August 21, 2025 • 41 mins
Collateralized loan obligation equity stands to gain as much as 15% this year, according to Tetragon Credit Partners. “It’s teens returns, high current cash flows and diversification,” said Dagmara Michalczuk, co-chief investment officer at the firm, which specializes in the riskiest part of the CLO market. “We are in vanilla corporate America, just using a little bit of leverage in financial engineering to generate those returns,” she tells Bloomberg News’ James Crombie and Bloomberg Intelligence’s Mike Campellone in the latest Credit Edge podcast. Michalczuk and Campellone also discuss the risk of loss from liability-management exercises, private debt valuations, loan defaults and relative value in European CLOs.
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Episode Transcript
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Speaker 1 (00:16):
Hello, Welcome to Credit Edge, a wiki Marcus podcast. My
name is James Crombie. I'm a senior editor at Bloomberg.
Speaker 2 (00:21):
And I'm Mike Campalone, a senior credit analyst covering high
yield and investment grade retailers at Bloomberg Intelligence. This week,
we're very pleased to welcome Dagmara Michael Chuck co, chief
investment Officer at Tetragon Credit Partners. How are you, Dag.
Speaker 3 (00:35):
I'm great. It's wonderful to be here with you. Right.
Speaker 2 (00:37):
We're so happy if you can join us. Tetragon Credit
Partners is one of the largest and longest tenured COLO
equity investors globally. Dagging. The team at Tetragon Credit Partners
have deployed over two point eight billion into COLO equity
trnges across over one hundred and twenty eight colos and
thirty six managers since two thousand and five. James, why
don't I hand it over to you to kick us off.
Speaker 1 (00:58):
Yeah. So, credit mark is a hot with bond spreads
at the TITUS in twenty seven years. As demand saws
and net news supply remains thin, investors are chasing returns
in everything from junk bonds to collateralize loan obligations, and
looking beyond the US, particularly Europe, for opportunity, excess cash
and not enough to buy raises the prospect of risk
being mispriced, while US rates staying hi for longer than
(01:21):
expected pushes more companies into default or bankruptcy. And we
are only just starting to see the impact on the
US economy of radical changes to trade and immigration policy. So, Doug,
what's your take? Because everything as rosy as credit markets
would suggest, how much should we worry about the fundamental
state of US companies and their ability to repay their debt.
Speaker 3 (01:39):
I think the environment that we've been in for the
past few years is characterized by two words that, what
can say, have been abused by everyone in the markets. One,
of course, is uncertainty, which seems to have become a
feature of the landscape rather than an exception. And the other, one,
of course, is resently in So although from a macroeconomic perspective,
we've continued to see noise in data, that's suggest that
(02:00):
the economy clearly is decelerating, potentially having an impact on
the labor picture. At the same time, we also have
saxflation or sticky inflation, as a risk. Corporate entities in
the US in particular have shown themselves to be very resilient,
and we've continued to see positive, although slowing earning's growth,
which has resulted in fairly stable credit metrics. So certainly,
(02:22):
forward looking credit investors need to remain disciplined and concerned
about what the uncertainties that we've seen to date mean
for the future. However, the resilience so far is allowing
investors to price risk is as tight as it is today.
Speaker 2 (02:39):
And diag on a similar line, are there any sectors
like retail, energy or chemicals that you'd like your managers
to avoid or reduced exposure to, just given that macro
that macro backdrop that you discussed.
Speaker 3 (02:51):
So I would say in general, you know, we spent
a lot of time picking managers and try not to
get too much into their day to day jobs of
picking it. Of course, we spend a lot of time
understanding prudent risk taking and understanding their preference for specific industries. Uh.
And one of the things that's really important to CELO
equity success in particular is diversification. So, of course, if
(03:13):
a credit manager is doing a good job selecting credits,
they're thinking ahead of the curve and and trying to
minimize exposure at this point in time, for example, to
cyclical cyclical industries. However, of course we know that the
world is not monolithic. There's not a lot of you know,
identical companies, and so there is potentially opportunities even within
industries that can be viewed as cyclical, and so we
(03:36):
trust our managers to to pick the right the right companies,
even with within the most sensitive industries. So diversification and
prudent risk taking is is probably the overarching idea for US.
Speaker 1 (03:49):
So dog with clos you know, we've had a lot
of guests on the show that you talk about them
is a really exciting opportunity, you know, high team team
returns one big investors in the structures are quote bulletproof.
But at the same time, there are a lot of concerns,
as we've talked about already about the US economy and
the ability of the highly indebted companies to keep up
with some of their debt payments, especially in leverage loans
(04:10):
which are floating and underlying rates are staying quite high.
How safe are these structures really?
Speaker 3 (04:18):
I think they've proven themselves over the last twenty five
or so years to be quite a resilient. The financial
engineering in this instance has worked incredibly well, and I
think there are a couple of reasons for that. The
first one is that they are actively managed for most
of the market. There are static deals, but most of
the market is actively managed. The second reason is their
(04:38):
financing structure which is non marked to market, and lastly diversification,
which I previously mentioned. So they are very resilient. With
that being said, of course, you can make mistakes and
if you look at col equity performance, about fourteen percent
of deals that have been realized to date realized lower
than a zero percent I rr. So it's possible to
(04:59):
make mistakes the space.
Speaker 1 (05:01):
And also you know, I mean this is not directly comparable,
but commercial real estate was seeing investors take a hit
even on trunches that were rated triple A, so you know,
you're not covered on everything, even though you are kind
of diversified in the pool. So you know, I mean,
I know it's been tested over over years. That again,
people still worry about clos, They still worry about leverage loans,
(05:21):
People still confuse clos and CDOs. Do you believe this
worry is unwarranted.
Speaker 3 (05:26):
I think the comparison, certainly to other securitized products is
not correct. Of course, investors need to understand their was
bord and be appropriately positioned in the capital structure. But
to a large extent, based on the history that we've seen,
and remember, we've gone through very very different environments higher
interest rates, lower interest rates, the financial crisis, the pandemic,
(05:49):
the ASA class survived. It's one of the only parts
of the securitized products universe that did incredibly well. And
so I do think that the structure is very, very resilient.
Of course, there's the element of valuation and risk pricing,
but I would not be kind of concerned about the
existential value of clos as an asset class.
Speaker 2 (06:12):
And deg loan spreads have continued to grind tighter all
summer long, making the COLO arbitrage word challenging. What have
you been able to do to alleviate some of that
spread compression.
Speaker 3 (06:24):
So one of the things that a controlling equity investor
can do is adjust the capital structure that is financing themselves.
And so we've spent a lot of time this summer
actively refinancing and reducing our funding costs. But even on
a new investment decision. Of course, we are not concurrently
necessarily buying assets and financing ourselves with liabilities, and so
(06:46):
there's a lot of art and tactics to deciding when
to put a trade on. And one of the things
that you can do, for example, is take advantage of
the fact that often asset prices move a lot faster
than facts and the reality, and so one can and
potentially source assets during a dislocation and then finance yourself
once the dislocation has past, which this year has shown
(07:08):
us can be a matter of a couple of weeks.
So a lot of value can be generated in the
asset class by being opportunistic and tactical.
Speaker 2 (07:16):
And then are there certain types of loans that you
look for your managers to avoid or minimize, like second
lean loans or given in loans.
Speaker 3 (07:25):
Yes, so we have a very specific view of what
is appropriate for leverage within the COLO structure and tend
to have a fairly conservative bias. So we really value
highly diversified, high credit quality portfolios that are also liquid,
So we certainly would not be comfortable investing in portfolios
that are very heavily allocated to second leans on secured bonds,
(07:51):
but also smaller companies. So we really value the power
of liquidity as a risk mitigation tool and also as
a way to take advantage of volatility that happens more
and more in the market.
Speaker 1 (08:02):
Just a follow up on my spend though, I mean,
the average margin on leverage loans is just getting squeezed
and squeezed by the repricings, and some some are getting
done as low as one seventy five over sofa, you
know for a leverage loan, which is very very tight.
I mean everything site across the boarding credit. But how
do you make that arbitrage work? And you know, how
do you maintain profitability at a time when the people
(08:23):
are really looking at clos the equity to deliver very
high returns.
Speaker 3 (08:28):
Yeah, so there's there's really two components of that. One
is that, of course, for the foreseable future, when you
first make a decision to invest in cl equity, need
to make sure that there is sufficient access, interest generation
and the portfolios to evolve over time, so to the
extent you can control your liability strike if you will.
It's always ideal to have the cheapest possible financing structure,
(08:50):
the most efficient financing structure. The other reality is that
spread compression is not a permanent state of the world.
And of course these are long lived investments. They typically
have reinvestment periods of anywhere from three to five years.
There's some reinvestment permitted even after the end of the
reinvestment period, and so in reality, you can have these
transactions lift for a very long time. And so part
(09:11):
of the decision making that you are considering is what
is your outlook on unfolatility and spread evolution. From there,
we know that these spreads don't last forever, but you
do have an ability to lock in these liabilities at
a very attractive spread, and so that is part of
the value of the current environment that's very attractive.
Speaker 1 (09:31):
And in terms of the returns that you're talking about
to your end users, I mean we hear high teens
as a kind of level generally. Is that what you're seeing.
Speaker 3 (09:42):
Yeah, So it really depends on again on your level
of risk taking, the amount of leverage that you want
to apply through the CLO structure. That can range from
ten x to seventeen X. But broadly speaking, the asset
class has delivered about twelve percent realized returns. Skilled participants
in the market can generate fifteen percent plus returns. Of course,
(10:03):
as I said initially, if you take more rescue should
be able to generate higher returns. And investors, you know,
clearly have a very wide range of managers, durations, markets
to choose from in order to decide where they want
to play in the space.
Speaker 1 (10:17):
And is that re term getting eroded by all of
the demand for limited supply of assets.
Speaker 3 (10:22):
It's clearly been a challenge. And the other challenge, of
course has been loss generation in the asset class. We've
seen elevated lemes and the so called dual track default
rate and recoveries being challenged across a number of sort
of repeat Chapter twenty two style restructurings. So yes, those
two concerns clearly do affect the expected returns and it's
(10:46):
important in that instance to pick managers who can outperform
the worst cases in the market.
Speaker 2 (10:54):
And switching gears a little bit dag something on everyone's
mind and credit lemes. What's been the proach of your
managers with respect to lemis you know, do they participate
in their restructuring? Are they sellers of the risk? Any color?
Speaker 3 (11:08):
There? So we invest with a diverse pool of managers
and the approaches differ. I think it's important to say
that our views as an equity investor is that lemies
are not constructive and not good for anyone in the market,
and so they should be avoided. It is probably a
fallacy to assume that if you're a large manager, you
(11:31):
will always end up on the right side of the trade,
because exceptions occur, and it's very difficult to do the
game theory of understanding exactly what position you'll be in.
But with that being said, we've had managers that have
been involved in priming transactions and lemies. We've also had
managers that have been negatively affected, and so it's it's
(11:51):
for us all about finding managers that in general are
in portfolios where they can exit the credit before the
enemy occurs, which of course is easier said than than done.
Speaker 2 (12:04):
And and do you see loan documentation being modified to
limit the ability of management teams to pursue an lemy.
Speaker 3 (12:10):
We have, but of course hope and wish would be
that there's a more concerted and consistent effort their cyclicality
to how how often these documents are adjusted. Typically, post
lemy documents are stronger than pre lemy documents, but of
course some flexibility can remain. So in general, again to
my earlier earlier point, we do think that it would
(12:32):
behove the entire industry to return discipline to the documentation.
And it's critically important for us when we're looking at
managers to ensure that they spend enough time and energy
and understanding what the documents allow and that it becomes
a part of their credit analysis.
Speaker 1 (12:47):
But clearly the trend right now seems to be that
there will be more lemies and they'll be more aggressive,
and not just in US, but they're going to spread
to Europe. So you know, it's kind of become a
fact of life. And you know, one guest, you know,
several months on the show described it as a as
a you know, just part of capitalism at work. You know,
you can't avoid it. So how realistic do you think
it really is to say just avoid them, given that
(13:10):
you know that's just what's happening.
Speaker 3 (13:13):
It is It is very difficult, and you know, there
is an argument to the reason for their existence, which
is that it is a more efficient way to refinance
recapitalize a company that's entered into some issues it's cheaper
than doing a bankruptcy process, and so it's not all bad.
I think that what we are advocating against is the
removal of the very aggressive lender on lender of violence
(13:35):
and non parada treatment, which is outside of the realm
of what the ATHA class should look like. But lems
in and of themselves can be an efficient way to
quickly readjust the capital structure and allow the company chance
to improve operating performance.
Speaker 1 (13:51):
But it's basically another form of default, right, I mean.
Speaker 3 (13:54):
It, it is absolutely another form of default. Another form
of default, of course is lost generation is selling a
name below the cost of which you acquired it. So
you know, exiting lemis at a loss could could result
in the same outcomes. So it's a very complicated process.
In general, the objective of the manager, a successful seal
(14:16):
of manager is to minimize losses, whether that's defaults, lemies
or trading.
Speaker 1 (14:21):
And do you expect I mean, we hear a lot
about default rates. We also hear that, you know, mostly
the concern is on the leverage loan side in terms
of you know, the outlook for more default. A lot
of the defaults are happening in the form of lemis.
Do you expect. I mean, we're coming to a point
in time when you know, the economy seems to be slowing,
rates are staying high, the maturities is coming up, and
(14:43):
a lot of the companies just are going to hit
the wall. Do you expect defaults to accelerate from here?
Speaker 3 (14:49):
That's not currently our baseline expectation. We've been of the
view that will have an extended default cycle that is
not similar to the sort of mountain acceleration of default
that we saw during prior cyclical downturns in the economy.
I would say the exception to that view, of course,
is that we are not expecting a recession in the
(15:11):
US at the moment. If if that occurs, we should
and may see an acceleration and default. But our current
expectation is that we'll see this four to five percent
perandum default rate for an extended period of time because
there's just idiosyncratic reasons for overlevered companies with elevated rates
to run into trouble. So hopefully, hopefully that is the case.
(15:33):
And again our view is that it's best to be
diversified and prudent in taking risk at the moment because
we're not getting compensated for potentially higher credit risk.
Speaker 1 (15:44):
And then so in basic terms, I mean, for for
our listeners who are not quite you know, up on
how CLO equity works. I mean it seems like if
if you expect more defaults in leverage loans and you're
on the riskiest rounde of the CLO, you're going to
take a big hit. But how do you avoid that?
Speaker 3 (16:01):
Yeah, so there is a natural hedge against that, which
is part of the power of COLO equity, which is
that you have financed yourself at a point in time
and locked in liabilities. And typically when you have a
default cycle really accelerate above the average historical number, you
also have a repricing of credit risk. And so there
(16:22):
is a natural increase in your interest income generation because
your portfolio is repricing wider, whether that's lower lower prices
or wider spreads, and that naturally offs that some of
the lost generation that also increases at that point in time.
And of course the challenge is making sure that your
lost generation does not completely eat away at the spread widening.
(16:43):
And that is the value of an actively managed portfolio.
Speaker 1 (16:47):
And is it also down to picking more experience manages.
Theres a ton of new managers coming in. It is
it very much like how do you choose your manager?
Speaker 3 (16:56):
Absolutely so for us, you know, picking the managers the
most credit decision, regardless of whether that is a short
term or long term investment, and we tend to be
long term investors. There are over one hundred and thirty
managers in the US alone, so it's a very very
crowded market, But the number of experienced managers that we
would be comfortable with is actually quite small relative to
(17:20):
that total market size. So we spend a lot of time,
of course, understanding their their experience, and would advise against
investing with folks that are new to either loans or
to COLO management. It's not enough to be a good
loan manager because the COLO structure is complicated and can
be harnessed to be very powerful for investors if the
(17:42):
manager understands all of the tricks of the trade.
Speaker 2 (17:46):
And deg you know, a relatively new investor in COLO,
liabilities have been COLO ETFs and we've seen continued growth
this year. I'd assume that growth has clearly helped push
liability spreads lower. But do you view this investor base
as committed to the product on a longer term basis.
Speaker 3 (18:06):
Yes, I think so. I would see this as part
of a general migration of alternative assa classes into more
retail focused investor bases. And of course the speed at
which it happens may not be as fast as the
initial launch of the products, but we would expect retail
participation to be a fairly constant part of the market.
Speaker 1 (18:28):
Yeah, the big thing with hitting on constantly is private credit.
And you know there's been talked about private credit clos
but I'm just interested in generally in your view of
how private credit is altering the landscape, how you work,
and what you invest in.
Speaker 3 (18:41):
So I would say so far it's been more of
a friend than a foe. And of course the phone
nature comes from potentially lack of discipline and too much
competition and a rational pricing of risk. The reason that
my assessment is that it's generally been a positive development
so far is that we've seen about twenty five billion
of triple C rated broadly syndicated loans refinanced into the
(19:05):
private credit market at par. One of the names that
is topical recently is Finastro, which obviously originally went into
the direct loan private credit space is a triple S
rated name and recently has come back to the broadly
syndicated loan market. It's a B minus company. So that's
just one example of that market providing an additional, more
(19:25):
patient form of capital that has more flexibility to remove
credit resk from our market. And I think a big
part of the thesis from participants in the BSL space
has been that private credit will serve as a sort
of speed bump at a buffer from really potentially accelerated
default that would be higher without the capital based there.
(19:46):
So it's good to have another pool of capital providing
liquidity to companies that has more patients, flexibility, tools in
the toolbox than the BSL market does, which of course
is so heavily dependent on ratings because it is a
COLO product.
Speaker 1 (19:58):
Does it ultimately take away the supply that you would
need to build a CLO.
Speaker 3 (20:02):
Some segments of the market to some extent, Yes, But
I would say in overall, given given the other value
they provide to the ecosystem, I would say the provision
of capital period during periods of distress is probably more
valuable than the competition for a few names when conditions
are good and in general, as we've seen so far
(20:22):
this year, the syndicated market has actually won out more
names than private credit has gained from BSL given the
spread compression that we've seen in the public market.
Speaker 1 (20:32):
And so over time, you don't think that the entire
leverage loan market goes private.
Speaker 3 (20:36):
I think that's unlikely. Clearly. There are some companies where
it does make a lot of sense, but that market
is more expensive, and so it's not a decision that
makes sense for all companies at all times. So it's
going to be, in our view, a market that is
much more closely linked together than it was in the past,
where liquidity lines are blurred and investors are looking at
(20:58):
and companies are looking at a number of options across
all those possibilities how yield BSL private credit? But I
don't see it as an existential threat to the syndicated
market and deck.
Speaker 2 (21:07):
So is it possible for your managers to invest in
private credit assets to.
Speaker 3 (21:12):
Some extent theoretically yes, but of course it would need
to be very very large companies, and it is constrained,
so there are small baskets for smaller companies. In general,
it's not something that we think is very sensible to
do in a lot of size, and I think it's
tricky to combine private credit and syndicated assets within a
(21:32):
CLO structure because it's hard to get the right pricing
on the liability side and the right structure. You have
to account for some flexibilities that may cost you in
structural efficiency, and so I think that you know, some
mixing is potentially sensible for the right managers that have
the right expertise, but it should be it should be
well well constrained.
Speaker 1 (21:53):
Could we catch a point that it's some sometime soon
where you're getting a private credit entirely private credit, not
middle market, but you know, big private credit loan clo.
Speaker 3 (22:03):
I think so. And of course, over the last few
years we've seen private credit issueans really accelerate and become
a more meaningful share of the COLO market. Most of
that activity is financing driven versus arbitrage driven issuance and
the syndicated market. I think it's a natural evolution of
the space, given the attractiveness of COLO financing relative to
(22:24):
other financing options that are available.
Speaker 1 (22:26):
So what's the timeframe then, Is it going to happen
this year?
Speaker 3 (22:29):
I think that it will require a little bit more time,
and it really depends on the appetite from external capital
or colo equity in those transactions, and I think that's
that's a much more difficult exercise than the public, more
transparent markets. It's a much higher level of understanding the
manager than the more transparent public markets.
Speaker 1 (22:48):
So when you look at private credit, then you know
you've been covering leverage loans and cls for a long time.
I'm just wondering, you know, what your view is a
valuation of private loans, because that seems to be a
big concern. Everyone's kind of worried about how they're being
marked and if they're being marked accurately in that's the
potential area of risk that we could see cutting across
all markets. Do you worry about that's a tool?
Speaker 3 (23:08):
I do. I do think that the amount of capital
that's been raised in that space and the need to
deploy it may create some erosion of discipline, if you will,
from the market participants. And I also worry that that
erosion of discipline spills over to the public markets. The
liquidity and the transparency of price discovery is really important,
(23:29):
and I think that translates into more than just you know,
concerns about market dynamics, but also potentially the wrong asset
allocation decisions being made given the illusion of stability that
one might have and in the private space, given the
lag in price discovery.
Speaker 1 (23:45):
So does that give the broadly syndicated market an edge
in relative terms?
Speaker 3 (23:50):
I do think that it maintains its value. Of course,
the critical decision, the critical fact pattern is does the
spread premium and private credit compensate investors enough for the
ill liquidity and the credit risk that exists within that market.
And the other feature that's often missed is that in
private credit it's very difficult to monetize volatility once it happens.
(24:10):
Once you're in a loan, you're stuck in that loan.
You may have an ability to mend an extent, but
it's difficult to rotate capital away from a specific name.
The volatility that you can monetize in the syndicated market
is a big advantage, and I think the higher data
of loans over time with other markets makes it a
very attractive asset class to invest in from an equity perspective, in.
Speaker 1 (24:32):
Terms of issuance of clos I mean, what's your view,
is it overdone? Do you continue the same trend you know,
what kind of risks do you potentially get from such
a big volume of issuance.
Speaker 3 (24:43):
So of course, the theoretical risk is that we've missed
priced risk and then there is going to be an
issue with losses and ultimately performance for those vintages, which
is why I think it's really important for investors to
be very thoughtful around vintage selection and sourcing the right opportunities.
You know, this year is looking like a very strong year.
Last year, of course, was a record year for the market,
(25:07):
and it's not necessarily all bad. The challenge for our
market has been the fact that the syndicated market has
not produced as many new entrants as as one would
expect to see given given the volume of CILO issues.
But there are other dynamics in the market, for example
redemptions and refinancings and the extension of reinvestment runway that
(25:27):
is allowing for recycling of existing secondary supply. So I
don't think we're at a at a at a danger
point at this stage. But on the margin, you know,
not all transactions will be successful because it does require
a lot of discipline to to have the right mix
of components to get the right return. Profile for the risk.
Speaker 1 (25:45):
But do you think the issuance just keeps expanding and
hitting new records each year? From here, we.
Speaker 3 (25:49):
Probably have not seen seen the record volumes yet. If
we know our market, our market always surprises us to
the upside. I don't think that's a near term development though,
given all the all the risks that we have building
on the horizon. So I think we hover around these
record levels uh and wait for another stabilization in the
world for for real acceleration.
Speaker 1 (26:11):
We're also at a point in time when you know
there's there's a lot of pressure on the FED to ease,
you know, certainly from the from the government in the US.
So rates you know, at some point should should come down.
I mean, depending on your view of inflation and and
and how things pan out. But for a floating rate product,
does that end up hitting its appeal? I mean, how
(26:32):
do you how do you get around that with investors
who maybe want to lock in fix rate at this
point and avoid floating.
Speaker 3 (26:38):
So I think it depends on whether you're a dead
investor and a quid investor. UH. And of course there
are both positive and negative impact of lower rates. Our
view happens to be that declining rates but not going
back to the serup policies or interest rate policies is
a net net positive for the for the syndicated and
high bond markets, and it's sort of a a very
(27:00):
good environment for companies. While of course rates declining from
four and a half to three and a half or
three percent wherever we end up does reduce your yield,
it is not positive from a credit perspective, so we
should see improvement and credit fundamentals, and so it's all
about that the interplay between those those two forces. And
as I said, our view is that it's not going
(27:22):
to be incredibly problematic from from a demand perspective. Of
course we will see rotation as we always do, particularly
from retail buyers, and that could be an opportunity for
the CLO market.
Speaker 1 (27:32):
As we mentioned at the beginning, there is sort of
a sense of maybe diversification geographically building you know, this
whole idea of American exceptionalism being tested, and you have
offices in London, you look at, you know, the market globally.
I'm wondering where you see the relative value between Europe
and the US right now.
Speaker 3 (27:51):
So for many many years we've looked at the European
market and have very firmly decided that the best opportunity
was in the US for a lot of reasons, better liquidity,
more volatility, more diversity, UH and a better ability to
manage risk. But given the recent development compression of earnings
growth and GDP growth between the two markets, Europe is
(28:13):
for the first time in many years more firmly on
our on our radar. We have not made any new
European investments to date, but we're looking at that market
much more closely than we have been in many, many years.
Speaker 1 (28:24):
But it's an issue of scale as it I mean,
just not big enough.
Speaker 3 (28:28):
It's an issue of scale, diversity, complexity. Of course, it's
not one market many bankruptcy jurisdictions. It's it's a It's
a more challenging market to maneuver in many ways. But
of course the trade off is that it's potentially more
stable and that could be a nice dallas to h
to the volatility in the US.
Speaker 1 (28:44):
And is there a better return in Europe right now
in even the smaller scale.
Speaker 3 (28:48):
Not yet in our assessment, but again, differential is getting smaller,
and of course there's other dynamics from an equity perspective,
including the availability of capital across the two markets, where
those differences may you know, lead us to invest in Europe.
Speaker 1 (29:02):
And in terms of investors coming in to the market,
I mean, what's the app site right now of foreign
investors in U S CLOS?
Speaker 3 (29:09):
Would you say, I would say that it's remained relatively stable.
We see pockets of new investors learning about the assa class,
particularly as assa classes like private equity face a lot
of headwinds, where col equity hits similar return targets, doesn't
have the J curve, has higher cash flows and is
potentially more resilient. These are marginal changes. We haven't seen
(29:32):
kind of whole sale lack of interest or you know,
doubling or tripling of interest. So these are marginal changes
that I guess every asset manager's experiences in slightly different ways.
Speaker 1 (29:43):
The new investors that you're seeing, what kind of questions
are they asking about CLOS because there still seems to
be you know, lack of understanding really about the product.
I mean, even though you know it's been going for
a long time and it has done well even through downturns,
as you mentioned, even through two thousand and eight, you
know what sort of questions are they putting to you.
Speaker 3 (30:00):
I think that we always lead with explaining to them
that it's worth to understand the asset class because that
complexity premium, once you get through it can be monetized
for a very long time. But the biggest I would
say source of misunderstanding or source of questions is understanding
the idea of leveraging leverage loans and explaining the power
and the value of the very unique financing structure of CLOS.
(30:24):
Ten X leverage can be a very high number objectively
if you don't understand that it's not mark to market,
that it's locked in, that it's match funded, all those
features that are very very important to giving CLOS and
COL equity the resilience that it's.
Speaker 2 (30:37):
Had, and deg what's the composition of your investor pool
and what makes COLO equity attractive to a non US investor.
Speaker 3 (30:47):
So our investor base is fairly diversified geographically, about fifty
to fifty mix between the US and Europe. We do
have some other geographiesy in the mechs as well, but
as a smaller percentage and a fairly wide range of investors,
you know, ranging from high net worth all the way
up to pensions and insurance companies. Typically non US investors
(31:09):
are looking to get US exposure, and clos and col
equity specifically allow investors outside of the US to get
access to corporate America in a very diversified, efficient fashion.
So it's it's investors looking to have exposure to credit
data in the US in a way that isolates credit
default risk without you know, exposing you to other types
(31:31):
of risk like interest rates, et cetera.
Speaker 1 (31:33):
One other aspects of the complexity premium. As you mentioned it,
there is this kind of misunderstanding of what these things
are and then you should get paid more because they're complicated,
although you know, you could argue that they're not that complicated really,
but they are also often in the in the lens
of regulators and you know, government entities, and you know,
(31:54):
for this reason, and you know, people sort of worry
about what they don't really understand. But do you expect
more headwinds from regulators as this kind of you know,
product get gets pushed more broadly to investors.
Speaker 3 (32:05):
I don't think so. Of course, we are seeing an expansion,
as we mentioned earlier, of the product into the retail space,
where I do think it's appropriate for regulators to ensure
that those investors understand what they are potentially getting exposed to.
But in general, the ASCA class, of course, has been
regulated and owned by a very wide variety of investors
(32:26):
across the world, and is generally very well understood by
by regulators and market participants.
Speaker 1 (32:32):
And is it true to say I mean this has
been this has been mentioned a few times that the
equity trund or equity in clos actually performed okay through
the finished crisis.
Speaker 3 (32:45):
It performed better than okay, performed outstandingly well. So that
set of vintages generated close to a nineteen twenty percent
i r R, which is one of the best vintages historically.
There were very unique reasons for them at including financing
at so for libor plus forty five basis points, which
(33:05):
we will not likely have again. But the power of
volatility and a locked in liability structure really shown through
in that in that environment. So if you invest appropriately,
prudently and have the right managers, going through volatility is
actually an incredibly valuable exercise for COLO equity, and it's
quite paradoxical for many For many folks looking at the
(33:27):
asset class for the first time.
Speaker 1 (33:29):
Twenty percent. That was through what like two thousand and six,
two thousand and eight or nine.
Speaker 3 (33:33):
What was the period, so pre crisis vintages, Yes, two
thousand and five to two thousand and seven roughly.
Speaker 1 (33:39):
Yeah, okay, and then what about COVID.
Speaker 3 (33:42):
COVID also actually had some very very good vintages, So
twenty twenty is an outstanding vintage. The reason for that
was that although liabilities were quite wide at that time,
investors were able to source assets at very cheap prices
uh and then see a very rapid price recovery. So
they monetized five to six points of discount timesten leverage,
(34:05):
which of course gets you a very very nice return
on an annualized basis.
Speaker 1 (34:09):
What do you expect for this year?
Speaker 3 (34:11):
We expect this year to be more of a vanilla
investment here in the sense that we are really putting
transactions on at the moment in the new issue market
for the value of the cheap liabilities. We are once
again close to twenty eighteen tights from an overall cost
of funding perspective, and so the value that you are
locking in as an equitin investor is the cheapness of
(34:31):
that financing structure, and very good opportunity, as I noted earlier,
to monetize short term periods of volatility, which seems to
have been a very common theme this year.
Speaker 1 (34:43):
So, Vanilla, what does that mean? Ten percent? Fifteen? What's
the number the teen?
Speaker 3 (34:48):
So anywhere from? You know, thirteen and a half fifteen percent?
Speaker 1 (34:52):
Okay, still not bad.
Speaker 3 (34:54):
Very very good relative to the risk and dag.
Speaker 2 (34:58):
You know, AI is making its presence felt in the
financial world. You know, I can't even count how many
times we hear it. To hear that word today over
here at Bloomberg, you know, do you use it in
any of your investment processes? And have any of your
managers embraced AI in their investment process?
Speaker 3 (35:16):
We certainly do, and it's been a very very important
part of the evolution of our systems and has made
us very very efficient. One of the things that we've
seen over the lifespan of our investment strategy is of course,
an expansion of data availability, which is power when you're
making investments, and for us, we focused a lot of
(35:39):
the systems development on ensuring that we're using data that
others may have available in a more efficient and more
unique way, and also that we're sourcing other data that
others may not be looking at in a way that
powers us to be more effective in making investment decisions.
So we think that it's a really important tool we do.
You know that some of our managers are also increasingly
(36:01):
relying on it, And even if it's something simple like
making routine operational processes more efficient, improving risk management over time,
we think that those will be very powerful additions to
the toolbox.
Speaker 1 (36:14):
Our listeners will know that at this point of the show.
I always I always like to ask, what is your edge?
How do you differentiate yourself? What are you doing that's
different to the rest.
Speaker 3 (36:24):
I think that our edge, of course, is our expertise
and length of understanding what this market looks like, knowing
managers and knowing market participants very well. But equally importantly,
it is our humbleness and discipline and our desire to
focus always on maximizing returns rather than any other objective.
(36:47):
And that is something that we think is really important,
particularly a time like we're in today, where risk premium
are compressed and investment decision making is a lot more
challenging than it is during a dislocation.
Speaker 1 (36:58):
Do you need to grow in the age of like
trillion dollar multi trillion dollar managers? Do you think that
the tetrigon needs to gain more scale?
Speaker 3 (37:06):
Look, a little bit more scale is always is always
desirable and helpful, But of course you don't want to
get so large that the opportunity set is not appropriate
for the capital that you have. So we really think
that being capacity constrained and having the right amount of
capital for the opportunity set is important. A lot of
capital has been raised in the space by as the
(37:27):
managers themselves, you're so called captive funds, and so that has,
in my view at least eroded a little bit of
the discipline that should be in place for scale of equity.
And so we think that you know, being nimble and
the right size and potentially a little bit smaller than
you would ordinarily think is not a bad is not
a bad position to be in.
Speaker 1 (37:49):
Is there one big credit opportunity out there? You think
people are missing one big thing that you know, you
think is the best relative value right now?
Speaker 3 (37:56):
I don't. I don't necessarily think that folks are missing
the opportunity and scale equity, but I would highlight that
as a continued opportunity. Of course, potentially a biased view
given my dedication to the asset class, but it is
an asset class that's delivered some very powerful things in
a single asset category. So again it's teams returns, high
current cash flows, and diversification because the asset class, through
(38:18):
its cash flow generation, actually exhibits very low correlation with
other things that you would have in a multi asset portfolio,
and I think relatively risk profile today you would need
to really take some esoteric credit risks and counter party
risks to generate those returns. And here we are in
Vanilla Corporate America just using a little bit of leverage
in financial engineering to generate those returns. So we think,
(38:40):
I think that it's a really compelling opportunity and it
makes sense to add to a portfolio.
Speaker 1 (38:45):
It's interesting to know, also, Vanilla America, these loans are
basically to companies that people kind of know that household names, right,
they're not obscure, you know, private equity shells that are
paying dividends that they're actually you know, companies you can
see out on the high street exactly.
Speaker 3 (39:00):
So it's American airlines and other businesses that you use
and know. So it's getting access to what drives growth
in the US and finances that growth, which ultimately has
been a core part of the successive of the US,
getting that efficiency of capital markets.
Speaker 1 (39:16):
But as a credit veteran, you must be worried about something.
I mean, we worry about stuff all the time. What
keeps you up at night? Dog worrying about the outlook.
Speaker 3 (39:23):
It's my job to worry all the time, although you
know glass half full, I guess as an equity investor
in credit, I worry about ultimately the loss performance of
the ATHA class given the amount of capital that's flashing
around in the system, and potentially the erosion of discipline.
I also worry about where the economy is heading. We've
(39:43):
had We've been waiting for a recesion in the US
for many years now, and it certainly will come at
some point. So spending a lot of time thinking about
how we position for that, you know, making sure that
we're building portfolios that are resilient and diversified enough to
withstand that downturn eventually, which create opportunity.
Speaker 1 (40:01):
Great stuff. Dag Michael Chuck Cocio at Tetragon Credit Partners,
thank you for being on the Credit Edge.
Speaker 3 (40:08):
Thank you, pleasure chatting with you, and.
Speaker 1 (40:10):
Of course very grateful to Mike Campalone from Bloomberg Intelligence.
Speaker 2 (40:13):
Cheers Mike, Thanks James, Thanks Dag.
Speaker 1 (40:15):
For more credit market analysis and insight, read all of
Mike's great work on the Bloomberg Terminal. Bloomberg Intelligence is
part of our research department, with five hundred analysts and
strategists working across all markets. Courage includes over two thousand
equities and credits pus outlooks on more than ninety industries
and one hundred market indices, currencies and commodities. Please do
subscribe to The Credit Edge wherever you get your podcasts.
(40:36):
We're on Apple, Spotify and all other good podcast providers,
including the Bloomberg Terminal at b pod Go. Give us
a review, tell your friends, or email me directly at
jcrombieight at Bloomberg dot net. I'm James Crombie. It's been
a pleasure having you join us again next week on
the Credit Edge.
Hello, Welcome to Credit Edge, a wiki Marcus podcast. My
name is James Crombie. I'm a senior editor at Bloomberg.
Speaker 2 (00:21):
And I'm Mike Campalone, a senior credit analyst covering high
yield and investment grade retailers at Bloomberg Intelligence. This week,
we're very pleased to welcome Dagmara Michael Chuck co, chief
investment Officer at Tetragon Credit Partners. How are you, Dag.
Speaker 3 (00:35):
I'm great. It's wonderful to be here with you. Right.
Speaker 2 (00:37):
We're so happy if you can join us. Tetragon Credit
Partners is one of the largest and longest tenured COLO
equity investors globally. Dagging. The team at Tetragon Credit Partners
have deployed over two point eight billion into COLO equity
trnges across over one hundred and twenty eight colos and
thirty six managers since two thousand and five. James, why
don't I hand it over to you to kick us off.
Speaker 1 (00:58):
Yeah. So, credit mark is a hot with bond spreads
at the TITUS in twenty seven years. As demand saws
and net news supply remains thin, investors are chasing returns
in everything from junk bonds to collateralize loan obligations, and
looking beyond the US, particularly Europe, for opportunity, excess cash
and not enough to buy raises the prospect of risk
being mispriced, while US rates staying hi for longer than
(01:21):
expected pushes more companies into default or bankruptcy. And we
are only just starting to see the impact on the
US economy of radical changes to trade and immigration policy. So, Doug,
what's your take? Because everything as rosy as credit markets
would suggest, how much should we worry about the fundamental
state of US companies and their ability to repay their debt.
Speaker 3 (01:39):
I think the environment that we've been in for the
past few years is characterized by two words that, what
can say, have been abused by everyone in the markets. One,
of course, is uncertainty, which seems to have become a
feature of the landscape rather than an exception. And the other, one,
of course, is resently in So although from a macroeconomic perspective,
we've continued to see noise in data, that's suggest that
(02:00):
the economy clearly is decelerating, potentially having an impact on
the labor picture. At the same time, we also have
saxflation or sticky inflation, as a risk. Corporate entities in
the US in particular have shown themselves to be very resilient,
and we've continued to see positive, although slowing earning's growth,
which has resulted in fairly stable credit metrics. So certainly,
(02:22):
forward looking credit investors need to remain disciplined and concerned
about what the uncertainties that we've seen to date mean
for the future. However, the resilience so far is allowing
investors to price risk is as tight as it is today.
Speaker 2 (02:39):
And diag on a similar line, are there any sectors
like retail, energy or chemicals that you'd like your managers
to avoid or reduced exposure to, just given that macro
that macro backdrop that you discussed.
Speaker 3 (02:51):
So I would say in general, you know, we spent
a lot of time picking managers and try not to
get too much into their day to day jobs of
picking it. Of course, we spend a lot of time
understanding prudent risk taking and understanding their preference for specific industries. Uh.
And one of the things that's really important to CELO
equity success in particular is diversification. So, of course, if
(03:13):
a credit manager is doing a good job selecting credits,
they're thinking ahead of the curve and and trying to
minimize exposure at this point in time, for example, to
cyclical cyclical industries. However, of course we know that the
world is not monolithic. There's not a lot of you know,
identical companies, and so there is potentially opportunities even within
industries that can be viewed as cyclical, and so we
(03:36):
trust our managers to to pick the right the right companies,
even with within the most sensitive industries. So diversification and
prudent risk taking is is probably the overarching idea for US.
Speaker 1 (03:49):
So dog with clos you know, we've had a lot
of guests on the show that you talk about them
is a really exciting opportunity, you know, high team team
returns one big investors in the structures are quote bulletproof.
But at the same time, there are a lot of concerns,
as we've talked about already about the US economy and
the ability of the highly indebted companies to keep up
with some of their debt payments, especially in leverage loans
(04:10):
which are floating and underlying rates are staying quite high.
How safe are these structures really?
Speaker 3 (04:18):
I think they've proven themselves over the last twenty five
or so years to be quite a resilient. The financial
engineering in this instance has worked incredibly well, and I
think there are a couple of reasons for that. The
first one is that they are actively managed for most
of the market. There are static deals, but most of
the market is actively managed. The second reason is their
(04:38):
financing structure which is non marked to market, and lastly diversification,
which I previously mentioned. So they are very resilient. With
that being said, of course, you can make mistakes and
if you look at col equity performance, about fourteen percent
of deals that have been realized to date realized lower
than a zero percent I rr. So it's possible to
(04:59):
make mistakes the space.
Speaker 1 (05:01):
And also you know, I mean this is not directly comparable,
but commercial real estate was seeing investors take a hit
even on trunches that were rated triple A, so you know,
you're not covered on everything, even though you are kind
of diversified in the pool. So you know, I mean,
I know it's been tested over over years. That again,
people still worry about clos, They still worry about leverage loans,
(05:21):
People still confuse clos and CDOs. Do you believe this
worry is unwarranted.
Speaker 3 (05:26):
I think the comparison, certainly to other securitized products is
not correct. Of course, investors need to understand their was
bord and be appropriately positioned in the capital structure. But
to a large extent, based on the history that we've seen,
and remember, we've gone through very very different environments higher
interest rates, lower interest rates, the financial crisis, the pandemic,
(05:49):
the ASA class survived. It's one of the only parts
of the securitized products universe that did incredibly well. And
so I do think that the structure is very, very resilient.
Of course, there's the element of valuation and risk pricing,
but I would not be kind of concerned about the
existential value of clos as an asset class.
Speaker 2 (06:12):
And deg loan spreads have continued to grind tighter all
summer long, making the COLO arbitrage word challenging. What have
you been able to do to alleviate some of that
spread compression.
Speaker 3 (06:24):
So one of the things that a controlling equity investor
can do is adjust the capital structure that is financing themselves.
And so we've spent a lot of time this summer
actively refinancing and reducing our funding costs. But even on
a new investment decision. Of course, we are not concurrently
necessarily buying assets and financing ourselves with liabilities, and so
(06:46):
there's a lot of art and tactics to deciding when
to put a trade on. And one of the things
that you can do, for example, is take advantage of
the fact that often asset prices move a lot faster
than facts and the reality, and so one can and
potentially source assets during a dislocation and then finance yourself
once the dislocation has past, which this year has shown
(07:08):
us can be a matter of a couple of weeks.
So a lot of value can be generated in the
asset class by being opportunistic and tactical.
Speaker 2 (07:16):
And then are there certain types of loans that you
look for your managers to avoid or minimize, like second
lean loans or given in loans.
Speaker 3 (07:25):
Yes, so we have a very specific view of what
is appropriate for leverage within the COLO structure and tend
to have a fairly conservative bias. So we really value
highly diversified, high credit quality portfolios that are also liquid,
So we certainly would not be comfortable investing in portfolios
that are very heavily allocated to second leans on secured bonds,
(07:51):
but also smaller companies. So we really value the power
of liquidity as a risk mitigation tool and also as
a way to take advantage of volatility that happens more
and more in the market.
Speaker 1 (08:02):
Just a follow up on my spend though, I mean,
the average margin on leverage loans is just getting squeezed
and squeezed by the repricings, and some some are getting
done as low as one seventy five over sofa, you
know for a leverage loan, which is very very tight.
I mean everything site across the boarding credit. But how
do you make that arbitrage work? And you know, how
do you maintain profitability at a time when the people
(08:23):
are really looking at clos the equity to deliver very
high returns.
Speaker 3 (08:28):
Yeah, so there's there's really two components of that. One
is that, of course, for the foreseable future, when you
first make a decision to invest in cl equity, need
to make sure that there is sufficient access, interest generation
and the portfolios to evolve over time, so to the
extent you can control your liability strike if you will.
It's always ideal to have the cheapest possible financing structure,
(08:50):
the most efficient financing structure. The other reality is that
spread compression is not a permanent state of the world.
And of course these are long lived investments. They typically
have reinvestment periods of anywhere from three to five years.
There's some reinvestment permitted even after the end of the
reinvestment period, and so in reality, you can have these
transactions lift for a very long time. And so part
(09:11):
of the decision making that you are considering is what
is your outlook on unfolatility and spread evolution. From there,
we know that these spreads don't last forever, but you
do have an ability to lock in these liabilities at
a very attractive spread, and so that is part of
the value of the current environment that's very attractive.
Speaker 1 (09:31):
And in terms of the returns that you're talking about
to your end users, I mean we hear high teens
as a kind of level generally. Is that what you're seeing.
Speaker 3 (09:42):
Yeah, So it really depends on again on your level
of risk taking, the amount of leverage that you want
to apply through the CLO structure. That can range from
ten x to seventeen X. But broadly speaking, the asset
class has delivered about twelve percent realized returns. Skilled participants
in the market can generate fifteen percent plus returns. Of course,
(10:03):
as I said initially, if you take more rescue should
be able to generate higher returns. And investors, you know,
clearly have a very wide range of managers, durations, markets
to choose from in order to decide where they want
to play in the space.
Speaker 1 (10:17):
And is that re term getting eroded by all of
the demand for limited supply of assets.
Speaker 3 (10:22):
It's clearly been a challenge. And the other challenge, of
course has been loss generation in the asset class. We've
seen elevated lemes and the so called dual track default
rate and recoveries being challenged across a number of sort
of repeat Chapter twenty two style restructurings. So yes, those
two concerns clearly do affect the expected returns and it's
(10:46):
important in that instance to pick managers who can outperform
the worst cases in the market.
Speaker 2 (10:54):
And switching gears a little bit dag something on everyone's
mind and credit lemes. What's been the proach of your
managers with respect to lemis you know, do they participate
in their restructuring? Are they sellers of the risk? Any color?
Speaker 3 (11:08):
There? So we invest with a diverse pool of managers
and the approaches differ. I think it's important to say
that our views as an equity investor is that lemies
are not constructive and not good for anyone in the market,
and so they should be avoided. It is probably a
fallacy to assume that if you're a large manager, you
(11:31):
will always end up on the right side of the trade,
because exceptions occur, and it's very difficult to do the
game theory of understanding exactly what position you'll be in.
But with that being said, we've had managers that have
been involved in priming transactions and lemies. We've also had
managers that have been negatively affected, and so it's it's
(11:51):
for us all about finding managers that in general are
in portfolios where they can exit the credit before the
enemy occurs, which of course is easier said than than done.
Speaker 2 (12:04):
And and do you see loan documentation being modified to
limit the ability of management teams to pursue an lemy.
Speaker 3 (12:10):
We have, but of course hope and wish would be
that there's a more concerted and consistent effort their cyclicality
to how how often these documents are adjusted. Typically, post
lemy documents are stronger than pre lemy documents, but of
course some flexibility can remain. So in general, again to
my earlier earlier point, we do think that it would
(12:32):
behove the entire industry to return discipline to the documentation.
And it's critically important for us when we're looking at
managers to ensure that they spend enough time and energy
and understanding what the documents allow and that it becomes
a part of their credit analysis.
Speaker 1 (12:47):
But clearly the trend right now seems to be that
there will be more lemies and they'll be more aggressive,
and not just in US, but they're going to spread
to Europe. So you know, it's kind of become a
fact of life. And you know, one guest, you know,
several months on the show described it as a as
a you know, just part of capitalism at work. You know,
you can't avoid it. So how realistic do you think
it really is to say just avoid them, given that
(13:10):
you know that's just what's happening.
Speaker 3 (13:13):
It is It is very difficult, and you know, there
is an argument to the reason for their existence, which
is that it is a more efficient way to refinance
recapitalize a company that's entered into some issues it's cheaper
than doing a bankruptcy process, and so it's not all bad.
I think that what we are advocating against is the
removal of the very aggressive lender on lender of violence
(13:35):
and non parada treatment, which is outside of the realm
of what the ATHA class should look like. But lems
in and of themselves can be an efficient way to
quickly readjust the capital structure and allow the company chance
to improve operating performance.
Speaker 1 (13:51):
But it's basically another form of default, right, I mean.
Speaker 3 (13:54):
It, it is absolutely another form of default. Another form
of default, of course is lost generation is selling a
name below the cost of which you acquired it. So
you know, exiting lemis at a loss could could result
in the same outcomes. So it's a very complicated process.
In general, the objective of the manager, a successful seal
(14:16):
of manager is to minimize losses, whether that's defaults, lemies
or trading.
Speaker 1 (14:21):
And do you expect I mean, we hear a lot
about default rates. We also hear that, you know, mostly
the concern is on the leverage loan side in terms
of you know, the outlook for more default. A lot
of the defaults are happening in the form of lemis.
Do you expect. I mean, we're coming to a point
in time when you know, the economy seems to be slowing,
rates are staying high, the maturities is coming up, and
(14:43):
a lot of the companies just are going to hit
the wall. Do you expect defaults to accelerate from here?
Speaker 3 (14:49):
That's not currently our baseline expectation. We've been of the
view that will have an extended default cycle that is
not similar to the sort of mountain acceleration of default
that we saw during prior cyclical downturns in the economy.
I would say the exception to that view, of course,
is that we are not expecting a recession in the
(15:11):
US at the moment. If if that occurs, we should
and may see an acceleration and default. But our current
expectation is that we'll see this four to five percent
perandum default rate for an extended period of time because
there's just idiosyncratic reasons for overlevered companies with elevated rates
to run into trouble. So hopefully, hopefully that is the case.
(15:33):
And again our view is that it's best to be
diversified and prudent in taking risk at the moment because
we're not getting compensated for potentially higher credit risk.
Speaker 1 (15:44):
And then so in basic terms, I mean, for for
our listeners who are not quite you know, up on
how CLO equity works. I mean it seems like if
if you expect more defaults in leverage loans and you're
on the riskiest rounde of the CLO, you're going to
take a big hit. But how do you avoid that?
Speaker 3 (16:01):
Yeah, so there is a natural hedge against that, which
is part of the power of COLO equity, which is
that you have financed yourself at a point in time
and locked in liabilities. And typically when you have a
default cycle really accelerate above the average historical number, you
also have a repricing of credit risk. And so there
(16:22):
is a natural increase in your interest income generation because
your portfolio is repricing wider, whether that's lower lower prices
or wider spreads, and that naturally offs that some of
the lost generation that also increases at that point in time.
And of course the challenge is making sure that your
lost generation does not completely eat away at the spread widening.
(16:43):
And that is the value of an actively managed portfolio.
Speaker 1 (16:47):
And is it also down to picking more experience manages.
Theres a ton of new managers coming in. It is
it very much like how do you choose your manager?
Speaker 3 (16:56):
Absolutely so for us, you know, picking the managers the
most credit decision, regardless of whether that is a short
term or long term investment, and we tend to be
long term investors. There are over one hundred and thirty
managers in the US alone, so it's a very very
crowded market, But the number of experienced managers that we
would be comfortable with is actually quite small relative to
(17:20):
that total market size. So we spend a lot of time,
of course, understanding their their experience, and would advise against
investing with folks that are new to either loans or
to COLO management. It's not enough to be a good
loan manager because the COLO structure is complicated and can
be harnessed to be very powerful for investors if the
(17:42):
manager understands all of the tricks of the trade.
Speaker 2 (17:46):
And deg you know, a relatively new investor in COLO,
liabilities have been COLO ETFs and we've seen continued growth
this year. I'd assume that growth has clearly helped push
liability spreads lower. But do you view this investor base
as committed to the product on a longer term basis.
Speaker 3 (18:06):
Yes, I think so. I would see this as part
of a general migration of alternative assa classes into more
retail focused investor bases. And of course the speed at
which it happens may not be as fast as the
initial launch of the products, but we would expect retail
participation to be a fairly constant part of the market.
Speaker 1 (18:28):
Yeah, the big thing with hitting on constantly is private credit.
And you know there's been talked about private credit clos
but I'm just interested in generally in your view of
how private credit is altering the landscape, how you work,
and what you invest in.
Speaker 3 (18:41):
So I would say so far it's been more of
a friend than a foe. And of course the phone
nature comes from potentially lack of discipline and too much
competition and a rational pricing of risk. The reason that
my assessment is that it's generally been a positive development
so far is that we've seen about twenty five billion
of triple C rated broadly syndicated loans refinanced into the
(19:05):
private credit market at par. One of the names that
is topical recently is Finastro, which obviously originally went into
the direct loan private credit space is a triple S
rated name and recently has come back to the broadly
syndicated loan market. It's a B minus company. So that's
just one example of that market providing an additional, more
(19:25):
patient form of capital that has more flexibility to remove
credit resk from our market. And I think a big
part of the thesis from participants in the BSL space
has been that private credit will serve as a sort
of speed bump at a buffer from really potentially accelerated
default that would be higher without the capital based there.
(19:46):
So it's good to have another pool of capital providing
liquidity to companies that has more patients, flexibility, tools in
the toolbox than the BSL market does, which of course
is so heavily dependent on ratings because it is a
COLO product.
Speaker 1 (19:58):
Does it ultimately take away the supply that you would
need to build a CLO.
Speaker 3 (20:02):
Some segments of the market to some extent, Yes, But
I would say in overall, given given the other value
they provide to the ecosystem, I would say the provision
of capital period during periods of distress is probably more
valuable than the competition for a few names when conditions
are good and in general, as we've seen so far
(20:22):
this year, the syndicated market has actually won out more
names than private credit has gained from BSL given the
spread compression that we've seen in the public market.
Speaker 1 (20:32):
And so over time, you don't think that the entire
leverage loan market goes private.
Speaker 3 (20:36):
I think that's unlikely. Clearly. There are some companies where
it does make a lot of sense, but that market
is more expensive, and so it's not a decision that
makes sense for all companies at all times. So it's
going to be, in our view, a market that is
much more closely linked together than it was in the past,
where liquidity lines are blurred and investors are looking at
(20:58):
and companies are looking at a number of options across
all those possibilities how yield BSL private credit? But I
don't see it as an existential threat to the syndicated
market and deck.
Speaker 2 (21:07):
So is it possible for your managers to invest in
private credit assets to.
Speaker 3 (21:12):
Some extent theoretically yes, but of course it would need
to be very very large companies, and it is constrained,
so there are small baskets for smaller companies. In general,
it's not something that we think is very sensible to
do in a lot of size, and I think it's
tricky to combine private credit and syndicated assets within a
(21:32):
CLO structure because it's hard to get the right pricing
on the liability side and the right structure. You have
to account for some flexibilities that may cost you in
structural efficiency, and so I think that you know, some
mixing is potentially sensible for the right managers that have
the right expertise, but it should be it should be
well well constrained.
Speaker 1 (21:53):
Could we catch a point that it's some sometime soon
where you're getting a private credit entirely private credit, not
middle market, but you know, big private credit loan clo.
Speaker 3 (22:03):
I think so. And of course, over the last few
years we've seen private credit issueans really accelerate and become
a more meaningful share of the COLO market. Most of
that activity is financing driven versus arbitrage driven issuance and
the syndicated market. I think it's a natural evolution of
the space, given the attractiveness of COLO financing relative to
(22:24):
other financing options that are available.
Speaker 1 (22:26):
So what's the timeframe then, Is it going to happen
this year?
Speaker 3 (22:29):
I think that it will require a little bit more time,
and it really depends on the appetite from external capital
or colo equity in those transactions, and I think that's
that's a much more difficult exercise than the public, more
transparent markets. It's a much higher level of understanding the
manager than the more transparent public markets.
Speaker 1 (22:48):
So when you look at private credit, then you know
you've been covering leverage loans and cls for a long time.
I'm just wondering, you know, what your view is a
valuation of private loans, because that seems to be a
big concern. Everyone's kind of worried about how they're being
marked and if they're being marked accurately in that's the
potential area of risk that we could see cutting across
all markets. Do you worry about that's a tool?
Speaker 3 (23:08):
I do. I do think that the amount of capital
that's been raised in that space and the need to
deploy it may create some erosion of discipline, if you will,
from the market participants. And I also worry that that
erosion of discipline spills over to the public markets. The
liquidity and the transparency of price discovery is really important,
(23:29):
and I think that translates into more than just you know,
concerns about market dynamics, but also potentially the wrong asset
allocation decisions being made given the illusion of stability that
one might have and in the private space, given the
lag in price discovery.
Speaker 1 (23:45):
So does that give the broadly syndicated market an edge
in relative terms?
Speaker 3 (23:50):
I do think that it maintains its value. Of course,
the critical decision, the critical fact pattern is does the
spread premium and private credit compensate investors enough for the
ill liquidity and the credit risk that exists within that market.
And the other feature that's often missed is that in
private credit it's very difficult to monetize volatility once it happens.
(24:10):
Once you're in a loan, you're stuck in that loan.
You may have an ability to mend an extent, but
it's difficult to rotate capital away from a specific name.
The volatility that you can monetize in the syndicated market
is a big advantage, and I think the higher data
of loans over time with other markets makes it a
very attractive asset class to invest in from an equity perspective, in.
Speaker 1 (24:32):
Terms of issuance of clos I mean, what's your view,
is it overdone? Do you continue the same trend you know,
what kind of risks do you potentially get from such
a big volume of issuance.
Speaker 3 (24:43):
So of course, the theoretical risk is that we've missed
priced risk and then there is going to be an
issue with losses and ultimately performance for those vintages, which
is why I think it's really important for investors to
be very thoughtful around vintage selection and sourcing the right opportunities.
You know, this year is looking like a very strong year.
Last year, of course, was a record year for the market,
(25:07):
and it's not necessarily all bad. The challenge for our
market has been the fact that the syndicated market has
not produced as many new entrants as as one would
expect to see given given the volume of CILO issues.
But there are other dynamics in the market, for example
redemptions and refinancings and the extension of reinvestment runway that
(25:27):
is allowing for recycling of existing secondary supply. So I
don't think we're at a at a at a danger
point at this stage. But on the margin, you know,
not all transactions will be successful because it does require
a lot of discipline to to have the right mix
of components to get the right return. Profile for the risk.
Speaker 1 (25:45):
But do you think the issuance just keeps expanding and
hitting new records each year? From here, we.
Speaker 3 (25:49):
Probably have not seen seen the record volumes yet. If
we know our market, our market always surprises us to
the upside. I don't think that's a near term development though,
given all the all the risks that we have building
on the horizon. So I think we hover around these
record levels uh and wait for another stabilization in the
world for for real acceleration.
Speaker 1 (26:11):
We're also at a point in time when you know
there's there's a lot of pressure on the FED to ease,
you know, certainly from the from the government in the US.
So rates you know, at some point should should come down.
I mean, depending on your view of inflation and and
and how things pan out. But for a floating rate product,
does that end up hitting its appeal? I mean, how
(26:32):
do you how do you get around that with investors
who maybe want to lock in fix rate at this
point and avoid floating.
Speaker 3 (26:38):
So I think it depends on whether you're a dead
investor and a quid investor. UH. And of course there
are both positive and negative impact of lower rates. Our
view happens to be that declining rates but not going
back to the serup policies or interest rate policies is
a net net positive for the for the syndicated and
high bond markets, and it's sort of a a very
(27:00):
good environment for companies. While of course rates declining from
four and a half to three and a half or
three percent wherever we end up does reduce your yield,
it is not positive from a credit perspective, so we
should see improvement and credit fundamentals, and so it's all
about that the interplay between those those two forces. And
as I said, our view is that it's not going
(27:22):
to be incredibly problematic from from a demand perspective. Of
course we will see rotation as we always do, particularly
from retail buyers, and that could be an opportunity for
the CLO market.
Speaker 1 (27:32):
As we mentioned at the beginning, there is sort of
a sense of maybe diversification geographically building you know, this
whole idea of American exceptionalism being tested, and you have
offices in London, you look at, you know, the market globally.
I'm wondering where you see the relative value between Europe
and the US right now.
Speaker 3 (27:51):
So for many many years we've looked at the European
market and have very firmly decided that the best opportunity
was in the US for a lot of reasons, better liquidity,
more volatility, more diversity, UH and a better ability to
manage risk. But given the recent development compression of earnings
growth and GDP growth between the two markets, Europe is
(28:13):
for the first time in many years more firmly on
our on our radar. We have not made any new
European investments to date, but we're looking at that market
much more closely than we have been in many, many years.
Speaker 1 (28:24):
But it's an issue of scale as it I mean,
just not big enough.
Speaker 3 (28:28):
It's an issue of scale, diversity, complexity. Of course, it's
not one market many bankruptcy jurisdictions. It's it's a It's
a more challenging market to maneuver in many ways. But
of course the trade off is that it's potentially more
stable and that could be a nice dallas to h
to the volatility in the US.
Speaker 1 (28:44):
And is there a better return in Europe right now
in even the smaller scale.
Speaker 3 (28:48):
Not yet in our assessment, but again, differential is getting smaller,
and of course there's other dynamics from an equity perspective,
including the availability of capital across the two markets, where
those differences may you know, lead us to invest in Europe.
Speaker 1 (29:02):
And in terms of investors coming in to the market,
I mean, what's the app site right now of foreign
investors in U S CLOS?
Speaker 3 (29:09):
Would you say, I would say that it's remained relatively stable.
We see pockets of new investors learning about the assa class,
particularly as assa classes like private equity face a lot
of headwinds, where col equity hits similar return targets, doesn't
have the J curve, has higher cash flows and is
potentially more resilient. These are marginal changes. We haven't seen
(29:32):
kind of whole sale lack of interest or you know,
doubling or tripling of interest. So these are marginal changes
that I guess every asset manager's experiences in slightly different ways.
Speaker 1 (29:43):
The new investors that you're seeing, what kind of questions
are they asking about CLOS because there still seems to
be you know, lack of understanding really about the product.
I mean, even though you know it's been going for
a long time and it has done well even through downturns,
as you mentioned, even through two thousand and eight, you
know what sort of questions are they putting to you.
Speaker 3 (30:00):
I think that we always lead with explaining to them
that it's worth to understand the asset class because that
complexity premium, once you get through it can be monetized
for a very long time. But the biggest I would
say source of misunderstanding or source of questions is understanding
the idea of leveraging leverage loans and explaining the power
and the value of the very unique financing structure of CLOS.
(30:24):
Ten X leverage can be a very high number objectively
if you don't understand that it's not mark to market,
that it's locked in, that it's match funded, all those
features that are very very important to giving CLOS and
COL equity the resilience that it's.
Speaker 2 (30:37):
Had, and deg what's the composition of your investor pool
and what makes COLO equity attractive to a non US investor.
Speaker 3 (30:47):
So our investor base is fairly diversified geographically, about fifty
to fifty mix between the US and Europe. We do
have some other geographiesy in the mechs as well, but
as a smaller percentage and a fairly wide range of investors,
you know, ranging from high net worth all the way
up to pensions and insurance companies. Typically non US investors
(31:09):
are looking to get US exposure, and clos and col
equity specifically allow investors outside of the US to get
access to corporate America in a very diversified, efficient fashion.
So it's it's investors looking to have exposure to credit
data in the US in a way that isolates credit
default risk without you know, exposing you to other types
(31:31):
of risk like interest rates, et cetera.
Speaker 1 (31:33):
One other aspects of the complexity premium. As you mentioned it,
there is this kind of misunderstanding of what these things
are and then you should get paid more because they're complicated,
although you know, you could argue that they're not that complicated really,
but they are also often in the in the lens
of regulators and you know, government entities, and you know,
(31:54):
for this reason, and you know, people sort of worry
about what they don't really understand. But do you expect
more headwinds from regulators as this kind of you know,
product get gets pushed more broadly to investors.
Speaker 3 (32:05):
I don't think so. Of course, we are seeing an expansion,
as we mentioned earlier, of the product into the retail space,
where I do think it's appropriate for regulators to ensure
that those investors understand what they are potentially getting exposed to.
But in general, the ASCA class, of course, has been
regulated and owned by a very wide variety of investors
(32:26):
across the world, and is generally very well understood by
by regulators and market participants.
Speaker 1 (32:32):
And is it true to say I mean this has
been this has been mentioned a few times that the
equity trund or equity in clos actually performed okay through
the finished crisis.
Speaker 3 (32:45):
It performed better than okay, performed outstandingly well. So that
set of vintages generated close to a nineteen twenty percent
i r R, which is one of the best vintages historically.
There were very unique reasons for them at including financing
at so for libor plus forty five basis points, which
(33:05):
we will not likely have again. But the power of
volatility and a locked in liability structure really shown through
in that in that environment. So if you invest appropriately,
prudently and have the right managers, going through volatility is
actually an incredibly valuable exercise for COLO equity, and it's
quite paradoxical for many For many folks looking at the
(33:27):
asset class for the first time.
Speaker 1 (33:29):
Twenty percent. That was through what like two thousand and six,
two thousand and eight or nine.
Speaker 3 (33:33):
What was the period, so pre crisis vintages, Yes, two
thousand and five to two thousand and seven roughly.
Speaker 1 (33:39):
Yeah, okay, and then what about COVID.
Speaker 3 (33:42):
COVID also actually had some very very good vintages, So
twenty twenty is an outstanding vintage. The reason for that
was that although liabilities were quite wide at that time,
investors were able to source assets at very cheap prices
uh and then see a very rapid price recovery. So
they monetized five to six points of discount timesten leverage,
(34:05):
which of course gets you a very very nice return
on an annualized basis.
Speaker 1 (34:09):
What do you expect for this year?
Speaker 3 (34:11):
We expect this year to be more of a vanilla
investment here in the sense that we are really putting
transactions on at the moment in the new issue market
for the value of the cheap liabilities. We are once
again close to twenty eighteen tights from an overall cost
of funding perspective, and so the value that you are
locking in as an equitin investor is the cheapness of
(34:31):
that financing structure, and very good opportunity, as I noted earlier,
to monetize short term periods of volatility, which seems to
have been a very common theme this year.
Speaker 1 (34:43):
So, Vanilla, what does that mean? Ten percent? Fifteen? What's
the number the teen?
Speaker 3 (34:48):
So anywhere from? You know, thirteen and a half fifteen percent?
Speaker 1 (34:52):
Okay, still not bad.
Speaker 3 (34:54):
Very very good relative to the risk and dag.
Speaker 2 (34:58):
You know, AI is making its presence felt in the
financial world. You know, I can't even count how many
times we hear it. To hear that word today over
here at Bloomberg, you know, do you use it in
any of your investment processes? And have any of your
managers embraced AI in their investment process?
Speaker 3 (35:16):
We certainly do, and it's been a very very important
part of the evolution of our systems and has made
us very very efficient. One of the things that we've
seen over the lifespan of our investment strategy is of course,
an expansion of data availability, which is power when you're
making investments, and for us, we focused a lot of
(35:39):
the systems development on ensuring that we're using data that
others may have available in a more efficient and more
unique way, and also that we're sourcing other data that
others may not be looking at in a way that
powers us to be more effective in making investment decisions.
So we think that it's a really important tool we do.
You know that some of our managers are also increasingly
(36:01):
relying on it, And even if it's something simple like
making routine operational processes more efficient, improving risk management over time,
we think that those will be very powerful additions to
the toolbox.
Speaker 1 (36:14):
Our listeners will know that at this point of the show.
I always I always like to ask, what is your edge?
How do you differentiate yourself? What are you doing that's
different to the rest.
Speaker 3 (36:24):
I think that our edge, of course, is our expertise
and length of understanding what this market looks like, knowing
managers and knowing market participants very well. But equally importantly,
it is our humbleness and discipline and our desire to
focus always on maximizing returns rather than any other objective.
(36:47):
And that is something that we think is really important,
particularly a time like we're in today, where risk premium
are compressed and investment decision making is a lot more
challenging than it is during a dislocation.
Speaker 1 (36:58):
Do you need to grow in the age of like
trillion dollar multi trillion dollar managers? Do you think that
the tetrigon needs to gain more scale?
Speaker 3 (37:06):
Look, a little bit more scale is always is always
desirable and helpful, But of course you don't want to
get so large that the opportunity set is not appropriate
for the capital that you have. So we really think
that being capacity constrained and having the right amount of
capital for the opportunity set is important. A lot of
capital has been raised in the space by as the
(37:27):
managers themselves, you're so called captive funds, and so that has,
in my view at least eroded a little bit of
the discipline that should be in place for scale of equity.
And so we think that you know, being nimble and
the right size and potentially a little bit smaller than
you would ordinarily think is not a bad is not
a bad position to be in.
Speaker 1 (37:49):
Is there one big credit opportunity out there? You think
people are missing one big thing that you know, you
think is the best relative value right now?
Speaker 3 (37:56):
I don't. I don't necessarily think that folks are missing
the opportunity and scale equity, but I would highlight that
as a continued opportunity. Of course, potentially a biased view
given my dedication to the asset class, but it is
an asset class that's delivered some very powerful things in
a single asset category. So again it's teams returns, high
current cash flows, and diversification because the asset class, through
(38:18):
its cash flow generation, actually exhibits very low correlation with
other things that you would have in a multi asset portfolio,
and I think relatively risk profile today you would need
to really take some esoteric credit risks and counter party
risks to generate those returns. And here we are in
Vanilla Corporate America just using a little bit of leverage
in financial engineering to generate those returns. So we think,
(38:40):
I think that it's a really compelling opportunity and it
makes sense to add to a portfolio.
Speaker 1 (38:45):
It's interesting to know, also, Vanilla America, these loans are
basically to companies that people kind of know that household names, right,
they're not obscure, you know, private equity shells that are
paying dividends that they're actually you know, companies you can
see out on the high street exactly.
Speaker 3 (39:00):
So it's American airlines and other businesses that you use
and know. So it's getting access to what drives growth
in the US and finances that growth, which ultimately has
been a core part of the successive of the US,
getting that efficiency of capital markets.
Speaker 1 (39:16):
But as a credit veteran, you must be worried about something.
I mean, we worry about stuff all the time. What
keeps you up at night? Dog worrying about the outlook.
Speaker 3 (39:23):
It's my job to worry all the time, although you
know glass half full, I guess as an equity investor
in credit, I worry about ultimately the loss performance of
the ATHA class given the amount of capital that's flashing
around in the system, and potentially the erosion of discipline.
I also worry about where the economy is heading. We've
(39:43):
had We've been waiting for a recesion in the US
for many years now, and it certainly will come at
some point. So spending a lot of time thinking about
how we position for that, you know, making sure that
we're building portfolios that are resilient and diversified enough to
withstand that downturn eventually, which create opportunity.
Speaker 1 (40:01):
Great stuff. Dag Michael Chuck Cocio at Tetragon Credit Partners,
thank you for being on the Credit Edge.
Speaker 3 (40:08):
Thank you, pleasure chatting with you, and.
Speaker 1 (40:10):
Of course very grateful to Mike Campalone from Bloomberg Intelligence.
Speaker 2 (40:13):
Cheers Mike, Thanks James, Thanks Dag.
Speaker 1 (40:15):
For more credit market analysis and insight, read all of
Mike's great work on the Bloomberg Terminal. Bloomberg Intelligence is
part of our research department, with five hundred analysts and
strategists working across all markets. Courage includes over two thousand
equities and credits pus outlooks on more than ninety industries
and one hundred market indices, currencies and commodities. Please do
subscribe to The Credit Edge wherever you get your podcasts.
(40:36):
We're on Apple, Spotify and all other good podcast providers,
including the Bloomberg Terminal at b pod Go. Give us
a review, tell your friends, or email me directly at
jcrombieight at Bloomberg dot net. I'm James Crombie. It's been
a pleasure having you join us again next week on
the Credit Edge.
Host
James Crombie
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