Dear reader,
I hope you know about Collateralised Loan Obligations (CLO). If not this article I wrote about FAIR and the words of CLOs gives a introduction.
Apart from the fact that a 3.55% quarterly slug arrives 2nd April it was gratifying to hear FAIR had taken two bites of the cherry. After proving that buy backs can work and can close the discount to NAV (from an impressive 22% discount to 0% over the past 6 months or so) and they have now ceased buy backs and are instead doing SELL BACKS. Re-issuing shares from treasury. Love it.
From inception in 2014, FAIR has grown its NAV by 94% and paid a stream of dividends several times the value of its market cap. Of course the danger with high yields is sustainability. The danger that the business “eats itself by its tail”. In other words if you’re paying a dividend out of capital and not out of profits then you are eating the seed corn.
Deciphering the world of CLOs:
(Excerpts from FAIR’s Feb Newsletter)
In FAIR’s latest report, they provide some colour on their success. Loan default rates have decreased slightly to 1.41%, while the forward-looking distress ratio decreased from 5.48% to 5.08% in the US and from 2.84% to 2.80% in Europe. CLOs can take a degree of losses (aka Over-collateralisation) before affecting either dividends or capital.
FAIR tells us: CLO spreads have continued to tighten, although pricing dispersion was more pronounced in February as primary European AAA CLO spreads ranged from 148 bps to 170 bps. This range reflects more pronounced manager tiering and differences in deal structures.
As a result of this spread tightening, CLO refinancing/reset activity in Europe and the US reached €1.4bn and $14.4bn, respectively, the highest monthly volume seen in over two years.
In plain English, this means the difference between SOFR and CLO products have been falling by around a third. Investors are demanding less compensation for holding CLOs, likely due to favorable market conditions and investor confidence.
FAIR continues: The more attractive cost of CLO financing has improved CLO equity arbitrage.
In plain English the CLO Financing Cost is the yield that investors demand for holding CLOs. More attractive means that investors are willing to accept lower yields on their CLO investments. CLO Equity Arbitrage means taking advantage of price differences between related financial instruments, specifically it is exploiting discrepancies between the value of the CLO equity (the riskiest tranche) and other parts of the CLO structure (such as senior tranches).
“the weighted average price for US CLO equity in the Master Fund’s portfolio has decreased from 44.7c to 35.8c in the last 12 months while the weighted average loan bid price has risen from 94.3c to 96.6c in the same period”
CLO equity is the highest risk and the highest return in CLO world. Think of it like getting on board an orange coloured aeroplane. You are at the back of the non-priority queue so take the biggest risk of losing your seat (aka default), but also you get the biggest rewards when things go right. Let’s say you get the extra leg room (extra yield). The above statement is telling you that you can buy CLO equity for 25% off and that sentiment towards the risk of loan has fallen by around a quarter . In other words the arbitrage is that the leg room got bigger for the last person on the plane, but you’re much more likely to get a seat too, because the risk for speedy boarding up front has dropped.
“Fair Oaks believes that, given the more benign macroeconomic environment, the Master Fund’s CLO equity valuations have the potential to follow the normalization path seen in CLO mezzanine debt. Tighter CLO liabilities are also increasing the probability of CLO resets, which would further enhance returns.”
Essentially, they expect that the value of CLO equity will move toward more typical levels, possibly aligning with historical trends or industry standards.
It’s like saying if the speedy boarders now have a lower risk then for non-priority the risk should also fall. The benign macroeconomic environment (a stable or favorable economic backdrop) is a key factor driving this expectation. Mezzanine debt is a middle layer of a CLO’s capital structure, sitting between senior debt and equity. It carries higher risk but also higher potential returns.
Tighter CLO Liabilities refers to the debt tranches (senior, mezzanine, and equity) within a CLO. When CLO liabilities become tighter, it means that the spreads (yield differences) between different tranches are narrowing.
In other words the price of speedy boarding is dropping!
As a result, there is an increased probability of CLO resets. A reset occurs when a CLO refinances or restructures its debt, often taking advantage of favorable market conditions. These resets can lead to improved terms, reduced costs, and ultimately enhanced returns for CLO investors.
In other words this is like an airline allowing you to rebuy your ticket at a lower price if the flight price drops.
So in summary, Fair Oaks anticipates that CLO equity valuations will normalise, due to better market conditions, price drops and lower risk. This means the NAV will go up.
I hope this helps demystify this complicated area a little bit and gives you a starting point for your own research and to consider whether you should become a “sophisticated” investor and invest in CLOs.
FAIR is one of the Oak Bloke Top 20 Ideas for 2024 and is up 1.7% YTD. (+3.55% divi in a few weeks) = 5.2%
This is not advice
Oak.
Excellent demystifying. One pedantic point - LIBOR rate has been replaced by SOFR rate.