December 6, 2024 • 37 mins
Shiloh Bates talks to the Bank of Montreal's Head of CLO Trading, Bilal Nasir. In this episode, Bilal uses the term "risk profiles" to describe the different characteristics of various CLO investment opportunities. If you've ever wondered about the ins and outs of CLO trading, this is the episode for you.
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(00:05):
Hi, I'm Shiloh Bates and welcometo the CLO Investor podcast.
CLO stands for collateralizedloan obligations,
which are securities backedby pools of leveraged loans.
In this podcast,
we discuss current news and the CLOindustry and I interview key market
players. Today I'mspeaking with Bilal Nasir,
(00:28):
Bank of Montreal's Head of CLO Trading.
When I first beganinvesting in CLO Securities,
I found my conversations with CLOtraders to be extremely helpful.
That's because I'm both aclient of CLO trading firms,
but also CLO securitiesare relatively illiquid,
and so CLO traders are, like me,
(00:52):
buying securities they expectto appreciate in value.
(Though likely they will trade thesecurity away before holding it too long.)
During the podcast,
Baal uses the term "risk profiles" asa fancy way to describe the different
characteristics of variousCLO investment opportunities.
(01:12):
If you are enjoying the podcast, pleaseremember to share, like, and follow.
And now my conversation with Bilal Nasir.
Bilal, welcome to thepodcast. Thanks for coming on.
Hi Shiloh. Thank you so much forhaving me and it's a real pleasure.
(01:32):
Just at the start,
I would like to note that the viewsexpressed here are of my own and not
necessarily of my employer.
Got it.
So why don't we start off by you tellingour listeners a little bit about your
background and how youbecame a CLO trader.
Absolutely.
So I started working on Wall Streetright out of grad school here in New York
(01:52):
and I found myself to be joining a bankright smack in the middle of the great
financial crisis. So in September of 2008,
I started working within an equityquant group at Lehman Brothers.
That lasted for a few months and thenthe group got disbanded and then I
moved into the credit worldwithin Barclays. As you know,
Barclays bought Lehman, and I was doinganalytics on credit default swaps.
(02:17):
In a couple of years from there,I joined BNP Paribas doing, again,
mostly quant related stuff.
I was working very closely with thestructured credit trading desk and in 2012
is when my CLO career really started,
joined the desk from there onand I was working at BNP till
2019 as a senior trader.
(02:38):
Late 2019 I joined Deutsche Bank torun the CLO trading effort there and
I was there till, callit the summer of 2022,
and then joined BMO thereafter.So Bank of Montreal at BMO,
I oversee the CLO trading effort.
I trade both US and European CLO markets.
We are an active participant in themarket, up and down the cap stack,
(03:00):
but specifically focusat the top of the stack,
AAAs and then deep mezz and equity.
Also trade some niche sectors likemiddle market and recurring revenue ABS.
Was CLO an asset class that you targetedat one point or was it just something
that fell in your lap and you ran with it?
So I was working within thestructured credit world.
(03:22):
I was getting a lot of exposureto bespoke tranches and this
was the next big push that, BNP Paribas,
the desk there wanted to get involved in,
in terms of the primaryissuance and secondary trading.
So in a way it was something that cameup as an opportunity and I got excited
about it. I wanted to join the tradingdesk in general after years of being
(03:46):
as a quant. So it fell in my lap,
but also it was an opportunity that Isaw and it looked like I was joining a
very interesting product space.
Great. So Bilal, how areCLO securities traded?
So yeah, once a deal is beingbrought into the primary market,
I would say a parallel to that world isthe IPO stage of a stock or a company
(04:08):
stock offering. So once thedeal prices, or it closes,
the CLO tranches are free to tradein the secondary market. Investors,
generally,
they're looking to buy a certaintranche of a deal in secondary market or
they're looking to sell atranche in the secondary market.
So they'll access liquidity and theywould be looking to sell or trade their
positions either outright andthat would be a broker dealer like
(04:32):
myself or BMO Capital Markets.
We make markets in the product and theywould come to us and sell the security
outright or a broker dealerwould facilitate bringing two parties together like
a buyer and seller. Typically,as I was mentioning earlier,
right when the deal prices, we don'treally see tranches trading off the break.
(04:52):
One reason for that is it takes a lotof effort to get allocations in the
primary market, as you very well know.
It takes some time and these assetsare very attractive and interesting for
investors. So that's one notable fun fact.
But is it also, though,
that right when the CLO formsafter pricing and then maybe
closing just that the deal doesn'thave all of its assets yet.
(05:14):
So it might have a hypotheticalportfolio where 90% of the assets are
identified, but there'ssome remaining to buy.
So isn't it also that the CLOisn't fully ramped at closing?
That is a reason that there's not aton of trading right out of the gate in
these securities.
So that's true, but we werein a market say 2017, 2018,
(05:35):
where there was just so much demandfor paper where we did see some
trading very shortly after pricing.But typically, to your point,
there's a element of thedeal hasn't fully ramped,
but also there's a longersettle date as well.
So typically right out the gateswhen the tranche has priced,
there's a T plus 30 settledate dynamic as well.
(05:57):
So you don't really see tranchestrading right off the break.
Okay. So the reason for that delayedsettle, though, is that for example,
if I buy a stock through myE-Trade account, it closes, it settles the next day,
but there's this delayedsettle in the primary,
the T plus 20 or 30 that you mentioned,
and that really just gives the CLO sometime to continue to ramp its assets,
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so it might not be fully invested.
So the delayed settle gives the CLO time,
the debt securities are spoken for,
but everybody knows theCLO is going to form,
but it gives you an extra month of freetime to ramp up and get the assets you
need into the CLO before the debtstarts accruing its interest cost.
Correct. And then moving rightalong, I think each tranche,
(06:41):
the way it's identified,it has a CUSIP or an ISIN.
Note a CUSIP or ISIN is similarto a social security number
for a person.
Typically we see a lot of USinvestors buy the 144-A version of
tranches and overseas or Europeaninvestors, they would look to buy Reg-S.
(07:02):
So the 144-A means it'sa private offering not
registered with the SEC, basically.
Yes.
And then once we are talking about anormal CLO trache that is past 30 days
of its issuance,
these tranches typically trade T plustwo or T plus one as it's now cash
(07:22):
settled,
but that has evolved from T plus threeto T plus two to T plus one in certain
instances.
And the T there is just the trade date.
So t plus one means if we do a trade onone business day, it settles the next.
Correct.
And then one unique thing in terms oftrading when it comes to CLO equity
is buyers and sellers typically agreeon who collects the upcoming payments.
(07:45):
So that's part of the tradeconfirmation dynamic or protocol.
So as you know, for me, I'm primarilyfocused on CLO equity and CLO BB.
So one option for me is just to buy thesesecurities in the primary when the CLO
is being created, which we do.And then in the secondary market,
my options are for buying or selling.
I could just reach out to you or anothertrader directly and offer to sell
(08:10):
or buy a position,
or I could use an auction processknown as biz wanted in competition.
Why don't you walk our listeners throughhow the auction process for CLOs work?
So investors like yourself will typicallymaintain some distribution of all the
relevant broker dealer desks in themarket, and typically we would receive,
or secondary desks receive,
(08:31):
an email blast saying we're lookingto sell a portfolio of positions,
debt or equity. Theheads-up there, generally,
is a day in advance and at timeswe see the same day list with
CUSIPs or ISINs or bonds there.
Generally that happens when there'stranches that trade a lot more frequently,
like triple A through double B,
(08:52):
and then it's a normal market environmentand a lot of people are familiar,
they don't have to do a lot of work there.
There's a specified time of the process.Let's say it's 10:00 AM Eastern.
The desk will send in bids and there'sa cutoff period or a grace period until
which bids are accepted.So it could be 30 minutes,
maybe an hour into the process.And then once bids are submitted,
(09:13):
they have to be good for a specifiedtime. So typically it's around two hours,
and then the process takes on from therein terms of who gets notified if you're
going to get maybe another round offeedback or not until the results are
announced.
What I've seen for BBs and equity is thatthere's really two types of processes.
So one is a best foot forward,
(09:35):
and basically that means I'mselling a piece of equity,
I reached out to all the investmentbanks that trade in it and I say, okay,
I'm selling this piece of aCLO, this tranche if you will,
I'm going to sell it tomorrow at noonor at least take bids for it and in the
best foot forward process, I'm goingto just sell to the highest bidder.
There's not going to be multiple roundsof bidding, so that's best foot forward.
(09:58):
And then another way to do it,which I think is also common,
is to have a top three process. Andusually how that works is that of,
say, 10 or so bids,
or potential bids that youget all at the top three,
know that they're in the topthree and they can all bid again.
And then the idea there is thatwhoever finished first in the top
(10:19):
three,
that person really can't improve uponthemselves so they can increase their bid,
but if it turns out at the end itwasn't necessary for them to do so,
then they're able to buyit using their old bid.
Are those the two most commonprocesses that you see?
So as you know, these aretypically the most common.
I think one thing to note around thebest foot process is just a much cleaner,
(10:43):
a much more transparent process.
It's usually the protocol or thego-to process that we see on upper
IG tranches. So AAA, AA, single A,
there's really no feedback given.
It's like lead with your best and theresults are notified within a couple of
hours. I think on the top three process,yes. So there's this round of feedback,
(11:04):
there is a variation that folks use whichis a strict top three versus a light
or a soft top three process.
So sometimes the risk profilescan have very divergent interests.
So there is an element of givinga round of feedback as to maybe
if investors are keen to buy a certainrisk profile that they can sharpen up.
We see that happen quite a bit.
(11:27):
And then it is interesting to notethat at times the BWIC process can be a
little frustrating because youmay or may not have bonds awarded.
There's a certain reserve level thatinvestors have in place and what that
really means is that,as I mentioned earlier,
these securities are very attractiveand interesting and sometimes there's
internal valuation in terms of what wouldit take to sell the security and also
(11:51):
replace it. If you were to think aboutthat and do the levels that you see,
or the execution levels that yousee, are they in line with that?
So I think if we wereworking on PhDs in economics,
it's a very common dissertationtheme to have a thesis
on auction theory and what getsthe highest proceeds to the seller.
(12:13):
Is it your view that the top threeprocess is the process that's best for the
seller and maybe also for the buyerbecause they get some incremental
information during the process?
I think it can be an effectiveway to get interest, but at times,
what we see in the market,
sometimes there's some unique riskprofiles that are put out for sale,
(12:34):
could be some more storied names,
or something that requires a littlemore analytical understanding.
Could be CLO equity.
If you access liquidity via a BWICprocess where everybody broadly
bids at times theinterest may not be there.
So it is not the most efficient way toget the best liquidity and at times a
(12:54):
trade by appointment or what do wecall out of comp can also be effective.
So let's come back to the outof competition sale in a second.
So how we've done BWICs at FlatRock, really my whole career,
how I've thought about it is I'vejust done a best foot forward process.
So I just take bids,there's no color given,
and we sell it to thehighest bidder or not.
(13:16):
So what I've seen from that is just thatit creates I think more variability in
the bids you get.
So some bids will be poor and you don'tneed them and that's fine and then other
people will really step up.
But what I've seen is that the best footforward process creates what I would
call big covers. And whatthat means is after the BWIC,
usually some market color on thetrade is put out to the market,
(13:39):
and nobody tells you where thetrade occurred at what level,
but they'll often tell you the coverbid, which is the second highest bid.
So you get some information there.
And what I think is that the bestfoot forward process results in a
variability of bids and usually a cover.
The highest bid is usually pretty good,and then you can discard the rest.
(14:01):
Whereas in the best foot forwardprocess, I think a lot of times,
the bids just coalesce around one level,and it may not be the optimal level.
I would say if you're BWIC-ing a securityand you actually definitely need to
sell it, then the top three processwould probably be the way to go. If it's,
hey, I'm BWIC-ing a few positions andI want to sell one or two of them and
(14:23):
maybe not all dependingon where bids come in,
then I think that's when I woulduse a best foot forward process.
The best foot forward process, if,when the market is very well defined,
I think it can be a very transparentprocess. Typically higher up the stack,
you don't see a lot of divergence,
so people tend to use for let's say AAA,
(14:44):
AA or single A securitiesa lot of best foot forward,
there's a functionality that is availablein Bloomberg where people put out
these lists and it's maybeautomated, you take the top bid,
and then there's the second bestbid, and they both get notified.
But I think the top three process canoffer some feedback and, at times,
folks don't really want to start verystrong and they want to see if their bid
(15:06):
is contextual and it gives theman opportunity to then sharpen up.
I think one other challenge withthe top three process, though,
is let's say I'm auctioning a fewsecurities and I say bids are due at noon.
Well basically no bids come inat noon, they all come in late,
at different times. It's kind of ajoke. So you're never really sure, okay,
is 12:45, then,
(15:28):
is that the cut whereI define the top three?
And then what happens if five minuteslater somebody else comes in with a good
bid and now they're in the top three?
I think it becomes quite atricky process to manage fairly.
Totally understand and I agree, of late,
I think the frustration thatcomes along with the BWIC process,
it can take a lot of time and attimes bonds don't end up trading.
(15:51):
So that adds to the complexity of theprocess and I think there's no real ideal
way, but it just depends how the processor what process you want to manage.
Over time, I think the processhas become a lot smoother,
whether it's the best foot forwardor top three. As the space has grown,
people have just gotten an understandingof what and how things work and it's,
I think from an investor perspective,
(16:13):
when you are looking toaccess liquidity for sure,
it's much easier process to manageon a best foot forward basis.
Sometimes you actually get good executionas well because there's just no back
and forth and games. There'sno game theory involved.
That's right. And then the resultof the BWIC process, though,
in your experience, lotsof bonds just don't trade.
(16:34):
So whatever the best bid was,didn't work for the seller,
and people did a bunch of work,and have nothing to show for it.
So how often does that happen?
I think it definitely happensmore frequently when it comes to the mezzanine and
equity tranches and especially whenthe market gets very dislocated,
it's often used as a tool to maybe sharesome color and some price discovery
(16:57):
data points for everyone to see.
This is where the bidscame in for this profile.
I do think that to my earlier point,
some of these risk profilesare just very attractive.
So folks are just unwilling to let goassets cheaply if the bid is not very
strong.
So that's another undercurrent thatwe see in the market through the BWIC
(17:18):
process that people will just tryto use that color to maybe then go
find bonds in the context of the bids.So there's a little back and forth there.
So then instead of usingthis BWIC auction process,
another option I have for buyingsecurities, or selling them,
is just work directlywith a trader like you.
(17:39):
So what's the advantage ordisadvantage of just doing it that way?
So I think the process is much easier.
I think if you go to or if you work witha desk that specializes in certain of
bonds they will have access to orthey'll be in touch with other investors
that own those securities so they canreally just make the process a lot
simpler. There's only twoparties involved, really,
(18:01):
it's the buyer and the seller.
And then also I think we've seenjust the execution level be a lot,
I would say stronger or in marketcontext. It's not theoretical or academic,
it's the real market when you have abuyer looking for a specific profile and a
seller looking to sell that specificprofile. So it's much cleaner,
it's much efficient. A lotof bonds do trade that way,
(18:24):
what we call by appointment,
because folks really don't wantto put them on BWICs and get the
desks that may or may not be involvedin trading that profile to be sending in
bids that are out of context.
In the BWIC process for sure, when youget bids for something you're selling,
I would describe it asI get two kinds of bids.
So one is a bid from someone like youwhere there's an end customer who wants
(18:47):
the bond and they have bid it accordingly.
The other bid that I would get wouldbe something I think from a trader or a
trading desk where there is no endclient that wants the bond and so
that's, we'll call it a back bid,
or it's at a level where the tradingdesk is comfortable owning the bond and
they'll find an investor to take itlater. That's the strategy there.
(19:08):
So you get this tiering of bids inthe BWIC and then what I think is
translating that or bringingit back to trading out of comp,
it seems like a lot of times dealersare getting hit on their back bids in
auctions for one reason or another andthen they take that bond into inventory
and maybe sit on it for a while, tradeit away to another investor at a gain.
(19:31):
Is that how you see your businessmodel or are you actually pairing
buyers and sellers more frequently whereyou're not actually holding a ton of
bonds in inventory or howdoes your business model work?
So I think the business model on ourside is much more we're trying to make
markets and looking for real demandand we like to trade as opposed
(19:52):
to build a lot of inventory. So Ithink it's mostly market making,
bringing buyers and sellers together,
and I think we're just a desk that iscomfortable bidding a lot of interesting
profiles. So that's maybe up thestack or deep mezz and equity.
So we do talk to a lot of investorsthat find that part of the cap stack
interesting.
(20:13):
Hence we have a lot of fires and sellersthat we're in touch with rather than
just holding securities for a long timeand sitting on that and taking them down
for both.
We have certainly the capability toprovide liquidity to our end clients
whenever it's needed. At times youmay not find a buyer that same day,
but certainly we like to turn thebook over and bring buyers and sellers
(20:34):
together and like to trade morefrequently than other desks.
So it sounds like you can investand trade up and down the stack.
Are there any securities outthere today, issued by CLOs,
that you find particularly compelling?
It's hard to get overly excited about themarket given we're sitting on CLO debt
spreads and yields are,
and the broader credit markets sittingat all time tights, maybe even off 2021.
(20:57):
But I do think therisk-reward that you get,
if you invest in some BSL profiles,
like maybe some BSL AAA or middlemarket AAAs are interesting.
And then down in mezz, some juniortriple Bs I think are interesting.
Some mezz profiles like in double B,single B, offer attractive yields,
and I do also trade Europe. So I thinkthere's some interesting risk profiles,
(21:20):
maybe doubles lookattractive right now. Lastly,
I do think that CLO equity is gettingmore and more attractive given the
liabilities are at their tightsand the arbs improve quite a bit.
So CLO equity is certainlygoing to be very relevant.
The arb is the naturalprofitability of the CLO?
Correct.
(21:40):
I think the payments on CLO equity arelooking a lot better and we're seeing a
lot of interest and I do see a lot ofinterest for that part of the cap stack as
we go into the new year as well.
Do you think equity will look all themore attractive in an environment where
rates are coming down?
So I think it will because we're goinginto a benign credit environment,
(22:02):
we're looking to see,
I think it's the expectation thatM and A activity will pick up,
so there'll be more opportunitiesto buy more loans for CLO managers,
sort of like the workhorseof this little complex.
So one of the trades that we've I thinkpartnered with together on was just the,
I don't want to use the word distressed,
but the dinged up double B tradewhere maybe if you liquidated the CLO,
(22:26):
theoretically, when we bought thedouble B, you would've been underwater,
you couldn't have liquidated all theloans and gotten back a hundred cents on
the double B. How do you get comfortableowning securities where for example,
the double B is often the junior-mostdebt tranche and the loan portfolio has
seen a pickup in loan defaults.
How do you get comfortable owningsecurities with that profile?
(22:48):
I think there's a coupleof things to mention there.
Obviously you have to do a lot of analysisof what the underlying risk to the
double B is, what are the underlyingloans that it is most sensitive to?
But I think the other dynamic isthe structure of what is at play.
So these deals, as you know,
they're a lot more seasoned and they'reeither very close to reinvestment period
(23:10):
or out of reinvestment period.
So there's an element of what happensto these deals if there's scheduled
principal payments that comethrough and how is the CLO manager,
what liberty do they haveto reinvest into the deal?
So in that trade you bought a CLOdouble B at a discount to par,
and you're hoping that the managerisn't going to buy more loans with the
(23:31):
proceeds that come back as loansprepay. You want the CLO to delever,
that's the better outcomefor the BB in that case.
So effectively you would hopethat the deal becomes static,
but then you really have to getcomfortable with the underlying credit.
The deal that we're talking about is moreseasoned, there's a lot of tail risks,
so is really the race against the time,
(23:51):
which is does the bond delever fasterthan the tail can get further stressed?
So I think there's that undercurrent.
So the tail being the worst performingloans that still remain in the CLO at
that point?
Correct.
And what's different about this tradeversus when you buy maybe a double B that
is from a relatively newer dealis it's still going to take
(24:15):
some time for the credit selectionto play out in different years,
but here the investor is buying and hasa pretty good sense of what the outcome
could look like, so it's adifferentiated risk profile.
And then if the deal deleversfaster than what is expected,
then you could have yourdebt, especially double B,
deep down mezz to be called andthere's a natural pull to par.
(24:39):
So yeah,
those are things to think about in thattrade and for deals that they still have
some runway in terms of theirreinvestment period. Again,
I think the contrast there is you havesome clarity as to what makes up the
portfolio of the deal versus maybe a newerdeal that hasn't really seen stresses
that come along maybe a year like Covidor 2022 and those stresses just play out
(25:01):
in your portfolio.
The way I think about the distresseddouble B trade is that an option you have
if you sit in my seat isto buy, say primary equity,
and in that for a new cleanportfolio with a great manager,
you might run a case where 2% of theloans default each year and you're
targeting returns of mid-teens.So that's one option for you.
(25:22):
The other option has been,
and this really isn't a trade we see alot of today because the market's rallied
so much, but through 2023, a lotof times, instead of buying equity,
you could buy a discounted double B andit's going to be a dinged up portfolio
and that's why it tradesat discount obviously.
But in those cases you might run a5% default rate and conclude that
(25:43):
you're still money goodthrough the double B,
and you might be able to get returnsthat are comparable to equity, or,
in some cases, better than equity.Again modeled at a 2% default rate.
So the double B comps really well toequity in markets where there's some
stress, which again Iwouldn't define as today.
(26:07):
Look,
I absolutely agree and Ithink what happens in the CLO market is it's not a very
continuous market in the sense that ifyou want to go buy a certain asset class
rating in the secondary market, sayyou wanted to go buy CLO equity,
it takes some time and effortto really find the profile.
So a lot of CLO equity buyers werelooking to pick up CLO equity in
(26:27):
late 2022, early 2023, but there wasjust not much available for sale.
We did see some of these dinged updouble Bs come up for sale, and,
to your point,
they were trading at levels thatcould match equity-level returns.
So I think that drew alot of interest in them,
plus the point about thedefault rate, you're right,
what we've seen even inGFC or in Covid and even
(26:51):
now is just vector shocks in termsof default rate spikes as opposed
to very high cumulative defaultrate till the end of the deals' life
cycles.
I think that's why some of these tradesare interesting because these BBs,
they're money good, they maynot see any kind of impairment.
So of the CLO universe out there,
(27:12):
there's maybe a hundred plus broadlysyndicated managers who are active
and 20 or so middle market managers.
Do you see a lot of trading activity inthe managers that are less well known,
managers that are maybe competent butstill building out their franchise,
or do you stick to trades with someof the biggest CLO managers out there?
(27:32):
We definitely look at newer CLOmanagers. It's a combination,
but I think it's a growing complex.
So there's new entrants into the CLOworld and we tend to be a little more
manage- agnostic and really look atperformance and I think we see that
happening across the investors thatthey're looking for maybe newer
strategies that a managercould be undertaking.
(27:54):
We're seeing a lot of CLO PMs move fromone shop to the other and what is being
marketed is there's a change in ourinvestment strategy going forward in order
to win more investors.
And I think it certainly makes sense ifyou have a newer manager that has just
raised an equity fund and looking toissue deals, let's say three or four,
I think they would love to get moreinvestors onto their platform by
(28:17):
offering them more conservative tools.
So I think it's definitely an interestingplay and then they could offer to give
up some spread in return and makethe investment more attractive.
So we definitely see that happening andthat's a trade that I think is worth
keeping an eye on.
So we definitely traffic and I thinkwe're definitely one of the desks --
(28:37):
So wait, the newer manager trade,
basically the trade off is youown a debt security and you get a
spread premium, so you pick upsomething in terms of return,
but if you're not goingto hold it to maturity,
the liquidity of that manager issomething you need to think about?
If you were ever to wantto sell the security,
the price isn't going to be comparableto a manager that's more well known in
(29:00):
the market.
Yeah, definitely.
I think liquidity is definitelythe aspect there to keep in mind,
but it's also worth looking at,
or understanding how did the CLOmanager raise their equity fund
if they're promising some bigger returns.
So they could be looking to invest inriskier portfolios to overcompensate for
that.
But then we see investors that havemore insurance based pedigree that
(29:23):
are entering the space,certainly know of a couple.
What we've noticed is liquiditytends to improve as soon as there's
a few data points in terms of performance,
and it's also very data driven as soonas folks see the deal trading or the
tranche is trading a little betterthere a sense of an understanding that
develops this risk is tradingakin to other similar in its
(29:47):
cohort.
And then for middle marketCLOs, which is important to me,
is a little niche forus here at Flat Rock,
how do you get comfortable tradingmiddle market CLO securities where the
underlying loans don'thave a daily traded price?
So I think that's the question that isin demand and I get the most often when
I'm trading middle market CLOs.
(30:08):
I think part of it is the structure ofthe middle market CLO I think is much
stronger.
I think that comes into discussionand then the fact that these deals are
compensating you by givingyou that extra spread over.
Now it's debatable in markets likethese where you're at the tights where
whether you are gettingenough compensation in terms of spread pickup on each of
the tranches. So there's that,
(30:30):
and then there's nuances like whathappens after the reinvestment period.
So there's a lot of investors thatcare about whether they're going to get
extended or whether their investmentis going to see extension risk or not.
But there is another element to thepoint that you made earlier about maybe
taking a bet on a newer manager.
So I started trading middle marketCLOs before they were so cool,
and I think there was a benttowards going with bigger platforms
(30:54):
that can originate a lot of assets.
So the main thing to think about thereis whether that manager has access to
enough assets to swapout maybe a stress deal.
So I think that is one of thethings that people care about.
It comes up in conversations and we'veseen some investors getting to look under
the hood by signing NDAs.
(31:14):
So I think that's another way thatpeople have gotten comfortable.
Just signing a nondisclosure agreementwill give you access to some loan level
information?
From a secondary perspective.
You can also look at some keyperformance metrics of the deal.
So even though you won't have statslike MBOC or par creation to be as
relevant because there's no understandingof what that means within middle
(31:38):
market CLOs, but you could look athow the triple C buckets are doing.
You can look at whether the equityreturns are looking, how they're looking.
So there's a few things that you couldlook at to ascertain the quality.
Bilal,
is there anything else we should discussthat's topical to you or your business
today?
I think one thing that we are seeingright now within the market is just the
(32:00):
growth of the retailinterests within CLOs.
We're seeing a lot of demandfor As and triple Bs emerging,
and I think what that hasdone to the secondary market,
we're seeing a lot of resilienceeven during ballots of volatility,
we didn't really see a lot of outflowsfrom some of these CLO funds or the
(32:20):
ETFs, so I think that's verynotable. I think for our business,
we're expecting to be activein the middle market comple,
we're an active participanton the secondary side,
so I think we're an interesting space,
an interesting time where we are seeinggrowth in the CLO market and more
focus on the productinternally, externally,
(32:40):
and we're positioning ourselves to bea relevant player within both BSL and
middle market on the secondaryside and on the origination side.
Great. Well, Bilal, thanks somuch for coming on the podcast.
Really enjoyed our conversation.
Thank you very much for having me.
The content here is for informationalpurposes only and should not be taken as
(33:04):
legal, business, tax,or investment advice,
or be used to evaluate anyinvestment or security.
This podcast is not directed at anyinvestment or potential investors in any
Flat Rock Global Fund. Definition Section
AUM refers to assets under management.
LMT or liability managementtransactions are an out of
(33:26):
court modification of a company's debt.
Layering refers to placing additionaldebt with a priority above the first lien
term loan. The securedovernight financing rate, SOFR,
is a broad measure of the costof borrowing cash overnight,
collateralized by treasury securities.The global financial crisis, GFC,
was a period of extreme stress in globalfinancial markets and banking systems
(33:50):
between mid 2007 and early 2009.
Credit ratings are opinions aboutcredit risk for long-term issues or
instruments.
The ratings lie on a spectrum rangingfrom the highest credit quality on one end
to default or junk on the other. AAAA is the highest credit quality.
A C or D, depending on theagency issuing the rating,
(34:12):
is the lowest or junk quality.
Leveraged loans are corporate loans tocompanies that are not rated investment
grade. Broadly syndicated loansare underwritten by banks,
rated by nationally recognized statisticalratings organizations and often
traded by market participants.
Middle market loans are usuallyunderwritten by several lenders with the
(34:33):
intention of holding theinvestment through its maturity.
Spread is the percentage difference incurrent yields of various classes of
fixed income securities versus treasurybonds or another benchmark bond
measure. A reset is a refinancing andextension of a CLO investment period.
EBITDA is earnings before interest,taxes, depreciation, and amortization.
(34:56):
An add back would attempt to adjustEBITDA for non-recurring items.
ETFs are exchange traded funds. LIBOR,
the London Interbank offer rate,
was replaced by softwareon June 30th, 2024.
Delever means reducing theamount of debt financing.
High yield bonds are corporate borrowingsrated below investment grade that are
(35:18):
usually fixed rate and unsecured
Default refers to missing a contractualinterest or principle payment.
Debt has contractual interestprinciple and interest payments,
whereas equity representsownership in a company.
Senior secured corporateloans are borrowings from a company that are backed by
collateral.
(35:39):
Junior debt ranks behind seniorsecured debt in its payment
priority.
Collateral pool refers to the sum ofcollateral pledged to a lender to support
its repayment.
A non-call period refers to the timein which a debt instrument cannot be
optionally repaid.
A floating rate investment has an interestrate that varies with an underlying
(36:01):
floating rate index.
General Disclaimer Section
references to interest rate movesare based on Bloomberg data.
Any mentions of specific companies arefor reference purposes only and are not
meant to describe the investment meritof or potential or actual portfolio
changes related to securities of thosecompanies unless otherwise noted.
(36:24):
All discussions are based on USmarkets and US monetary and fiscal
policies.
Market forecasts and projections arebased on current market conditions
and are subject to change without notice.
Projections should not beconsidered a guarantee.
The views and opinions expressed by theFlat Rock global speaker are those of
(36:44):
the speaker as of the dateof the broadcast and do not necessarily represent the
views of the firm as a whole.
Any such views are subject to changeat any time based upon market or other
conditions,
and Flat Rock Global disclaims anyresponsibility to update such views.
This material is not intended to berelied upon as a forecast, research,
(37:05):
or investment advice. It isnot a recommendation, offer,
or solicitation to buyor sell any securities,
or to adopt any investment strategy.
Neither Flat Rock Global nor the FlatRock Global Speaker can be responsible for
any direct or incidental loss incurredby applying any of the information
offered.
None of the information provided shouldbe regarded as a suggestion to engage in
(37:30):
or refrain from any investment relatedcourse of action as neither Flat Rock
Global nor its affiliates are undertakingto provide impartial investment
advice, act as an impartial advisor,or give advice in a fiduciary capacity.
Additional information about this podcastalong with an edited transcript may be
obtained by visiting flatrockglobal.com.
Hi, I'm Shiloh Bates and welcometo the CLO Investor podcast.
CLO stands for collateralizedloan obligations,
which are securities backedby pools of leveraged loans.
In this podcast,
we discuss current news and the CLOindustry and I interview key market
players. Today I'mspeaking with Bilal Nasir,
(00:28):
Bank of Montreal's Head of CLO Trading.
When I first beganinvesting in CLO Securities,
I found my conversations with CLOtraders to be extremely helpful.
That's because I'm both aclient of CLO trading firms,
but also CLO securitiesare relatively illiquid,
and so CLO traders are, like me,
(00:52):
buying securities they expectto appreciate in value.
(Though likely they will trade thesecurity away before holding it too long.)
During the podcast,
Baal uses the term "risk profiles" asa fancy way to describe the different
characteristics of variousCLO investment opportunities.
(01:12):
If you are enjoying the podcast, pleaseremember to share, like, and follow.
And now my conversation with Bilal Nasir.
Bilal, welcome to thepodcast. Thanks for coming on.
Hi Shiloh. Thank you so much forhaving me and it's a real pleasure.
(01:32):
Just at the start,
I would like to note that the viewsexpressed here are of my own and not
necessarily of my employer.
Got it.
So why don't we start off by you tellingour listeners a little bit about your
background and how youbecame a CLO trader.
Absolutely.
So I started working on Wall Streetright out of grad school here in New York
(01:52):
and I found myself to be joining a bankright smack in the middle of the great
financial crisis. So in September of 2008,
I started working within an equityquant group at Lehman Brothers.
That lasted for a few months and thenthe group got disbanded and then I
moved into the credit worldwithin Barclays. As you know,
Barclays bought Lehman, and I was doinganalytics on credit default swaps.
(02:17):
In a couple of years from there,I joined BNP Paribas doing, again,
mostly quant related stuff.
I was working very closely with thestructured credit trading desk and in 2012
is when my CLO career really started,
joined the desk from there onand I was working at BNP till
2019 as a senior trader.
(02:38):
Late 2019 I joined Deutsche Bank torun the CLO trading effort there and
I was there till, callit the summer of 2022,
and then joined BMO thereafter.So Bank of Montreal at BMO,
I oversee the CLO trading effort.
I trade both US and European CLO markets.
We are an active participant in themarket, up and down the cap stack,
(03:00):
but specifically focusat the top of the stack,
AAAs and then deep mezz and equity.
Also trade some niche sectors likemiddle market and recurring revenue ABS.
Was CLO an asset class that you targetedat one point or was it just something
that fell in your lap and you ran with it?
So I was working within thestructured credit world.
(03:22):
I was getting a lot of exposureto bespoke tranches and this
was the next big push that, BNP Paribas,
the desk there wanted to get involved in,
in terms of the primaryissuance and secondary trading.
So in a way it was something that cameup as an opportunity and I got excited
about it. I wanted to join the tradingdesk in general after years of being
(03:46):
as a quant. So it fell in my lap,
but also it was an opportunity that Isaw and it looked like I was joining a
very interesting product space.
Great. So Bilal, how areCLO securities traded?
So yeah, once a deal is beingbrought into the primary market,
I would say a parallel to that world isthe IPO stage of a stock or a company
(04:08):
stock offering. So once thedeal prices, or it closes,
the CLO tranches are free to tradein the secondary market. Investors,
generally,
they're looking to buy a certaintranche of a deal in secondary market or
they're looking to sell atranche in the secondary market.
So they'll access liquidity and theywould be looking to sell or trade their
positions either outright andthat would be a broker dealer like
(04:32):
myself or BMO Capital Markets.
We make markets in the product and theywould come to us and sell the security
outright or a broker dealerwould facilitate bringing two parties together like
a buyer and seller. Typically,as I was mentioning earlier,
right when the deal prices, we don'treally see tranches trading off the break.
(04:52):
One reason for that is it takes a lotof effort to get allocations in the
primary market, as you very well know.
It takes some time and these assetsare very attractive and interesting for
investors. So that's one notable fun fact.
But is it also, though,
that right when the CLO formsafter pricing and then maybe
closing just that the deal doesn'thave all of its assets yet.
(05:14):
So it might have a hypotheticalportfolio where 90% of the assets are
identified, but there'ssome remaining to buy.
So isn't it also that the CLOisn't fully ramped at closing?
That is a reason that there's not aton of trading right out of the gate in
these securities.
So that's true, but we werein a market say 2017, 2018,
(05:35):
where there was just so much demandfor paper where we did see some
trading very shortly after pricing.But typically, to your point,
there's a element of thedeal hasn't fully ramped,
but also there's a longersettle date as well.
So typically right out the gateswhen the tranche has priced,
there's a T plus 30 settledate dynamic as well.
(05:57):
So you don't really see tranchestrading right off the break.
Okay. So the reason for that delayedsettle, though, is that for example,
if I buy a stock through myE-Trade account, it closes, it settles the next day,
but there's this delayedsettle in the primary,
the T plus 20 or 30 that you mentioned,
and that really just gives the CLO sometime to continue to ramp its assets,
(06:19):
so it might not be fully invested.
So the delayed settle gives the CLO time,
the debt securities are spoken for,
but everybody knows theCLO is going to form,
but it gives you an extra month of freetime to ramp up and get the assets you
need into the CLO before the debtstarts accruing its interest cost.
Correct. And then moving rightalong, I think each tranche,
(06:41):
the way it's identified,it has a CUSIP or an ISIN.
Note a CUSIP or ISIN is similarto a social security number
for a person.
Typically we see a lot of USinvestors buy the 144-A version of
tranches and overseas or Europeaninvestors, they would look to buy Reg-S.
(07:02):
So the 144-A means it'sa private offering not
registered with the SEC, basically.
Yes.
And then once we are talking about anormal CLO trache that is past 30 days
of its issuance,
these tranches typically trade T plustwo or T plus one as it's now cash
(07:22):
settled,
but that has evolved from T plus threeto T plus two to T plus one in certain
instances.
And the T there is just the trade date.
So t plus one means if we do a trade onone business day, it settles the next.
Correct.
And then one unique thing in terms oftrading when it comes to CLO equity
is buyers and sellers typically agreeon who collects the upcoming payments.
(07:45):
So that's part of the tradeconfirmation dynamic or protocol.
So as you know, for me, I'm primarilyfocused on CLO equity and CLO BB.
So one option for me is just to buy thesesecurities in the primary when the CLO
is being created, which we do.And then in the secondary market,
my options are for buying or selling.
I could just reach out to you or anothertrader directly and offer to sell
(08:10):
or buy a position,
or I could use an auction processknown as biz wanted in competition.
Why don't you walk our listeners throughhow the auction process for CLOs work?
So investors like yourself will typicallymaintain some distribution of all the
relevant broker dealer desks in themarket, and typically we would receive,
or secondary desks receive,
(08:31):
an email blast saying we're lookingto sell a portfolio of positions,
debt or equity. Theheads-up there, generally,
is a day in advance and at timeswe see the same day list with
CUSIPs or ISINs or bonds there.
Generally that happens when there'stranches that trade a lot more frequently,
like triple A through double B,
(08:52):
and then it's a normal market environmentand a lot of people are familiar,
they don't have to do a lot of work there.
There's a specified time of the process.Let's say it's 10:00 AM Eastern.
The desk will send in bids and there'sa cutoff period or a grace period until
which bids are accepted.So it could be 30 minutes,
maybe an hour into the process.And then once bids are submitted,
(09:13):
they have to be good for a specifiedtime. So typically it's around two hours,
and then the process takes on from therein terms of who gets notified if you're
going to get maybe another round offeedback or not until the results are
announced.
What I've seen for BBs and equity is thatthere's really two types of processes.
So one is a best foot forward,
(09:35):
and basically that means I'mselling a piece of equity,
I reached out to all the investmentbanks that trade in it and I say, okay,
I'm selling this piece of aCLO, this tranche if you will,
I'm going to sell it tomorrow at noonor at least take bids for it and in the
best foot forward process, I'm goingto just sell to the highest bidder.
There's not going to be multiple roundsof bidding, so that's best foot forward.
(09:58):
And then another way to do it,which I think is also common,
is to have a top three process. Andusually how that works is that of,
say, 10 or so bids,
or potential bids that youget all at the top three,
know that they're in the topthree and they can all bid again.
And then the idea there is thatwhoever finished first in the top
(10:19):
three,
that person really can't improve uponthemselves so they can increase their bid,
but if it turns out at the end itwasn't necessary for them to do so,
then they're able to buyit using their old bid.
Are those the two most commonprocesses that you see?
So as you know, these aretypically the most common.
I think one thing to note around thebest foot process is just a much cleaner,
(10:43):
a much more transparent process.
It's usually the protocol or thego-to process that we see on upper
IG tranches. So AAA, AA, single A,
there's really no feedback given.
It's like lead with your best and theresults are notified within a couple of
hours. I think on the top three process,yes. So there's this round of feedback,
(11:04):
there is a variation that folks use whichis a strict top three versus a light
or a soft top three process.
So sometimes the risk profilescan have very divergent interests.
So there is an element of givinga round of feedback as to maybe
if investors are keen to buy a certainrisk profile that they can sharpen up.
We see that happen quite a bit.
(11:27):
And then it is interesting to notethat at times the BWIC process can be a
little frustrating because youmay or may not have bonds awarded.
There's a certain reserve level thatinvestors have in place and what that
really means is that,as I mentioned earlier,
these securities are very attractiveand interesting and sometimes there's
internal valuation in terms of what wouldit take to sell the security and also
(11:51):
replace it. If you were to think aboutthat and do the levels that you see,
or the execution levels that yousee, are they in line with that?
So I think if we wereworking on PhDs in economics,
it's a very common dissertationtheme to have a thesis
on auction theory and what getsthe highest proceeds to the seller.
(12:13):
Is it your view that the top threeprocess is the process that's best for the
seller and maybe also for the buyerbecause they get some incremental
information during the process?
I think it can be an effectiveway to get interest, but at times,
what we see in the market,
sometimes there's some unique riskprofiles that are put out for sale,
(12:34):
could be some more storied names,
or something that requires a littlemore analytical understanding.
Could be CLO equity.
If you access liquidity via a BWICprocess where everybody broadly
bids at times theinterest may not be there.
So it is not the most efficient way toget the best liquidity and at times a
(12:54):
trade by appointment or what do wecall out of comp can also be effective.
So let's come back to the outof competition sale in a second.
So how we've done BWICs at FlatRock, really my whole career,
how I've thought about it is I'vejust done a best foot forward process.
So I just take bids,there's no color given,
and we sell it to thehighest bidder or not.
(13:16):
So what I've seen from that is just thatit creates I think more variability in
the bids you get.
So some bids will be poor and you don'tneed them and that's fine and then other
people will really step up.
But what I've seen is that the best footforward process creates what I would
call big covers. And whatthat means is after the BWIC,
usually some market color on thetrade is put out to the market,
(13:39):
and nobody tells you where thetrade occurred at what level,
but they'll often tell you the coverbid, which is the second highest bid.
So you get some information there.
And what I think is that the bestfoot forward process results in a
variability of bids and usually a cover.
The highest bid is usually pretty good,and then you can discard the rest.
(14:01):
Whereas in the best foot forwardprocess, I think a lot of times,
the bids just coalesce around one level,and it may not be the optimal level.
I would say if you're BWIC-ing a securityand you actually definitely need to
sell it, then the top three processwould probably be the way to go. If it's,
hey, I'm BWIC-ing a few positions andI want to sell one or two of them and
(14:23):
maybe not all dependingon where bids come in,
then I think that's when I woulduse a best foot forward process.
The best foot forward process, if,when the market is very well defined,
I think it can be a very transparentprocess. Typically higher up the stack,
you don't see a lot of divergence,
so people tend to use for let's say AAA,
(14:44):
AA or single A securitiesa lot of best foot forward,
there's a functionality that is availablein Bloomberg where people put out
these lists and it's maybeautomated, you take the top bid,
and then there's the second bestbid, and they both get notified.
But I think the top three process canoffer some feedback and, at times,
folks don't really want to start verystrong and they want to see if their bid
(15:06):
is contextual and it gives theman opportunity to then sharpen up.
I think one other challenge withthe top three process, though,
is let's say I'm auctioning a fewsecurities and I say bids are due at noon.
Well basically no bids come inat noon, they all come in late,
at different times. It's kind of ajoke. So you're never really sure, okay,
is 12:45, then,
(15:28):
is that the cut whereI define the top three?
And then what happens if five minuteslater somebody else comes in with a good
bid and now they're in the top three?
I think it becomes quite atricky process to manage fairly.
Totally understand and I agree, of late,
I think the frustration thatcomes along with the BWIC process,
it can take a lot of time and attimes bonds don't end up trading.
(15:51):
So that adds to the complexity of theprocess and I think there's no real ideal
way, but it just depends how the processor what process you want to manage.
Over time, I think the processhas become a lot smoother,
whether it's the best foot forwardor top three. As the space has grown,
people have just gotten an understandingof what and how things work and it's,
I think from an investor perspective,
(16:13):
when you are looking toaccess liquidity for sure,
it's much easier process to manageon a best foot forward basis.
Sometimes you actually get good executionas well because there's just no back
and forth and games. There'sno game theory involved.
That's right. And then the resultof the BWIC process, though,
in your experience, lotsof bonds just don't trade.
(16:34):
So whatever the best bid was,didn't work for the seller,
and people did a bunch of work,and have nothing to show for it.
So how often does that happen?
I think it definitely happensmore frequently when it comes to the mezzanine and
equity tranches and especially whenthe market gets very dislocated,
it's often used as a tool to maybe sharesome color and some price discovery
(16:57):
data points for everyone to see.
This is where the bidscame in for this profile.
I do think that to my earlier point,
some of these risk profilesare just very attractive.
So folks are just unwilling to let goassets cheaply if the bid is not very
strong.
So that's another undercurrent thatwe see in the market through the BWIC
(17:18):
process that people will just tryto use that color to maybe then go
find bonds in the context of the bids.So there's a little back and forth there.
So then instead of usingthis BWIC auction process,
another option I have for buyingsecurities, or selling them,
is just work directlywith a trader like you.
(17:39):
So what's the advantage ordisadvantage of just doing it that way?
So I think the process is much easier.
I think if you go to or if you work witha desk that specializes in certain of
bonds they will have access to orthey'll be in touch with other investors
that own those securities so they canreally just make the process a lot
simpler. There's only twoparties involved, really,
(18:01):
it's the buyer and the seller.
And then also I think we've seenjust the execution level be a lot,
I would say stronger or in marketcontext. It's not theoretical or academic,
it's the real market when you have abuyer looking for a specific profile and a
seller looking to sell that specificprofile. So it's much cleaner,
it's much efficient. A lotof bonds do trade that way,
(18:24):
what we call by appointment,
because folks really don't wantto put them on BWICs and get the
desks that may or may not be involvedin trading that profile to be sending in
bids that are out of context.
In the BWIC process for sure, when youget bids for something you're selling,
I would describe it asI get two kinds of bids.
So one is a bid from someone like youwhere there's an end customer who wants
(18:47):
the bond and they have bid it accordingly.
The other bid that I would get wouldbe something I think from a trader or a
trading desk where there is no endclient that wants the bond and so
that's, we'll call it a back bid,
or it's at a level where the tradingdesk is comfortable owning the bond and
they'll find an investor to take itlater. That's the strategy there.
(19:08):
So you get this tiering of bids inthe BWIC and then what I think is
translating that or bringingit back to trading out of comp,
it seems like a lot of times dealersare getting hit on their back bids in
auctions for one reason or another andthen they take that bond into inventory
and maybe sit on it for a while, tradeit away to another investor at a gain.
(19:31):
Is that how you see your businessmodel or are you actually pairing
buyers and sellers more frequently whereyou're not actually holding a ton of
bonds in inventory or howdoes your business model work?
So I think the business model on ourside is much more we're trying to make
markets and looking for real demandand we like to trade as opposed
(19:52):
to build a lot of inventory. So Ithink it's mostly market making,
bringing buyers and sellers together,
and I think we're just a desk that iscomfortable bidding a lot of interesting
profiles. So that's maybe up thestack or deep mezz and equity.
So we do talk to a lot of investorsthat find that part of the cap stack
interesting.
(20:13):
Hence we have a lot of fires and sellersthat we're in touch with rather than
just holding securities for a long timeand sitting on that and taking them down
for both.
We have certainly the capability toprovide liquidity to our end clients
whenever it's needed. At times youmay not find a buyer that same day,
but certainly we like to turn thebook over and bring buyers and sellers
(20:34):
together and like to trade morefrequently than other desks.
So it sounds like you can investand trade up and down the stack.
Are there any securities outthere today, issued by CLOs,
that you find particularly compelling?
It's hard to get overly excited about themarket given we're sitting on CLO debt
spreads and yields are,
and the broader credit markets sittingat all time tights, maybe even off 2021.
(20:57):
But I do think therisk-reward that you get,
if you invest in some BSL profiles,
like maybe some BSL AAA or middlemarket AAAs are interesting.
And then down in mezz, some juniortriple Bs I think are interesting.
Some mezz profiles like in double B,single B, offer attractive yields,
and I do also trade Europe. So I thinkthere's some interesting risk profiles,
(21:20):
maybe doubles lookattractive right now. Lastly,
I do think that CLO equity is gettingmore and more attractive given the
liabilities are at their tightsand the arbs improve quite a bit.
So CLO equity is certainlygoing to be very relevant.
The arb is the naturalprofitability of the CLO?
Correct.
(21:40):
I think the payments on CLO equity arelooking a lot better and we're seeing a
lot of interest and I do see a lot ofinterest for that part of the cap stack as
we go into the new year as well.
Do you think equity will look all themore attractive in an environment where
rates are coming down?
So I think it will because we're goinginto a benign credit environment,
(22:02):
we're looking to see,
I think it's the expectation thatM and A activity will pick up,
so there'll be more opportunitiesto buy more loans for CLO managers,
sort of like the workhorseof this little complex.
So one of the trades that we've I thinkpartnered with together on was just the,
I don't want to use the word distressed,
but the dinged up double B tradewhere maybe if you liquidated the CLO,
(22:26):
theoretically, when we bought thedouble B, you would've been underwater,
you couldn't have liquidated all theloans and gotten back a hundred cents on
the double B. How do you get comfortableowning securities where for example,
the double B is often the junior-mostdebt tranche and the loan portfolio has
seen a pickup in loan defaults.
How do you get comfortable owningsecurities with that profile?
(22:48):
I think there's a coupleof things to mention there.
Obviously you have to do a lot of analysisof what the underlying risk to the
double B is, what are the underlyingloans that it is most sensitive to?
But I think the other dynamic isthe structure of what is at play.
So these deals, as you know,
they're a lot more seasoned and they'reeither very close to reinvestment period
(23:10):
or out of reinvestment period.
So there's an element of what happensto these deals if there's scheduled
principal payments that comethrough and how is the CLO manager,
what liberty do they haveto reinvest into the deal?
So in that trade you bought a CLOdouble B at a discount to par,
and you're hoping that the managerisn't going to buy more loans with the
(23:31):
proceeds that come back as loansprepay. You want the CLO to delever,
that's the better outcomefor the BB in that case.
So effectively you would hopethat the deal becomes static,
but then you really have to getcomfortable with the underlying credit.
The deal that we're talking about is moreseasoned, there's a lot of tail risks,
so is really the race against the time,
(23:51):
which is does the bond delever fasterthan the tail can get further stressed?
So I think there's that undercurrent.
So the tail being the worst performingloans that still remain in the CLO at
that point?
Correct.
And what's different about this tradeversus when you buy maybe a double B that
is from a relatively newer dealis it's still going to take
(24:15):
some time for the credit selectionto play out in different years,
but here the investor is buying and hasa pretty good sense of what the outcome
could look like, so it's adifferentiated risk profile.
And then if the deal deleversfaster than what is expected,
then you could have yourdebt, especially double B,
deep down mezz to be called andthere's a natural pull to par.
(24:39):
So yeah,
those are things to think about in thattrade and for deals that they still have
some runway in terms of theirreinvestment period. Again,
I think the contrast there is you havesome clarity as to what makes up the
portfolio of the deal versus maybe a newerdeal that hasn't really seen stresses
that come along maybe a year like Covidor 2022 and those stresses just play out
(25:01):
in your portfolio.
The way I think about the distresseddouble B trade is that an option you have
if you sit in my seat isto buy, say primary equity,
and in that for a new cleanportfolio with a great manager,
you might run a case where 2% of theloans default each year and you're
targeting returns of mid-teens.So that's one option for you.
(25:22):
The other option has been,
and this really isn't a trade we see alot of today because the market's rallied
so much, but through 2023, a lotof times, instead of buying equity,
you could buy a discounted double B andit's going to be a dinged up portfolio
and that's why it tradesat discount obviously.
But in those cases you might run a5% default rate and conclude that
(25:43):
you're still money goodthrough the double B,
and you might be able to get returnsthat are comparable to equity, or,
in some cases, better than equity.Again modeled at a 2% default rate.
So the double B comps really well toequity in markets where there's some
stress, which again Iwouldn't define as today.
(26:07):
Look,
I absolutely agree and Ithink what happens in the CLO market is it's not a very
continuous market in the sense that ifyou want to go buy a certain asset class
rating in the secondary market, sayyou wanted to go buy CLO equity,
it takes some time and effortto really find the profile.
So a lot of CLO equity buyers werelooking to pick up CLO equity in
(26:27):
late 2022, early 2023, but there wasjust not much available for sale.
We did see some of these dinged updouble Bs come up for sale, and,
to your point,
they were trading at levels thatcould match equity-level returns.
So I think that drew alot of interest in them,
plus the point about thedefault rate, you're right,
what we've seen even inGFC or in Covid and even
(26:51):
now is just vector shocks in termsof default rate spikes as opposed
to very high cumulative defaultrate till the end of the deals' life
cycles.
I think that's why some of these tradesare interesting because these BBs,
they're money good, they maynot see any kind of impairment.
So of the CLO universe out there,
(27:12):
there's maybe a hundred plus broadlysyndicated managers who are active
and 20 or so middle market managers.
Do you see a lot of trading activity inthe managers that are less well known,
managers that are maybe competent butstill building out their franchise,
or do you stick to trades with someof the biggest CLO managers out there?
(27:32):
We definitely look at newer CLOmanagers. It's a combination,
but I think it's a growing complex.
So there's new entrants into the CLOworld and we tend to be a little more
manage- agnostic and really look atperformance and I think we see that
happening across the investors thatthey're looking for maybe newer
strategies that a managercould be undertaking.
(27:54):
We're seeing a lot of CLO PMs move fromone shop to the other and what is being
marketed is there's a change in ourinvestment strategy going forward in order
to win more investors.
And I think it certainly makes sense ifyou have a newer manager that has just
raised an equity fund and looking toissue deals, let's say three or four,
I think they would love to get moreinvestors onto their platform by
(28:17):
offering them more conservative tools.
So I think it's definitely an interestingplay and then they could offer to give
up some spread in return and makethe investment more attractive.
So we definitely see that happening andthat's a trade that I think is worth
keeping an eye on.
So we definitely traffic and I thinkwe're definitely one of the desks --
(28:37):
So wait, the newer manager trade,
basically the trade off is youown a debt security and you get a
spread premium, so you pick upsomething in terms of return,
but if you're not goingto hold it to maturity,
the liquidity of that manager issomething you need to think about?
If you were ever to wantto sell the security,
the price isn't going to be comparableto a manager that's more well known in
(29:00):
the market.
Yeah, definitely.
I think liquidity is definitelythe aspect there to keep in mind,
but it's also worth looking at,
or understanding how did the CLOmanager raise their equity fund
if they're promising some bigger returns.
So they could be looking to invest inriskier portfolios to overcompensate for
that.
But then we see investors that havemore insurance based pedigree that
(29:23):
are entering the space,certainly know of a couple.
What we've noticed is liquiditytends to improve as soon as there's
a few data points in terms of performance,
and it's also very data driven as soonas folks see the deal trading or the
tranche is trading a little betterthere a sense of an understanding that
develops this risk is tradingakin to other similar in its
(29:47):
cohort.
And then for middle marketCLOs, which is important to me,
is a little niche forus here at Flat Rock,
how do you get comfortable tradingmiddle market CLO securities where the
underlying loans don'thave a daily traded price?
So I think that's the question that isin demand and I get the most often when
I'm trading middle market CLOs.
(30:08):
I think part of it is the structure ofthe middle market CLO I think is much
stronger.
I think that comes into discussionand then the fact that these deals are
compensating you by givingyou that extra spread over.
Now it's debatable in markets likethese where you're at the tights where
whether you are gettingenough compensation in terms of spread pickup on each of
the tranches. So there's that,
(30:30):
and then there's nuances like whathappens after the reinvestment period.
So there's a lot of investors thatcare about whether they're going to get
extended or whether their investmentis going to see extension risk or not.
But there is another element to thepoint that you made earlier about maybe
taking a bet on a newer manager.
So I started trading middle marketCLOs before they were so cool,
and I think there was a benttowards going with bigger platforms
(30:54):
that can originate a lot of assets.
So the main thing to think about thereis whether that manager has access to
enough assets to swapout maybe a stress deal.
So I think that is one of thethings that people care about.
It comes up in conversations and we'veseen some investors getting to look under
the hood by signing NDAs.
(31:14):
So I think that's another way thatpeople have gotten comfortable.
Just signing a nondisclosure agreementwill give you access to some loan level
information?
From a secondary perspective.
You can also look at some keyperformance metrics of the deal.
So even though you won't have statslike MBOC or par creation to be as
relevant because there's no understandingof what that means within middle
(31:38):
market CLOs, but you could look athow the triple C buckets are doing.
You can look at whether the equityreturns are looking, how they're looking.
So there's a few things that you couldlook at to ascertain the quality.
Bilal,
is there anything else we should discussthat's topical to you or your business
today?
I think one thing that we are seeingright now within the market is just the
(32:00):
growth of the retailinterests within CLOs.
We're seeing a lot of demandfor As and triple Bs emerging,
and I think what that hasdone to the secondary market,
we're seeing a lot of resilienceeven during ballots of volatility,
we didn't really see a lot of outflowsfrom some of these CLO funds or the
(32:20):
ETFs, so I think that's verynotable. I think for our business,
we're expecting to be activein the middle market comple,
we're an active participanton the secondary side,
so I think we're an interesting space,
an interesting time where we are seeinggrowth in the CLO market and more
focus on the productinternally, externally,
(32:40):
and we're positioning ourselves to bea relevant player within both BSL and
middle market on the secondaryside and on the origination side.
Great. Well, Bilal, thanks somuch for coming on the podcast.
Really enjoyed our conversation.
Thank you very much for having me.
The content here is for informationalpurposes only and should not be taken as
(33:04):
legal, business, tax,or investment advice,
or be used to evaluate anyinvestment or security.
This podcast is not directed at anyinvestment or potential investors in any
Flat Rock Global Fund. Definition Section
AUM refers to assets under management.
LMT or liability managementtransactions are an out of
(33:26):
court modification of a company's debt.
Layering refers to placing additionaldebt with a priority above the first lien
term loan. The securedovernight financing rate, SOFR,
is a broad measure of the costof borrowing cash overnight,
collateralized by treasury securities.The global financial crisis, GFC,
was a period of extreme stress in globalfinancial markets and banking systems
(33:50):
between mid 2007 and early 2009.
Credit ratings are opinions aboutcredit risk for long-term issues or
instruments.
The ratings lie on a spectrum rangingfrom the highest credit quality on one end
to default or junk on the other. AAAA is the highest credit quality.
A C or D, depending on theagency issuing the rating,
(34:12):
is the lowest or junk quality.
Leveraged loans are corporate loans tocompanies that are not rated investment
grade. Broadly syndicated loansare underwritten by banks,
rated by nationally recognized statisticalratings organizations and often
traded by market participants.
Middle market loans are usuallyunderwritten by several lenders with the
(34:33):
intention of holding theinvestment through its maturity.
Spread is the percentage difference incurrent yields of various classes of
fixed income securities versus treasurybonds or another benchmark bond
measure. A reset is a refinancing andextension of a CLO investment period.
EBITDA is earnings before interest,taxes, depreciation, and amortization.
(34:56):
An add back would attempt to adjustEBITDA for non-recurring items.
ETFs are exchange traded funds. LIBOR,
the London Interbank offer rate,
was replaced by softwareon June 30th, 2024.
Delever means reducing theamount of debt financing.
High yield bonds are corporate borrowingsrated below investment grade that are
(35:18):
usually fixed rate and unsecured
Default refers to missing a contractualinterest or principle payment.
Debt has contractual interestprinciple and interest payments,
whereas equity representsownership in a company.
Senior secured corporateloans are borrowings from a company that are backed by
collateral.
(35:39):
Junior debt ranks behind seniorsecured debt in its payment
priority.
Collateral pool refers to the sum ofcollateral pledged to a lender to support
its repayment.
A non-call period refers to the timein which a debt instrument cannot be
optionally repaid.
A floating rate investment has an interestrate that varies with an underlying
(36:01):
floating rate index.
General Disclaimer Section
references to interest rate movesare based on Bloomberg data.
Any mentions of specific companies arefor reference purposes only and are not
meant to describe the investment meritof or potential or actual portfolio
changes related to securities of thosecompanies unless otherwise noted.
(36:24):
All discussions are based on USmarkets and US monetary and fiscal
policies.
Market forecasts and projections arebased on current market conditions
and are subject to change without notice.
Projections should not beconsidered a guarantee.
The views and opinions expressed by theFlat Rock global speaker are those of
(36:44):
the speaker as of the dateof the broadcast and do not necessarily represent the
views of the firm as a whole.
Any such views are subject to changeat any time based upon market or other
conditions,
and Flat Rock Global disclaims anyresponsibility to update such views.
This material is not intended to berelied upon as a forecast, research,
(37:05):
or investment advice. It isnot a recommendation, offer,
or solicitation to buyor sell any securities,
or to adopt any investment strategy.
Neither Flat Rock Global nor the FlatRock Global Speaker can be responsible for
any direct or incidental loss incurredby applying any of the information
offered.
None of the information provided shouldbe regarded as a suggestion to engage in
(37:30):
or refrain from any investment relatedcourse of action as neither Flat Rock
Global nor its affiliates are undertakingto provide impartial investment
advice, act as an impartial advisor,or give advice in a fiduciary capacity.
Additional information about this podcastalong with an edited transcript may be
obtained by visiting flatrockglobal.com.
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