Talk Your Book: Investing in Securitization

0:00Ben Carlson:Today's Animal Spirits Talk Your Book is brought to you by Janice Henderson Investors. Go to JaniceHenderson.com to learn more about their whole suite of Securitize ETFs, including JAAA and JSI. That's JaniceHenderson.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing.

0:21Michael Batnick:Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:46Ben Carlson:Welcome to Animal Spirits with Michael and Ben. Michael, I think you could make the case that this has been like one of the weirdest, probably the weirdest decade ever for fixed income. And it's been kind of a light bulb moment for a lot of people. Yeah. Like, oh, I have to like expand my horizons here. Yeah. I got, people got smoked. And we've talked to a lot of different fixed income products over the years on Talk Your Book. And I got to be honest, I, the CLO stuff is still, was still a little over my head in some ways. Because I feel like it is, it gets lumped in with CDOs. It's like, oh, I know what those are.

1:23Ben Carlson:Michael Lewis taught me, right? to curitize stuff. I think it took a long time for people to maybe be more acclimated with this. And it seems like they are now very acclimated. So we talked to Mike Laughlin. Mike is an executive director and the ETF client product specialist for Janus Henderson Investors. And they have the biggest CLO ETF in the game, which, let's see. So JAA, JAAA is the name. It's a Janus Henderson AAA CLO ETF. As far as I can tell from YCharts, $27 billion under management. And this thing is not that. This thing has only been around since late 2020. That is a lot of money. It's a massive, massive.

2:03Ben Carlson:Obviously, the timing could not have been better for them.

2:06Michael Batnick:Well, I think the story is clean. AAA rated. No defaults in the history of the asset class. 50 basis points spread over... Corporate bonds. Corporate bonds. Yep. Very, very, very little volatility.

2:20Ben Carlson:If you look at the line on this chart, it's a smooth ride.

2:25Michael Batnick:So I get it.

2:27Ben Carlson:Yes. And to be honest, it's not very easily understood. I asked Mike, why does this product deserve a spread over other types of bonds? Well, it's harder to understand. It's more complicated.

2:38Michael Batnick:It's the lack of understanding premium.

2:42Ben Carlson:Yes, which makes sense to me. So anyway, we talked all about JAAA. We talked about JSI, which is their securitized ETF, all this stuff. on how securitization works, I think it's worth getting into. This is a kind of conversation where it's worth getting into the weeds for because this stuff is not easy to understand. So here's our conversation with Michael Offlin from Janus Henderson Investors.

3:06Michael Batnick:Mike, welcome to the show. Great to be here. First time guest, long time listener. Really excited. Thank you for having me. All right. Well, appreciate that. We're excited as well because the Janus Henderson AAA CLO ETF, ticker is JAAA. It's J with three A's. J-triple-A. We say J-triple-A. Okay. There we go. Correct me if I'm wrong. This has got to be the biggest CLO ETF in the market, right? It is. Yeah. Yeah. By a factor of a couple of times. Yeah. Yeah. So you guys launched this in, I think, 2021, maybe like 2020. And it's like gone vertical, the total assets of their management,$27 billion up from a base of zero, I guess, unless you converted it.

3:46Michael Batnick:So I don't think you did. Why is there so much money in this thing? What is it about the AAA CLO that investors find so damn attractive? So I think it's helpful to start by just unpacking the attributes. So if you're looking at JAAA today, it's roughly 5 % yield. Since inception at the end of 2020, the volatility has been around 1%. It's floating rate, so there's no interest rate duration. And in the history of US capital markets, there's never been a default in this asset class. So 2008, 2020, 2022, period, full stop, there's never been a default in a AAA CLO. And so that overall combined set of attributes has been very attractive.

4:27Obviously, right after or not too long after we launched it, the Fed engaged in sort of the fastest rate hiking cycle we've seen in a couple of generations. And so that put the yield at a very attractive level also. and advisors can just find a lot of uses for this in a portfolio, whether it's step out of cash, earning more than a money market, whether it's rotating from other parts of fixed income where spreads are kind of tight today, or whether it's just trying to reduce sensitivity to rates. We've seen advisors find many different use cases for that attractive attribute profile.

4:59Ben Carlson:I have a couple of follow-ups. So how long has this asset been an asset classic? How long have CLOs been around for? They've been around for a few decades. Traditionally, this was a more institutional asset class. Oftentimes, insurance companies have been longtime big players in this. Banks have been big players in this asset class, but three decades or so.

5:18Michael Batnick:Let's stick at the high level before we drill into what the hell is even a CLO and what's underneath the hood. I'm looking at the brochure that you guys have, and I'm looking at one of the charts you have. It says compelling yield potential. And it says CLOs are trading 51 basis points over credit, to which I say, 51 basis points. What is this competitive yield for ants. I mean, that's not a lot. But to your point, this is a legitimate asset class that's been time-tested. I think it gets a bad rap for the misunderstandings about it getting lumped up with a CDO squared and all that sort of stuff, which we could talk about.

5:50Michael Batnick:But if you look at the chart of JAA, like the total return price, there is very, very little volatility. So even though you're, I'm sort of kidding here, only picking up 51 basis points, there's no free, free, free, free, free lunch. But this looks pretty compelling. With where spreads are today, if you were looking at it versus call it like money market or other ultra shorts, you're getting about 130 basis points over money market today. I actually, last week, I pulled up the AAA corporate index in Bloomberg, which was spread to treasury of 35 basis points. So you're getting like 100 over AAA corps.

6:27And even if you looked at BBB corps, again, as of last week in Bloomberg, that was about 95 over Treasury. So in this asset class, you own a AAA CLO and you outyield a BBB corporate bond or that index by, call it, 35 basis points. That's pretty attractive, to your point, with very, very low volatility.

6:46Ben Carlson:So we've made a bunch of comparisons to different areas of the bond market, credit and money markets and the ag or whatever. What do you find this as a comparison to? Because it's obviously, it sounds to me like it's floating rate debt, right? So the maturity is obviously relatively short, I would imagine. What's a good comp for this? Something else in the fixed income arena? What would this be a replacement for, I guess? Most commonly, other forms of ultra short bonds is, I think, the most common sourcing area or for folks who are looking to take that step out of cash. For a long time, we were in the Morningstar ultra short bond category.

7:20Morningstar recently created securitized categories themselves. So now they broke out securitized as different asset classes. So they moved us as part of that. But forever, we were part of the ultra short category. And I think that's the first place that people look. What does that maturity look like? There's no, obviously, underlying interest rate duration. The legal maturity of a CLO, and it might be helpful to unpack exactly what a CLO is and how it functions, can be anywhere from 11 to 13 years. Typically, they don't live that long. A typical realized deal life might be seven or eight years.

7:55The underlying loans are typically five to seven year loans. So it kind of depends exactly where in the structure we're talking there. But they act more short-term because the rate's moving. Correct. Yeah. So these are spread products, but they're floating rate. And so the reason they have no interest rate duration is because there's the rate on these floats. And so every three months in January, April, July, and October, you get resets of the yield.

8:24Michael Batnick:All right. Let's see how good you are, Mr. Laughlin. What in God's name is a CLO? Yeah. So it stands for collateralized loan obligation. And so this is part of the broader securitized market, which sometimes that word can have negative connotation when it really shouldn't. It just means to create a security. And so the underlying of a CLO, the underlying collateral is a senior secured bank loan to a US company. If you actually own a floating rate mutual fund or a floating rate ETF, you own the same collateral. And in JAAA, our product, we only use the broadly syndicated loans. So we don't have any private credit-based CLOs in JAAA.

9:07So these are broadly syndicated senior secured bank loans to US companies. Your clients would know it's American Airlines, Bass Pro Shops, right? Those are the types of companies that would be the loans that comprise the CLO. And just for reference, it's actually quite a large market. So the bank loan market in the US is like 1.6 trillion and about 70 % of all CLOs today, or excuse me, all bank loans today get packaged into CLOs, making the CLO market like around 1.1 trillion. So quite big. But a CLO issuer, not Janus, but there's about 140 firms in the US that issue CLOs today, will take a pool of these corporate loans and securitize it into a CLO.

9:51And when they do that, imagine you have a billion dollars as your pool of collateral, your underlying loans. You'll end up with a stack. So you'll have a triple A tranche of that CLO, a AA, a single A, a triple B, a double B, and an equity tranche. And so JAAA specifically buys that equity tranche. But long answer to a short question, a CLO is a pool of securitized bank loans.

10:14Ben Carlson:So why would a corporation borrow this way as opposed to just issuing normal corporate debt? They may not be able to access the corporate bond market. They may have more attractive financing in the bank loan market. There can be different reasons within their own capital structure that they may choose to go the loan route versus the high-yield bond route. When we say AAA credit quality, it's the structure that provides that credit quality. The underlying loans themselves are, again, no different than what you would find in a floating rate mutual fund or ETF. They themselves are generally below investment grade loans.

10:59Michael Batnick:How does this differ from the bank loan ETFs? Is this only taking the top slice in terms of the least risky? So in a bank loan ETF, what you physically own is the loan itself. In JAAA, you own a AAA bond of a CLO. And the difference there is, back to my example, imagine you took a billion dollars of corporate loans as your collateral pool. The AAA tranche would maybe be$650 million. So you're over collateralized by 35 % just in the structure itself. And that stack functions kind of like a waterfall in the sense that, again, you have a AAA, a AA, a single A. Well, within each CLO, the AA can't get paid one penny until the AAA gets paid in full.

11:45The single A can't get paid one penny until the triple and AA get paid in full. So returns flow down that waterfall. And conversely, losses flow up. If there are defaults coming from the underlying loans, they will be absorbed by those lower tranches first. And so you're over collateralized in the structure. There's subordination in the structure. And even if we go back to the financial crisis, the peak corporate loan default rate we saw in 08 was around 14%. But again, in this structure, in the AAA tranche, you're over collateralized by 35%. It takes an extremely draconian scenario to break the structure of the CLO itself.

12:24Ben Carlson:So we get questions all the time in our inbox from people. And the last few years, a lot of them have been just about bonds. And I made the point before that a lot of investors woke up to the idea of, oh, my gosh, it's been 40 years since we've had to think about higher inflation. And so I think a lot of people woke up to the fact that there are different parts of the fixed income market that react differently under these economic environments, right? And so obviously, a fund like yours, where the rates were floating in very short duration, that can weather that kind of storm much better than a different type of fund.

12:55Ben Carlson:So obviously, maybe investors are thinking, I need to have some sort of inflation-like protection for this. Beyond that and the floating rate notes working well when rates go up, what's the sweet spot for this strategy working? Are you saying, well, the best case scenario is, rates rise and we pick up the yield pretty quickly and we don't have interest rate risk. What other scenarios are good for this fund? I like to think about it in the terms of there's three reasons why you own fixed income. It's for the income, it's for capital preservation slash stability, and then it's for equity beta diversification.

13:25And I think you can really hammer those first two with this strategy. So to your point, in an environment where you're getting rising rates, well, you don't have that duration drag and the yield is increasing. That's great. But even in an environment of falling rates, you're still getting a great return per unit of risk in this asset class. And the rates here fall with a lag because the CLOs reset every three months. You can get a rate cut that doesn't feed through immediately to the CLOs and you can pick up a little bit of additional yield in the meantime. And so we've seen interest in the product.

14:00I mean, certainly when the Fed did raise rates, that caused a lot of interest in the space. But especially now as money market rates are falling, and you gentlemen are closer to the end client, we tend to hear that 4 % on money market is kind of like a psychologically important level. And now you're seeing money market rates in the kind of mid threes. We see a lot of crossover buyers, even as rates are coming down because folks want to capture that spread and still get back in the upper fours or five range.

14:28Michael Batnick:How do the mechanics of the ETF and the CLO work? Like money comes in, I'm guessing on a daily basis, and it goes where? Yeah. So cash flows come in and this is an ETF. So we can take that in kind. So we can take security CLO QSIPs in kind, or we can take in cash. As I mentioned, this is a much larger and deeper market than I think a lot of folks realize. It's a$1.1 trillion market. And so as money comes in, these are all QSIPs in the marketplace that our portfolio managers on JAAA can add to the portfolio. It's really not that different from any other standard bond. So is a AAA CLO a AAA CLO?

15:14Michael Batnick:How much variation is there from one to the next? There can be some variation, especially in terms of the issuers themselves. So I mentioned there's about 140 firms in the US that have issued CLOs or that currently issue CLOs. Some have very long track records have been doing this for a very long time and have very large AUM bases. And some are newer entrants, some are newer players into the market. And so there can be quality differences associated with the issuers of the CLOs. There can be differences in terms of non-call periods. There can be differences in terms of reinvestment periods. So some of the technical attributes of the underlying CLOs themselves.

15:55So they're not completely uniform in that way. And those are some of the things that are... This is an actively managed product. We're not tracking a passive index here. Those are the sorts of attributes that we manage.

16:07Michael Batnick:So when you say there's 140 CLO issuers, just so Ben understands clearly, is Janice an issuer or are you a manager or somewhere in between? No, CLO issuers would be like a KKR, a Carlyle, an Apollo, those sorts of firms. They're the ones taking a pool of loans, packaging it, securitizing it into a CLO. JAAA, our ETF buys the AAA bond of that CLO. All right. So I'm glad you mentioned those names because in the news is private credit and the concerns about the outflows and the software exposure and CLOs are getting lumped in there a little bit. What are some of the things that you see out there and you're like, this person clearly has no idea what they're talking about?

16:53So when it comes to software, it is a meaningful chunk of the overall loan market, 15 % to 20 % of the overall loan market. In JAAA, that's true as well, right? Given our size, we do have some exposure to those loans. But I think the main point is you don't actually own a software loan. You own the AAA bond of a CLO that is comprised of hundreds of different loans from dozens of different industries at any point in time.

17:24Michael Batnick:Talk about that a little bit more because I think that is one of the key concepts. It might be helpful to use, there was an example last summer, if you are familiar with a firm called First Brands, it went bankrupt over the summer. They were an auto parts supplier, made a lot of headlines. So if you owned a First Brand loan in a bank loan mutual fund and they go bankrupt or they default, you own the loan, you're impaired on that loan. In JAAA, we own 400 or 500 different CLOs, each that own 300 or 400 different loans from two or three dozen industries. So even in a scenario where First Brands, which was a pretty big issuer in the loan market, goes bankrupt, you are not only diversified across hundreds, tens of thousands of loans, but then you're protected by the structure itself.

18:15because you have all that subordination below you that is absorbing those losses.

18:21Ben Carlson:So these are AAA rated, they're securitized. Why is there a spread over corporates? What's the, because the risk and reward thing has to be attached somehow. So why is there a higher yield in these assets? So I think partially it comes, they are more complex. There is sort of more modeling that has to be done when you're managing these assets. Also, I think it's just a less trafficked part of the market, right? When you look at what are the broad benchmarks that everybody is using, if you're talking about the ag, the ag is treasuries, corporate bond, and agency mortgages. If you expand it to the universal, you add high yield, you add dollar denominated non-US debt.

18:58But the CLOs are not part of any of these major benchmarks. They tend to be very under allocated to in most portfolios, certainly most wealth portfolios. I think it's a combination of additional complexity and just in general, not being an asset class that prior to, let's say, the ETF wrapper coming along and JAAA coming along was open to enough investors to compress that spread all the way.