Speaker 1: Welcome to Inside Active, a podcast about active managers that
Speaker 1: goes beyond sound bites and headlines and looks deeper into
Speaker 1: their processes, challenges, and philosophies and security selection. I'm David Cohne,
Speaker 1: i lead mutual fund and active Research at Bloomberg Intelligence.
Speaker 1: Today my coast is Rehdel Bachmann, Chief structured finance strategist
Speaker 1: at Bloomberg Intelligence RADDA. Thank you for joining me as
Speaker 1: my coast today.
Speaker 2: Oh, it's my pleasure.
Speaker 1: So since our discussion today is going to be on CLOS,
Speaker 1: I did want to ask about a note you put
Speaker 1: out recently about USCLO structural performance. Can you give our
Speaker 1: listeners a brief overview of how current fiscal policy could
Speaker 1: affect CLO returns?
Speaker 2: Yes, So that was something I wanted to alert CLO
Speaker 2: investors too, because it's something it's a kind of risk
Speaker 2: that they might not be used to. In the West.
Speaker 2: Have been used to central banks running orthodox monetary policies,
Speaker 2: which means that they're very much focused on price stability.
Speaker 2: They may have other objectives as well, but price to
Speaker 2: bility is certainly a key one, and as a result
Speaker 2: of that, what we expect to happen when inflation goes
Speaker 2: up is that policy rates also go up, and vice versa.
Speaker 2: So our presumption tends to be that foreign nodes, including
Speaker 2: ef ends, including clos are effectively sort of inflation hedged.
Speaker 2: When inflation goes up, yes, the principle becomes less valuable
Speaker 2: in real terms, but as policy goes up, floating rates
Speaker 2: go up, and as a result, coupons go up, and
Speaker 2: then the higher couponts compensate for the loss of the
Speaker 2: real value in the principle. So that's how we used
Speaker 2: to think about it. Of course, if you're an emerging
Speaker 2: markets investor, then you're used to different types of monetary policies,
Speaker 2: especially physically dominated monetary policies. These are situations where the
Speaker 2: government is really dictating monetary monetary policy, usually with a
Speaker 2: view to enabling the funding of the state. And so
Speaker 2: what happens under these regimes often is that inflation is higher,
Speaker 2: but despite that, interest rates are lower than there would
Speaker 2: be under orthodox minetary policy, and all of a sudden,
Speaker 2: when that happens, and when you're under that regime, then
Speaker 2: the clos are no longer effective for inflation headed because
Speaker 2: what happens is that inflation goes up the floating rates
Speaker 2: don't go up, so the coupons don't go up, and
Speaker 2: as a result of that, you don't get compensated for
Speaker 2: the loss in the real value of the principle. And
Speaker 2: of course, currently we have the situation in the US
Speaker 2: where there's a wankling over ultimately what the monetary policy
Speaker 2: should be. The FED, at least so far, seems to
Speaker 2: be more leaning towards the orthodox minetary policy to some extent,
Speaker 2: and of course the administration would like to have a
Speaker 2: monetary policy that's more focused on funding the state, lower
Speaker 2: interest rates and higher inflation. And so this is going
Speaker 2: to change, especially if we do end up in a
Speaker 2: situation where we have a fully physically dominated monetary policy
Speaker 2: in the US. Yes, that's going to change the risk
Speaker 2: return trade for clos, and then there's a discussion about
Speaker 2: how exactly that would affect clos. The collateral performance will
Speaker 2: will be good because the borrowers in the colateral pull
Speaker 2: on the same situation as the state. They benefit from
Speaker 2: an erosion of the real value of the principle that
Speaker 2: they owe, and they benefit from having to pay low
Speaker 2: interest rates because the loans are also floaters. And of
Speaker 2: course from a structural perspective, the CELO wouldn't be much
Speaker 2: impact it because the structure itself doesn't have interested exposure
Speaker 2: because both the liabilities and the assets of floaters. But
Speaker 2: for the COLO investors, the brisk returns of period of
Speaker 2: are very different under fiscal dominance than they are on
Speaker 2: the orthodox minitary policy.
Speaker 3: Yeah.
Speaker 1: Interesting, Well, I'm sure our guests today could also provide
Speaker 1: some color into that. So out further ado, I'd like
Speaker 1: to welcome friend Rodoloso and Bill so calls Inside Active.
Speaker 1: Bill is director of product Management at VNAC, and Fran
Speaker 1: is head of Fixed Income ETF portfolio Management at VNACK
Speaker 1: and a portfolio manager on the VNAC CLO ETF and
Speaker 1: the AA B B c l O ETF ticker c
Speaker 1: l O I in c l O B. Brandon, Bill,
Speaker 1: thank you so much for joining us today.
Speaker 3: It's great to be here. Thanks David, thanks for having us.
Speaker 1: To get started. I'll go first to you. Bill. Can
Speaker 1: you walk us through the main investment thesis for CLO
Speaker 1: I in cl O B.
Speaker 3: Yeah, of course.
Speaker 4: So, you know, I think for both funds the thesis
Speaker 4: is really that CLOS can help build a stronger bond portfolio.
Speaker 4: And that all investors should have access to clos and
Speaker 4: of course that wasn't really the case until we started
Speaker 4: seeing these ETFs launch, But so that that's one aspect
Speaker 4: of the other is that, you know, we believe you
Speaker 4: can achieve better outcomes by not constraining yourself to a
Speaker 4: single rating category, and that you really do need to
Speaker 4: take an active approach in this market. So as far
Speaker 4: as you know, the constraining yourself to a single rating category,
Speaker 4: you know, if you look at the the COLO market
Speaker 4: today and historically it's been dominated by institutional investors and
Speaker 4: they do tend to focus on single ratings. So banks
Speaker 4: are the biggest investors in clos and certainly the biggest
Speaker 4: in triple a's, and you're not really going to see
Speaker 4: them going to mezzanine tranches. And the reason is that
Speaker 4: they're highly regulated, they have regulatory capital constraints, and really
Speaker 4: only triple as makes sense for them. But when when
Speaker 4: we were thinking about launching our funds, you know, we
Speaker 4: took the approach that you know, most investors don't have
Speaker 4: these constraints and you can get more income and find
Speaker 4: additional opportunities if you can take advantage of the whole
Speaker 4: capital structure. So both of our ETFs are based on
Speaker 4: this idea that you know, if you can invest broadly
Speaker 4: and take advantage of that capital structure that the CLO has.
Speaker 3: You can you can have better outcomes.
Speaker 4: And uh col I focuses on investment grade tranches and
Speaker 4: we think that it's a useful strategy within a broader
Speaker 4: core bond portfolio, and we also offer COLOB which focuses
Speaker 4: on mezzanine tranches, so primarily double A to double B.
Speaker 4: So it's, you know, it's a higher returning potential but
Speaker 4: also higher risk strategy that we think can be a
Speaker 4: good compliment a high yield.
Speaker 1: So you mentioned, you know, it's typically institutional investors that
Speaker 1: have had access to these Who's the target investor for
Speaker 1: these to ETFs? Is it you know everyone or are
Speaker 1: you kind of looking to get more of retail investors involved.
Speaker 4: Well, you know, I'd say there's not necessarily one type
Speaker 4: of target investor necessarily, and I think that's one great
Speaker 4: thing about the ETF is that all types of investors
Speaker 4: can can buy it and have the same exposure at
Speaker 4: the same cost.
Speaker 3: You know.
Speaker 4: That being said, in our funds, we've primarily seen interests
Speaker 4: and aum come from the wealth channel, so this is
Speaker 4: this is r as SO registered investment advisors and also
Speaker 4: advisors that you know, broker dealers, including some of the
Speaker 4: big wirehouses that you know that everyone knows. And these
Speaker 4: of course are investors who haven't really had access to
Speaker 4: celos before these etf started launching, certainly not in a
Speaker 4: liquid vehicle. So so for many of these investors it's
Speaker 4: the first time they're they're learning about celos and and
Speaker 4: have the opportunity to add them into their portfolio. UH.
Speaker 4: We have also seen a pretty sizable interest from institutional
Speaker 4: investors as well in RTF and primarily that's the insurance market,
Speaker 4: so insurance general accounts, and unlike the wealth channel, you know,
Speaker 4: for many of these insurance companies, celos are not new.
Speaker 4: These are insurance companies in general are big investors in
Speaker 4: celos and and often they they may have invested directly
Speaker 4: with COLO tranch manager, but with ETFs, you know, in
Speaker 4: smaller portfolios or with smaller insurance companies, you know, an
Speaker 4: allocation to a separate account with a CLO tranch manager.
Speaker 4: UH maybe was too large for some of these smaller portfolios.
Speaker 4: So the ETFs are are great to get that exposure.
Speaker 4: I think we're also seeing the ETFp used as part
Speaker 4: of a broader COLO allocation. So sometimes these general accounts
Speaker 4: are buying clos directly or or maybe through a separate account,
Speaker 4: but they're using the ETF alongside those holdings as a
Speaker 4: liquidity sleeve. So so it's a way to optimize liquidity.
Speaker 2: Yeah.
Speaker 1: Now my next question could be for either one of you,
Speaker 1: how do you define the market opportunity for CLO tranches today?
Speaker 5: They'll do I'm gonna lead off. I'll say say this,
Speaker 5: there's a relative value opportunity to begin with. So if
Speaker 5: you compare the higher rated tranches versus other forms of abs,
Speaker 5: you know, the CLO tranches are going to offer a
Speaker 5: more attractive spread than almost all the other alternatives, and
Speaker 5: certainly versus investment grade corporates at any step along the
Speaker 5: rating scale, a meaningful pickup in yield. So just in
Speaker 5: general from an allocation perspective, of course, with the floating
Speaker 5: rate nature, you can add yield and reduce duration in
Speaker 5: your portfolio, you know, thereby reducing one form of risk.
Speaker 5: So we think with you know, investment grade clos, there's
Speaker 5: this opportunity to really add some kind of permanent allocation
Speaker 5: to enhance overall, you know, your sharp ratio basically, you know,
Speaker 5: in terms of today sort of bottom up opportunities or
Speaker 5: relative value within.
Speaker 3: The CLO market.
Speaker 5: Certainly, spreads have compressed in every corner of the credit
Speaker 5: market in general. And although COLO spreads are wide on
Speaker 5: a relative versus other asset classes, it's not a time
Speaker 5: we believe, Nor by the way we work with the
Speaker 5: subadvisor on these funds, Pine Bridge, who's got very deep
Speaker 5: experience in this space, we're both in agreement this is
Speaker 5: not a time to go too far down the credit
Speaker 5: spectrum in order to add yield, So a more conservative
Speaker 5: approach is warranted. But there are plenty of bottom up opportunities.
Speaker 5: You can still find value in the secondary market and
Speaker 5: some of the lower rated tranches, more so in the
Speaker 5: primary market, where the spreads are still slightly more attractive
Speaker 5: in the higher rated tranches. But that type of positioning
Speaker 5: right now should still provide an attractive yield to investors
Speaker 5: versus most other alternatives in the income space.
Speaker 3: Yeah.
Speaker 1: And since you know, our our focus of the podcast
Speaker 1: is active management, and Bill alluded to it earlier, you know,
Speaker 1: I just want to ask, especially for our listeners. You know,
Speaker 1: why is active management required for this type of investment?
Speaker 4: You know, I think there's a few ways to answer that,
Speaker 4: so so on. You really can't invest passively. I mean,
Speaker 4: this is not a market where you can track an index, right,
Speaker 4: I mean, just the way these dealers trade and the
Speaker 4: way they're issued, it would be very difficult to have
Speaker 4: a true passive product. But you know, I think we
Speaker 4: we view it beyond that and really in terms of
Speaker 4: the value that active management can provide in this asset class.
Speaker 4: So it's really from two ways. I mean, one is
Speaker 4: from a top down perspective, you know, in terms of
Speaker 4: deciding how to position the portfolio. From a from a
Speaker 4: risk perspective, so ratings, allocations or spread duration exposure, right,
Speaker 4: you know, you you really do need to take a
Speaker 4: macro view and and look at the current market and
Speaker 4: your outlook and know when to maybe add risk, but
Speaker 4: also when to d risk. And and I think also
Speaker 4: becau understanding how different trenches are impacted by you know,
Speaker 4: by the different types of investors in this market, I
Speaker 4: think is also important. And you you you do need
Speaker 4: an understand a deep understanding of the CLO market. And
Speaker 4: I think it's actually quite unique from that perspective. Uh
Speaker 4: So that's the top down part, but also from a
Speaker 4: bottom up perspective, you know, you can't just invest based
Speaker 4: on a rating. When you look at manager, vintage, underlying portfolio,
Speaker 4: I mean, all of these will will impact the performance
Speaker 4: of a clo and your d dispersion in performance even
Speaker 4: among celos within the same rating category.
Speaker 3: So security selection can also be very additive.
Speaker 2: Yeah, so I wanted to come back to what the
Speaker 2: Bible was talking about before regarding the investor base. So
Speaker 2: we have the sort of the wealth clients, and we
Speaker 2: have the insurance companies, and as you're pointing out, the
Speaker 2: insurance companies already familiar with clos, so maybe from that
Speaker 2: perspective they a bit less interesting here. But I think
Speaker 2: the wealth clients might be quite interesting here because clearly
Speaker 2: c ETFs have grown quite a bit, especially in the US.
Speaker 2: They're starting to grow in Europe as well. And as
Speaker 2: they grow and they become a larger part of the
Speaker 2: investor base for clos, they will start to influence how
Speaker 2: clos themselves are trading, and that means that all investors
Speaker 2: in clos will have an interest in understanding how c
Speaker 2: ETFs will influence the market and how these assets are
Speaker 2: being traded, how their price, how liquid they are, how
Speaker 2: stable the liquidy is as well, And so I was
Speaker 2: wondering what is sort of the nature of these wealth investors.
Speaker 2: Are they providing sticky money or is it more flighty money?
Speaker 2: How exactly do you think they will start to affect
Speaker 2: how etfclos will invest in the market, and that intourn
Speaker 2: will affect the COLO market.
Speaker 5: We are seeing stickier allocations at the start here, and
Speaker 5: one it's been a long call it sales cycle into
Speaker 5: allocations from the wealth channel, because these guys and ladies
Speaker 5: do their homework. They are not going to jump into
Speaker 5: this asset clash just because it's now got about forty
Speaker 5: billion in ETF flows.
Speaker 3: So there's a lot of education up front. Number one.
Speaker 5: Number two, the premise, particularly with the investment grade COLO allocations,
Speaker 5: is that these do belong as part of a core
Speaker 5: fix income allocation. They hadn't for most people in the
Speaker 5: West channel because there was no access. So it's our
Speaker 5: belief that in that channel people have bought in to
Speaker 5: that concept. And there's plenty of history through lots of
Speaker 5: market cycles. Remember, clos have been around since the nineteen nineties,
Speaker 5: so there's lots of data and history to back up
Speaker 5: the notion of sort of a core allocation. All that
Speaker 5: being said, since colo ETFs have come into existence, although
Speaker 5: we have seen pockets of volatility, we have not seen
Speaker 5: a truly dramatic turn in a credit cycle. So there
Speaker 5: will be some testing of you know, supply demand for
Speaker 5: these vehicles, you know, when we really do and we
Speaker 5: know it will happen at some point when it's difficult
Speaker 5: to say. We think the performance of the asset class
Speaker 5: through a more dramatic turn into credit cycle will again
Speaker 5: the asset class will again I prove itself. But there probably,
Speaker 5: you know, will be maybe some less committed investors who decide,
Speaker 5: you know, perhaps at the wrong time, but you know,
Speaker 5: we maybe that this isn't for them, So we'll see
Speaker 5: how that goes. I just wanted to point out that
Speaker 5: that hasn't fully occurred yet.
Speaker 1: If we get into the portfolio management aspect just a
Speaker 1: little bit, how do you evaluate the underlying collateral? You
Speaker 1: know what metrics attract.
Speaker 5: There's there's a lot of metrics that are tracked and
Speaker 5: certainly you know, pine Bridge as a colo issuer themselves
Speaker 5: as having a very very large leveraged finance group with
Speaker 5: lots of individual credit analysts. You know, they have systems
Speaker 5: built to do a very granular view of each clo,
Speaker 5: which means looking at the loan level to assess risks
Speaker 5: and then of course stress testing, uh, you know, with
Speaker 5: sector disruptions, overall market disruptions, and they are monitoring making
Speaker 5: sure there are already a lot of restrictions on clos
Speaker 5: in order for these tranches to earn their ratings, so
Speaker 5: enforced levels of diversification. A typical COLO these days is
Speaker 5: going to have three to four hunds loans if not
Speaker 5: more in the portfolio.
Speaker 3: You're not going to see.
Speaker 5: Individual issuers being representing more than one or two percent
Speaker 5: of these portfolios, so they're already highly diversified. They have
Speaker 5: to meet all sorts of coverage tests as well, but
Speaker 5: you'll see a very very granular look. And I should
Speaker 5: mention also, and Bill already did that the manager selection
Speaker 5: is extremely important. I think there are more than one
Speaker 5: hundred and fifty COLO managers in the US market alone
Speaker 5: right now, and they are not all equally experienced or
Speaker 5: equally capable, So that manager selection understanding the team, the experience,
Speaker 5: the level of analysis they're doing, how they manage the portfolio.
Speaker 5: Key critical component of colos in general is that they
Speaker 5: themselves the collateral pools are actively managed. So those COLO
Speaker 5: managers is not just important how they initially construct the CLO,
Speaker 5: but how they manage it over time and whether or
Speaker 5: not they act in the best interest of the debt
Speaker 5: holders in various circumstances. So a lot of inputs, I
Speaker 5: guess is a short answer to that question.
Speaker 1: So just a follow up, how do you decide between
Speaker 1: investing in new issuance versus secondary market trongest.
Speaker 5: Yeah, there's a relative value sort of question there. Typically
Speaker 5: you would expect to in most environments to gain some
Speaker 5: additional spread by going into the new issue market, but
Speaker 5: there can be even when that is the case, and
Speaker 5: currently that is the case where the new issue market
Speaker 5: is the relative value or the excess spread is narrowed
Speaker 5: even in October with a little bit of volatility earlier
Speaker 5: in the month, to where the primary market is not
Speaker 5: absolutely the more active space to be, but still a
Speaker 5: little bit of value there. But there are so many
Speaker 5: other factors. For instance, pine Bridge, right now, we talked
Speaker 5: about being conservatively positioned in this portfolio, when they are
Speaker 5: looking for lower rated tranches or doing a bottom up
Speaker 5: look to see if there's some value out there in
Speaker 5: the market. Given the overall positioning, there's not a desire
Speaker 5: to add long duration in the triple B part of
Speaker 5: the portfolio right now, because that additional sensitivity to credit
Speaker 5: spread movements, or that additional spread duration in those lower
Speaker 5: rated tranches would lead to greater sensitivity should there be
Speaker 5: a backup and spread. So it's in the secondary market
Speaker 5: well seasoned tranches where you might be able to find
Speaker 5: some attractively priced deals that also have a shorter duration,
Speaker 5: so you're not as sensitive even when you're going down
Speaker 5: the credit spectrum to gain some additional yield.
Speaker 2: Sticking with the secondary market, I was actually wondering, I mean,
Speaker 2: we've had quite a bit of tariff turmal a few
Speaker 2: months ago now, quite a few months ago now, but
Speaker 2: I thought this was actually an interesting sort of test case,
Speaker 2: and I'm just wondering, how do you think, as the
Speaker 2: CELO investor, tariffs will affect the performance of the CEOs,
Speaker 2: and how do you think your ETF investors think the
Speaker 2: tariffs will affect the clos. It says there are difference
Speaker 2: or are you sort of on the same page on this.
Speaker 5: I think there are as many opinions as there are
Speaker 5: investors at this point because it's such a rapidly changing environment.
Speaker 5: I think the generally accepted wisdom is really though, that
Speaker 5: there is a level of uncertainty, and there is a
Speaker 5: level of call it your credit, negative impact or impingement
Speaker 5: on profitable in certain sectors. Who's paying How that all
Speaker 5: plays out is still in I think most investors' minds
Speaker 5: a bit to be determined. So the initial impact the
Speaker 5: tariff tantrum that did create some interesting opportunities in the
Speaker 5: market and was a small test, but really what we've
Speaker 5: seen since then is more of a discounting of the
Speaker 5: impact of tariffs because you know, there's certainly we think
Speaker 5: there will be greater impact, and it will happen over time,
Speaker 5: and some of it's been postponed by front loading inventories
Speaker 5: or other measures, and simply you know, policies changing on
Speaker 5: the fly and suspensions. But you know, generally speaking, it
Speaker 5: will impact the market overall, should probably at some point
Speaker 5: lead to wider spreads in some sectors. But I don't
Speaker 5: think there's any conception answers and where that is, and
Speaker 5: I think both investors and COLO managers and COLO trench
Speaker 5: managers all all parties you'll share some form of those opinions,
Speaker 5: or most of most parties in all three cohorts.
Speaker 2: Yeah, And I'm actually thinking maybe we are sort of
Speaker 2: in a similar situation with the topic that we started
Speaker 2: out with, which is what is going to happen to
Speaker 2: interest rates and inflation? And we're to monetor policy in
Speaker 2: the US more generally going forward, and I could imagine
Speaker 2: that currently it's not quite clear how things will ultimately
Speaker 2: pan out. Will the years really have a completely fiscally
Speaker 2: dominated monetary policy, will it be somewhere in the middle,
Speaker 2: will it go back to orthodox monetary policy? Do you
Speaker 2: do you sense that there's a consensus amongst dicilar investors
Speaker 2: or the ETF investors. Maybe not? And if there isn't,
Speaker 2: is it something that people are nervous about or is
Speaker 2: there not other're not too worried about it.
Speaker 5: There is in my mind, and they'll please disagree. As
Speaker 5: you talk to a lot of other people as well,
Speaker 5: there is no consensus. I think there's a perceived risk
Speaker 5: of too much easing. Of course, there are people out
Speaker 5: there who still argue that the FED has moved too slowly.
Speaker 5: Is my personal opinion that to this point, with or
Speaker 5: without the perceived interference from executive members of that branch,
Speaker 5: the FED is probably where they would have been right
Speaker 5: now without all the noise. So the question is more
Speaker 5: about twenty twenty six. We think if left to their
Speaker 5: own devices, the prospects for cuts in twenty twenty six
Speaker 5: at this point, based on what we know, would probably
Speaker 5: be pretty slim. So anyway, I think there's a level
Speaker 5: of concern if I think if it were really priced in,
Speaker 5: you would see some different market conditions, including a much
Speaker 5: steeper yield curve. And we're just you know, although you
Speaker 5: could say the curve is normalized, it's still not even
Speaker 5: steep from historical point of view. It's sixty basis points
Speaker 5: or so, say between two year and ten year treasuries
Speaker 5: inside of long term average. And by the way, with
Speaker 5: you agree with so much of what you're saying about
Speaker 5: the risk to you know, physical dominance, a less independent
Speaker 5: central bank, and you know, potential stagflation. One thing I
Speaker 5: would say again, you know, highly rated clos would suffer
Speaker 5: from lower coupons in that environment, not benefit you know
Speaker 5: from you know, the short rates that should be rising,
Speaker 5: and you know, everyone every corner of the income market
Speaker 5: that would probably suffer from a negative real rate point
Speaker 5: of view, But you definitely would not be wanting to
Speaker 5: have long duration exposure in that type of environment either.
Speaker 5: So that's like the cleanest, sturdy sh argument, where you know,
Speaker 5: relatively speaking, you still might be better off at the
Speaker 5: front end, but you know that that's just obviously not
Speaker 5: a good environment for income allocations, at least heading into
Speaker 5: it in general.
Speaker 2: Yeah, and you're bringing up ratings and hence credit risk,
Speaker 2: and I think on that front, we obviously just had
Speaker 2: first brands, and you know, it's still developing situations. Obviously
Speaker 2: there are lots of accusations of fraud. I guess eventually
Speaker 2: things will become clearer and we'll know what exactly happened.
Speaker 2: But of course, what has happened in terms of the reaction,
Speaker 2: maybe more in depressed than with investors, but maybe also
Speaker 2: with investors, is that people have been starting to worry
Speaker 2: a little bit that this might not be just it
Speaker 2: using credit risk, even though it is fraud, and that
Speaker 2: can often be using credit or if it is fraud,
Speaker 2: it can often be using cretic but it might actually
Speaker 2: be more systematic, or the idea is that, well, if
Speaker 2: there's fraud here, if that's what happened, then maybe there's
Speaker 2: that's that's more indicative of a problem across maybe private credit,
Speaker 2: or maybe it's a problem across borrows that appear in
Speaker 2: Coelo pools, and so it's a bigger concern than if
Speaker 2: it was just a single name that was involved here.
Speaker 2: And I guess that sort of narrative has gotten a
Speaker 2: bit of an uplift from the fact that we have
Speaker 2: seen in USABS another name that seems to have somewhat
Speaker 2: similar problems, which is Tricolor, and so maybe that can
Speaker 2: be used as some I think tootal evidence that maybe
Speaker 2: there's more to destore than just a single name. We'll
Speaker 2: eventually find out whether that's true or not. But currently,
Speaker 2: how have the co Lo ETF investors been processing this information?
Speaker 2: All of the news headlines about what has happened or
Speaker 2: not happened at First Brands, about CLO's exposures to First
Speaker 2: Brand and and what impact that might have CEOs, how
Speaker 2: have they been trying to digest this information.
Speaker 4: Well, we've certainly gotten a few questions about, you know,
Speaker 4: exposure to First brands, and I wouldn't say it's been
Speaker 4: you know, overwhelming in terms or the investors seem overly concerned,
Speaker 4: And I would say, you know, the nice thing about
Speaker 4: Coelos is that there is transparency, so we can we
Speaker 4: can certainly answer those questions. And you know, our our portfolios,
Speaker 4: like you know, I think most clos have have pretty
Speaker 4: very small exposure right to to these single names or
Speaker 4: in this case, to first brands, So if you're in
Speaker 4: the senior chanches, you know there's very little impact. But
Speaker 4: but to your point, the bigger concern is whether these
Speaker 4: are indications of something more systemic, and you know our
Speaker 4: viewers that it's not. But we we've actually been saying
Speaker 4: for quite some time that you know, we we do
Speaker 4: it expect to see some distress among weaker credits in
Speaker 4: the loan market. And the fact is that certainly not
Speaker 4: every part of the economy is firing on all cylinders
Speaker 4: and first brands, and try color show that even though
Speaker 4: you know, these could be probably more a result of
Speaker 4: mismanagement and potentially fraud.
Speaker 3: Rate cuts could.
Speaker 4: Take some pressure off some of these borrowers. But but
Speaker 4: we don't expect to see a significant number of cuts
Speaker 4: in and really any you know, impact of some slow
Speaker 4: down in the economy is going to have an impact.
Speaker 4: And in the meantime, of course, right these barbers do
Speaker 4: need to refinance their loans. So from a COLO perspective,
Speaker 4: you know, we don't view this as a systemic issue
Speaker 4: at this point. We think fundamentals overall are you know,
Speaker 4: remain strong. But you do really need to look under
Speaker 4: the hood. And I think this is where you know,
Speaker 4: security selection and credit analysis are really important, especially if
Speaker 4: you're investing at lower rated tranches.
Speaker 1: Yeah, so just another you know, as we're talking about risks,
Speaker 1: how is liquidity risk and clos assessed? And you know,
Speaker 1: what is your view on the liquidity portfolio of these portfolios?
Speaker 1: And you know, it's always a stressed market condition.
Speaker 5: When you're asking that question, you're asking more about the
Speaker 5: clo etf So the liquidity in the tranches or the
Speaker 5: liquidity in the clos themselves and the underlying collateral pools. Yeah, okay,
Speaker 5: so and we could speak to both. I mean, obviously
Speaker 5: the but the loan market itself, the leverage on the
Speaker 5: market which makes up the pools. You're fairly look, of course,
Speaker 5: liquidity drops off in times of stress, and the same
Speaker 5: will tend to happen in the CLO trans space, but
Speaker 5: it's always a matter of degree as you go down
Speaker 5: the credit ratings ectrum. So we've seen, you know, since
Speaker 5: we've launched COLI about three and a half years ago,
Speaker 5: we've actually seen triple A tranches which this fund has
Speaker 5: you know, maintained a decent sized position in among the
Speaker 5: rest of them, some great trade b sort of liquidity
Speaker 5: outlet even versus other types of fixing connollocations. Certainly that
Speaker 5: happened with the British pension funds back in twenty twenty two,
Speaker 5: where it was triple A clos became the liquidity tool
Speaker 5: for them, So not without some price loss, but you know,
Speaker 5: a couple of points versus multiple multiples of that you
Speaker 5: might experience in other parts of the credit spectrum.
Speaker 3: As you go down the credit curve.
Speaker 5: Yeah, you're going to see wider spreads and greater wider
Speaker 5: bit ass spreads, greater price losses. But it's really interesting
Speaker 5: in the COLO market to remember number one, the triple
Speaker 5: A tranches over sixty percent of the market, so you
Speaker 5: already have you know, smaller markets in all of the
Speaker 5: other tranches, but those as you go down the the
Speaker 5: b wick volume that bid wanted in competition, or the
Speaker 5: amount of trading that goes on as a percentage of
Speaker 5: the amount outstanding goes up the further you go down
Speaker 5: the credit spectrum. So those markets do tend to clear
Speaker 5: through periods of stress, but not without higher transaction costs.
Speaker 5: If it's you know, the going down to the double b's,
Speaker 5: which might you know, the bottom rung of what's in
Speaker 5: our colo b ETF you might see you have point
Speaker 5: to a point bid asked in normal times, and that
Speaker 5: could widen out, you know, significantly in other periods, which
Speaker 5: is again why effrective management in this.
Speaker 3: Area is super super important.
Speaker 5: That's also why when we wanted to approach the mezzanine
Speaker 5: part of the capital stack, we wanted to include double
Speaker 5: a's and single as to have those more liquid trudges.
Speaker 5: Single a's obviously you're not going to be like triple b's,
Speaker 5: but double a's are not far off in terms of
Speaker 5: maintaining a high degreeclid in the stress periods, at least historically.
Speaker 2: Yeah, and speaking of historically, I mean we I can't
Speaker 2: help but notice that we very much in the tail
Speaker 2: end of the year now and so now your thoughts
Speaker 2: turned to twenty twenty six, and in that context, I've
Speaker 2: sort thought about what might happen with the silo market
Speaker 2: and cotfs next year. And when you two things to
Speaker 2: note right, One is they have grown a lot become
Speaker 2: a more important part of the investor base, and we
Speaker 2: have actually seen an extreme version of that with the
Speaker 2: cilos themselves. They're now one of the most important, is
Speaker 2: not the most important investor in the underlying levish loan market.
Speaker 2: And the question, Denny, is do we think that something
Speaker 2: similar like that might actually start to happen in the
Speaker 2: COLO market as well? Will ETF funds become so dominant
Speaker 2: that they become the dominant investor in the acid class?
Speaker 3: So our view is that, you know, we don't.
Speaker 4: We don't expect that ETF will become the dominant investor
Speaker 4: in in the COLO market. There's obviously a lot of
Speaker 4: other types of UH institutional investors that have a very
Speaker 4: large presence, and we don't see that changing. And I,
Speaker 4: you know, I think it's important to note that ETFs
Speaker 4: have they have grown a lot in the last few years,
Speaker 4: but it's still a small part of the overall market.
Speaker 4: That being said, I mean, they as they do grow
Speaker 4: and we maybe we're already seeing some of this, there
Speaker 4: can be impacts at the margins, right when you consider
Speaker 4: that historically a lot of the COLO investors were more
Speaker 4: buy and hold. Now you have.
Speaker 3: ETFs, which at least you know, have the ability.
Speaker 4: To have daily inflows and outflows, and that can certainly
Speaker 4: have an impact. And you might have investors with different
Speaker 4: that that react differently right to different events. So, you know,
Speaker 4: looking thinking back to a year ago, at the end
Speaker 4: of last year and into this year, we saw very
Speaker 4: strong and accelerating inflows into into cl O E t
Speaker 4: S and I would say the majority of that was
Speaker 4: going into two triple a's and we we did start
Speaker 4: to see you know that triple A spreaders.
Speaker 3: Just looked really tight. We didn't see value there.
Speaker 4: Now that's not to say that this is all because
Speaker 4: of col O ETFs, but I think it's also interesting
Speaker 4: to look at April when we that was that was
Speaker 4: really the first short tests that we have seen for
Speaker 4: cl O E t F since they launched, where we
Speaker 4: did see some redemptions and they weren't insignificant. I mean,
Speaker 4: it was small relat to AUM, but we did see
Speaker 4: redemptions across most of the colts and and actually saw
Speaker 4: some uh, you know, some of the widening we saw
Speaker 4: interpol As was maybe a little more than you might expect.
Speaker 4: And again it's hard to attribute that necessarily to co
Speaker 4: O ETFs, but you know, I think the point is
Speaker 4: that you do have now buying and selling from a
Speaker 4: new type of investor in the SELO market, and that
Speaker 4: can have an impact that the margins. I don't think
Speaker 4: it's driving the market, but it can have can maybe
Speaker 4: exaggerate some of the market moves in some parts of
Speaker 4: the market, you know, and for us that that could
Speaker 4: out influence our allocation because we are looking to see
Speaker 4: where there's value, So that type of behavior can can
Speaker 4: certainly impact our how.
Speaker 3: How we are invested in.
Speaker 5: There's another interesting aspect of this as well, which is
Speaker 5: if you want to draw a parallel with high you
Speaker 5: bonds different a different market. But as the ETFs grew
Speaker 5: and people became concerned about their impact in daily liquidity
Speaker 5: vehicles on the overall market, what you tend to see
Speaker 5: in times of stress, once those funds hit critical mass
Speaker 5: is much of the volume trading volumes would go up
Speaker 5: in ETFs. They would go down in the cash market
Speaker 5: due to a drop off from liquidity and a stress market.
Speaker 5: The percentage of primary market activity i e. Redemptions and
Speaker 5: creations as a percentage of volume in those ETFs also plummeted,
Speaker 5: which means the ETF market makers were managing and laying
Speaker 5: off their risk in the secondary market for those shares.
Speaker 5: So in a way, the price movements might have been
Speaker 5: contributing or advertising the volatility in the market, but there
Speaker 5: wasn't the degree of force selling that people might have
Speaker 5: either feared or wished for or imagined. Because the critical
Speaker 5: mass had been achieved and the secondary market trading became
Speaker 5: a great way to manage risk in an aspirational sense,
Speaker 5: that's what we were hoping for the COLO universe.
Speaker 3: We think to some degree that did occur in April.
Speaker 5: The market now has recovered and grown more since then,
Speaker 5: and we think, you know, there's a possibility that that
Speaker 5: type of evolution continues.
Speaker 2: Yeah, And actually you mentioned evolution, and I think a
Speaker 2: previously early to differentiation. I was also thinking, so now
Speaker 2: that we have a dismal mass of co ETFs, I
Speaker 2: would have thought the various managers are going to start
Speaker 2: to think more about how to differentiate themselves and in
Speaker 2: the process there might be more of a product differentiation
Speaker 2: as well. So clearly BSL clos are the dominant type
Speaker 2: of cilo still and my guess is a large part
Speaker 2: of the investments made by clotfs go into BSL clos.
Speaker 2: But we also have other cls nowadays. So we have
Speaker 2: mid market clos that have been around for quite a bit,
Speaker 2: then quite large now and more recently we've seen sire
Speaker 2: commercial real estate clos appear on the scene. And of
Speaker 2: course a lot of people have been talking about private
Speaker 2: credit clos, some wondering and I really been maybe looking
Speaker 2: a fair few years ahead now, not just to twenty
Speaker 2: twenty six, but a bit further. Is there a prospect
Speaker 2: that the clotf market will start to offer a broader
Speaker 2: range of ETFs where some focus more on BSL clos,
Speaker 2: some focus more on mid market, some might be focusing
Speaker 2: for more on CER clos, some might be more dynamically
Speaker 2: allocating between the various types of clos. How do you
Speaker 2: see that developing?
Speaker 4: I think that's definitely, you know, I think I definitely
Speaker 4: expect to see continued product development in this space. That
Speaker 4: you know, anytime you have strong inflows. It does attract
Speaker 4: new ideas, I guess I would say, and as you said,
Speaker 4: we're seeing middle market private credit celos being put into ETF.
Speaker 4: I think there's even a leveraged l O ATF now,
Speaker 4: and you know people are looking at it, not directly related,
Speaker 4: but you know, private true direct lending now in ETFs. Ultimately,
Speaker 4: I think the market, of course will determine whether there's
Speaker 4: demand for these products, and especially as you get more
Speaker 4: niche I think, you know, they really need to have
Speaker 4: a compelling value proposition within a portfolio. But I guess
Speaker 4: I would also say, you know, you know, we've talked
Speaker 4: about liquidity a few times today and in the product
Speaker 4: development process, I mean, we view a liquidity assessment as
Speaker 4: really a crucial part of that, really like the initial
Speaker 4: part of any product development or any idea. When you're
Speaker 4: talking about et s, right, ets have daily inflows and outflows.
Speaker 4: They trade through the day, so you need pricing trans fancy.
Speaker 4: So you really do need a large and liquid underlying
Speaker 4: market because otherwise you can run into issues. And I
Speaker 4: think you know it's fans had a lot of uh,
Speaker 4: the products, some of these especially some of these more
Speaker 4: you know, let's call them. Innovative products that have launched
Speaker 4: in recent years haven't really been through any tests, whether
Speaker 4: you know, some market event like a big credit shock
Speaker 4: or a liquidity event, and you just really don't want
Speaker 4: to be in a scenario where you have trouble to
Speaker 4: satisfy redemptions or you're you find yourself selling assets at
Speaker 4: fire cell prices. So you know, the way we chose
Speaker 4: to differentiate was going beyond triple A, right, but still
Speaker 4: saying within b SL clos and just taking a broader approach.
Speaker 4: And you know, our products were designed to be more
Speaker 4: of a strategic holding in a portfolio. So accordingly, we
Speaker 4: looked at you know, making sure that the underlying market
Speaker 4: was large and liquid and really and set the right
Speaker 4: guardrails really to to to manage liquidity risk.
Speaker 1: So this could be for either one of you. But
Speaker 1: what do you consider the key headwinds and tailwinds for
Speaker 1: the cl market, both investment grade and non investment grade
Speaker 1: over the next you know, say, twelve to twenty four months.
Speaker 5: Stark in reverse sort of the tailwinds. We're still in
Speaker 5: a the nine credit environment. You still got base rates
Speaker 5: that are just below four percent, so you've got solid
Speaker 5: credit underpinning still an attractive spread over you know, a moderate,
Speaker 5: modestly attractive base rate. That's still a positive rate by
Speaker 5: a decent clip. So you know, those are those are
Speaker 5: the tailwinds that even if people are worried about the
Speaker 5: first headwind I'll mention, which is simply you know, more
Speaker 5: rate cuts would tend to lower the coupons unless the
Speaker 5: credit spreads widened out to compensate for that. So, uh,
Speaker 5: you know, we still think there's a relative attractiveness to
Speaker 5: clos that is going to continue into twenty twenty six.
Speaker 5: Even if we see you know, another recut in December
Speaker 5: and one or two over the course of the next
Speaker 5: year to rate those points earlier. If there's more than
Speaker 5: that next year, that may change some of the dynamics,
Speaker 5: But for now we see that combinations as still you know,
Speaker 5: a good, good tailwind for the COLO space. Potential headwinds
Speaker 5: Aside from that, you know, overly aggressive FED cutting is
Speaker 5: more just macro. Right. If if we see a turn
Speaker 5: driven by you know, a couple of the key concerns
Speaker 5: we've seen out there, the labor market, uh, you know,
Speaker 5: well the consumer in the US finally show some weakness
Speaker 5: that starts impacting various sectors of the economy.
Speaker 3: Will tariffs have you know.
Speaker 5: An outsize impact that people seem to be as we
Speaker 5: talked about earlier, maybe discounting some of that impact. Now,
Speaker 5: is there been a delayed effect and will that come
Speaker 5: to rusful geopolitics, anything that could upset this benign credit story.
Speaker 5: But when you look at earnings and you know, leverage ratios,
Speaker 5: even in the risky credit space, even the fault rates
Speaker 5: which had ticked up, but we're still somewhat modest and
Speaker 5: certainly manageable within the COO context.
Speaker 3: Uh, you know that that hasn't been the case yet.
Speaker 1: Well, unfortunately we need to end here. But this was
Speaker 1: a fantastic conversation. I really thank both of you for
Speaker 1: joining us today.
Speaker 3: Thanks very much joining us. Really enjoyed it. Yeah, this
Speaker 3: was a lot of fun. Thank you guys and Retto.
Speaker 1: I'd like to thank you for being my co host today.
Speaker 2: No worries at all, what's my pasure and.
Speaker 1: I want to thank you for listening. If you liked
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Speaker 1: our next episode. This is David Cohne with Inside Active