is the loans with the liabilities, which is the CLO debt.

6:21So you don't have a mismatch. All right. So pretty straightforward. No, I'm just kidding. That was a lot. We're going to So we're going to unpack this over the next 30 minutes. So, all right. These are like loans of loans with different tranches. Fran, what exactly are we looking at here? Think of a CLO as a fund. And that fund has an equity investor. Sometimes it's the fund manager. Sometimes it's outside parties. That represents about 10 % of the capitalization of that fund. 90 % of the capitalization of that fund comes through the issuance of debt. Those are CLO tranches. They range from AAA, typically down to BBB.

7:03So there's sort of one in each major rating category. So from an end investor point of view, you can lend money to the CLO structure by choosing the level of risk you want to take. You could lend money at the AAA level, which has a super high degree of subordination underneath it, which receives really most of the first cash flows that accrue to that CLO. As I said, a CLO is like a fund. What's being held by that fund are, as Bill said, broadly syndicated loans or bank loans, which are typically sub-investment grade. But it's a large diversified portfolio of loans. And that is where a lot of the protection comes in for investors.

7:45There's that and the subordination of the lower-rated debt tranches and, of course, equity to the higher-rated debt tranches. So in 2022, when we had the bond bear market, it wasn't really a credit event. It was an interest rate risk event, right? So my guess is because of the floating rate nature of these, CLOs managed that period pretty good then. Yeah, so the floating rate nature certainly helped in 2022, 2023. It continues the rate volatility we've seen. And it's the floating rate nature, but also, as I'm sure we'll discuss, you get a spread pickup as well, a very attractive spread over the floating rate.

8:26And that also helped with returns. So you guys timed the launch very well. It was June 2022. As Ben mentioned, we were in a really nasty bond bear market, but that was primarily in treasuries of all things and investment grade bonds. So from 2022 to today, almost a billion dollars in assets has entered. In fact, it was over a billion at one point. But so obviously, there is a massive amount of demand for something like this. Why do you think investors are starving for this sort of investment? A couple of reasons. One is, yep, they're looking at the returns that they've delivered through bouts of rate volatility.

9:05But number two, when you look at even longer term risk and return charts, you know, CLOs have really high sharp ratios. They have better returns than investment grade credit with lower volatility. Even the lower rated tranches have higher returns than U.S. high yield corporates. with the low interest rate or zero interest rate duration. They're not correlated to, say, your ag or other core fixed income instruments. So there's this diversification benefit as well. So it's a combination of risk, return, diversification. Is one of the downsides then if we have a disinflationary environment or a deflationary environment and other bonds get a little boost because of yields falling, is that where CLOs struggle?

9:55What's the downside for these assets? The coupon will go down if the Fed starts cutting rates. That's just the nature of floating rate. But there's no price in that. So it's not really a downside. You're not going to see rate sensitivity from a price perspective. Really, these are credit instruments. So the main risk here is that you have a credit event that spreads wide and out. And you're going to see that reflected in the price, the value of the CLOs. They're much more sensitive, especially as you go down the capital structure, they're much more sensitive to credit. So I want to talk about the packaging of this product because there's been an extraordinary disamount.

10:36That's not a word. There's been no volatility. If you're looking at the price return of this thing, it is up and to the right. The max drawdown is like 3%. So talk to us about the mismatch between like the liquidity that you get in the ETF wrapper versus the underlying portfolio of loans within each loan that's in this portfolio. Like, so, and then I guess in the event that there is a credit event in the economy, would we see this thing, you know, gap down 15 % or how would the price discovery work? And forgive me for the long rambling question. Oh, a few things. Maybe we'll start at the end of that question.

11:16How much CLO prices? Remember, these are debt instruments that are collateralized by those loans. These actually trade more like bonds. They're normal settle, T plus one settle. there's not necessarily a lot of electronic trading it's a lot of end investor to end investor via trade lists like bid wanted in competition or offer wanted in competition lists but they also trace their transparent so the clo tranches that are issued by these structures have a very different dynamic in terms of the liquidity although leveraged loans also trade pretty regularly and are quoted. They just have longer settlement cycles.

11:56So particularly in the AAA and AA tranches, even down to the single A, there is a lot of liquidity, meaning you can see quarter point bid-ask spreads through bouts of volatility. There are typically buyers because there are bank treasuries, there are corporate treasuries, there are insurance companies, Japanese banks are a well-known user of particularly the AAA tranches. Same goes with a lot of those institutions for AA tranches. It's as you go further down to say the BBB and BBB tranches where, Michael, to your question, where you might see those 15 % drawdowns, that's possible. And that has happened.

12:41And that's where a lot of, you know, BBB CLOs, by the way, very few of them have ever defaulted historically, like a very, very small number. So the structures have held up, but the price volatility in response to shifts in the credit market is there. And that's, you know, that further down the capsec is where you see that type of price volatility. In terms of the ETFs performance, maybe, Bill, I'll let you speak further to that. But I'll start by saying we haven't seen that much even spread volatility over the last several years, even since this was launched or the other CLO ETFs that are out there.

13:27And Bill, maybe you want to talk a little bit more how this ETF would respond to that. Well, I guess I would just say, to Fran's point, the last three years, we've only seen really tightening spreads with a few blips here and there, including very recently. But, of course, you don't have the rate sensitivity. And that's usually your biggest driver of returns in fixed rate core bonds. So you don't have that. You have the credit sensitivity, which we haven't seen a lot of lately. But it is why we do think when you are investing in CLOs, you need to have the right strategy. You want to invest broadly across the capital structure.

14:12given that you will have lower liquidity and higher volatility as you move outside of AAAs, you want to have the ability to stay nimble, to manage risks, but also to find the best opportunities. And we think being very active in your approach and having flexibility that doesn't just look at the rating is the right way to manage those risks. We had an example just several months after we launched the ETF, there was the sort of LDI crisis with the UK pension funds. And they needed to raise liquidity. They were decent-sized holders of the higher-rated CLO tranches. That's what they sold. They sold AAA, even some AA CLOs, not because they were for sellers, it's because that's where they could get the liquidity.

15:09And so that was a pretty good example. CLOs did get a lot of attention at that point in time because that's what those funds are selling, but the price volatility did not show up in those higher rated tranches. There were plenty of buyers at that point in time. You mentioned the spreads. People have been worried for, I guess, a couple of months now that we're seeing a slowdown in the economy, The stock market is rolling over. People are becoming worried again. And one of the things people in the finance world keep pointing to is, well, spreads are still pretty darn tight and they haven't blown out yet.

15:43Does this surprise you at all? And I guess my follow up would be, is the bond market going to be prescient enough to see a slowdown coming and then spreads will blow out or the spreads blow out after the fact that you already see the slowdown is here? First of all, you're talking to someone who's been in the bond and credit markets for 30 years. So I'm always thinking spreads are too tight. So that's just the nature of being a bond market pessimist. I should have started in equities. It would have changed everything. But yeah, I mean, when you look at fundamentals sort of to a backward looking view on spreads, you could justify them.

16:22The question for us has been looking forward our potential paths for the market, for the economy, for corporate balance sheets are the various risks priced in enough. And I think a lot of people agree there's not a lot of room for error in credit spreads. But on the other hand, you've got base rates that are pretty high levels. So you could look at over 5 % yield on investment grade corporates, over 7 % yield on even high yield fixed rate corporate bonds. CLOs, which are much higher in credit quality overall, coupons are still over 6%. The weighted average yield to worst is still close to 6%. These are still attractive all-in yields with a lot of carry that could cushion against wider spreads, not a 500 basis point blowout in spreads that might come with a surprisingly deep and rapid recession.

17:24so we expect that there will be more spread volatility and more rate volatility. We think CLOs are a way of actually going up in quality for people with high yield or levered loan allocations now to help weather some of that. So as investors talk to you about some of the opportunities, risks in the fund, and they go to your faction like, oh, OK, let me just take a look at what's under the hood, and they look at the top 10 holdings. They say, well, okay, Neuberger Berman loan advisor, CLO. And Fred, I see you laughing because it's a bunch of CLOs in here. So what exactly are investors getting exposure to when you really look under the hood?

18:06Well, with each CLO in the ETF portfolio, underlying that are typically hundreds of individual leveraged loans. So ultimately, they're getting the payments from those loans, but with the protection that the CLO structure provides. They're also getting the expertise of the CLO manager. So you mentioned Neuberger Berman. So Neuberger Berman is actively managing that portfolio of that CLO. And in our ETF, they're getting the credit selection of our sub-advisor, which is Pinebridge Investments, to look into the loan portfolio, assess the manager, assess the terms of the CLO to make sure there's value in holding that deal.

18:54You mentioned the structure of the CLO. So this is senior to everything else. So in the event of distress or bankruptcy, this is the slice that gets paid first? Yeah. So there's multiple layers of subordination. There's the underlying loans, which are senior to bonds. So you do have senior secured exposure in the underlying loans. Those are securitized. And what we hold is the CLO debt. So in addition to the underlying strength of the collateral, you have the subordination that's built into the structure of the CLO. So if you're buying a AAA or a AA, for example, you have the subordination of all the tranches underneath you, as well as the first loss equity tranche.

19:43In the event of a real recession, what would you expect losses to look like? And now like, but also like drawdowns can be divorced from actual losses, no? Like investors could overreact. In a recession or a big credit event, we would expect to see spread widening and some level of drawdown. And what that level is will depend on the severity of spread widening. We don't expect to see defaults. In CLOI, which is our investment-grade CLOs, investment-grade tranches, just from a mathematical perspective, when you look at the the amount of subordination, even below BBB, it's very difficult to have enough defaults in a loan portfolio where you're going to see impairment of even the BBB.

20:34And when I say very difficult, we're talking multiples of the historical average of leverage loan defaults. And you need to see that over typically five to seven years. So it's just something that doesn't happen. So default risk is not the primary risk when you're investing in investment-grade CLOs. It's spread risk. It's the mark-to-market that you might experience when spreads widen. All right. So I don't want to put words in your mouth, but I feel like that particular risk of spreads widening, that happens in a recession, of course, no? That is your primary risk. The depth of losses will vary up and down the cap stack, right?

21:17So the high yield tranche of double Bs, you know, maybe start trading down into the mid to low 80s in terms of cents on the dollar. You know, the higher rated AAA down to single A, you know, you might see 5 % drawdowns, maybe more in an extreme scenario. But, Michael, you already made the point. Those permanent losses, which would come from the CLO tranches themselves defaulting, there's a historical record going back 30 years. So these existed during the global financial crisis. in fact they've existed since the earlier or mid 90s the structures were actually less robust than they are today in terms of having a little lower levels of subordination not quite as strict on the diversification mandates to get the get the ratings there was virtually no tranches that suffered permanent losses you know in the five years like 2008 to 2013 we have a chart in one of our books of losses, meaning default losses among CLO tranches.

22:27And it's basically a flat line at zero. Yes, a handful of BB tranches and a very, very small handful of BBB tranches did default. But those were like on a market basis, it was negligible permanent loss. But the volatility can be high. These correlate with the loan market and the high yield market. They don't correlate with the treasury market. This is a good transition into your investment process. So I'm curious, do you have a specific part of the CLO market that you focus on? Do you only invest in high quality bonds? Do you have credit standards or is it more due to the environment that you pick what is looking the best because of the spreads or because of the economy?

23:07Do you have a specific area you focus on? Well, we have two ETFs. One focuses just on investment grade. So AAA to triple B CLO tranches. The other invests in lower rated mezzanine, which is basically everything below AAA. So it's going to give you a higher yield with more volatility, of course, in the event that you do see a recessionary environment. But how those CLOs are selected, it's actually by Pinebridge Investments. So they're the sub-advisor on the ETFs. They have decades of experience in this market. They've managed similar strategies for their institutional clients. As far as the process, Fran, do you want to walk through that?

23:54Sure. There's both a top-down and a bottom-up element. So certainly, macro views and a macro call would lead to relative positioning and say that the top of the stack, the AAA, AA versus whether or not there's enough value, say, in the all investment grade one to be going more heavily into the BBB tranches. There's also a big bottom up component. Michael, you asked about some of the risks, like the managers themselves can be risks. There are about 200 managers in the space overall. And there are maybe 52 that are represented, I think is the last number in CLOI today. So there are some managers that Pinebridge will will stay away from.

24:39They don't believe they're good stewards of that portfolio. So there's a tiering of managers. That's one risk. But other sort of bottom-up analysis, they literally look into the underlying loans for all of these structures. And that takes a lot of systems and a lot of analysts. And that's why we hired a sub-advisor for this product, because they had all of this infrastructure. You can anticipate where the equity tranche might start suffering fairly significant first loss absorption or where a CLO might start breaching some of the diversification mandates that are in the documentation to begin with.

25:22I mean, these things, as Bill said, 150 to 350, some structures have 450 loans in them. You won't see individual issuer concentrations typically go above 2%. No industry is going to be more than 10%. So there's all sorts of enforced levels of diversification. Structures that breach these or that have too much exposure to triple C-rated loans, those might be things that the sub-advisor will avoid. Or maybe if the AAA tranche is trading at a significant discount to par and a breach is going to force acceleration of payments to the AAA tranche, that might actually be an opportunity. So it's obviously a very nuanced market.

26:06I don't want to go too much deeper than that. But needless to say, there's a process that starts with manager assessment. It goes into looking at each individual CLO or deal from documentation to what's in the portfolio. Then there's a top-down portfolio construction. Is it time for risk off or risk on? In CLOI, by the way, even risk on, we're never going to be really below at least 40 % in the AAA and AA tranches combined to always maintain that liquidity portion of the portfolio. So not to give your compliance people a heart attack, but we've got a lot of trading data and trading history from the high yield ETFs.

26:52They were around in the GFC. And of course, afterwards, so they lost almost 50 % on a price basis, just in terms of the price drawdown. In 2020, during the sharp sell off, these things were down over 20%. Would you expect CLOI to trade in line with that? Like, does it have that sort of potential price volatility in a nasty global event? Part of it is going to depend how it's allocated at that time. And that's why we have a broad strategy with that top down lens, right, in terms of allocating the portfolio. So if it's mostly in AAA or AAA, I would not expect that. And that's where the active management comes in.

27:37I think with CLOB, which is the lower rated strategy, you could have returns certainly closer in line with what you see in high yield or leveraged loans. It's probably the best. The ETFs didn't exist in 2020, but there's been a broad index that's been live since about 2020. the sell-off, at least in as much as it's reflected in the index performance during 2020, the broad CLO index behaved more like investment-grade corporates, which was still a very significant drawdown for that brief period. What is the case for CLOs in somebody's portfolio? What does this compete with or replace? And why would you invest in this versus something else?