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ADISA Video: Applying Senior Secured Loans (CLOs) to Portfolios

“For junior CLO securities, we usually see an 8% to 10% annualized distribution yield rate with these funds,” Joseph Roth, head of distribution for Eagle Point Credit Management, said to ADISA board member Greg Mausz.

In this interview, Roth takes a deep dive into collateralized loan obligations, a pool of senior secured loans that uses a capital structure made of debt and equity to fund that purchase.

Video Transcript

Greg Mausz   00:10

Welcome to another edition of Focus on Alternatives brought to you by ADISA, the Alternative and Direct Investment Securities Association. For more information about alternative investments please visit adisa.org and check out the resource library. My name’s Greg Mausz, I’m your host today and I’m joined by Joey Roth. He’s the head of distribution for Eagle Point Credit Management. Thank you for joining us here.

Joseph Roth   00:35

Thank you, Greg.

Greg Mausz   00:36

So, we’re going to be talking CLOs, not everybody knows that acronym or what it is. So why don’t we start with the basics, what is CLOs?

Joseph Roth   00:44

Absolutely, so CLO is an acronym for collateralized loan obligation. A CLO is a special purpose entity whose sole purpose is to own and manage a pool of senior secured loans. In this discussion will focus on larger U.S. companies as the borrowers and the underlying collateral for CLOs. And these are actively managed pools of senior secured loans, meaning this is not a static pool that simply runs off and amortizes over time. There are reinvestment periods that enable us the investor and the collateral manager to purchase new loans and trade in and out of loans during a certain time period. So, CLOs on the left-hand side of the balance sheet own pools of senior secured floating rate loans to large U.S. companies.

On the right-hand side of the balance sheet, you’ll see the capital structure of a CLO. CLOs use a combination of debt and equity to fund the purchase and ownership of the senior secured loans, the assets. The debt is rated by Moody’s S&P or Fitch. It starts at the very top with AAA, AAA rating. It goes all the way down AA, A, BBB, BB all the way down and then there’s an equity tranche at the bottom of the capital structure which typically represents about 10%. So that’s what a CLO is. At the end of the day, it is a pool of senior secured loans that uses a capital structure made-up of debt and equity to fund that purchase, and it’s an actively managed vehicle as opposed to a static pool that simply amortizes overtime.

Greg Mausz   02:34

Ok. Well senior secured loans versus bonds, are they the same thing or different?

Joseph Roth   02:40

Different. So senior secured loans first of all floating rate assets, so senior secured loans the interest rate readjusts usually every three months based on the rates set by either Libor or SOFR. Whereas bonds are fixed rate products as you’ve seen in today’s market, when yields change in the market and you have a fixed rate product like you do in a bond the value of that security can go up and down because the coupon does not adjust.

Greg Mausz   03:14

Yeah, makes sense. OK I like that floating rate that’s good. Especially considering this current market environment. So as these CLOs get structured of all these senior loans, what are all the parties that are involved?

Joseph Roth   03:25

Absolutely, so there are a handful of different parties this is a very well-established market. There’s about a bit, just under a trillion of CLO securities outstanding today. And the first is the investors, so we have the investors in the CLOs again that starts with AAA investors down AA, A rated BBB all the way down to the equity. So different investors in different parts of the CLO capital structure. You have law firms that provide legal advice to structuring than the documentation for all the agreements that govern the CLO vehicles. You have banks that are underwriters, and they are the arrangers, they arrange the financing for the CLO. You have collateral managers, they’re really the day-to-day manager of the CLO vehicle. So, they’re trading the loans they’re assembling the pool and they’re managing the vehicle on a day-to-day basis. And also, you have rating agencies, whereas I mentioned the debt securities issued by CLOs are rated by Moody’s S&P or Fitch.

Greg Mausz   04:32

Those are a lot of parties involved, but I’m guessing that’s a good thing because it makes sure that these are properly structured and everything ticked and tied, right?

Joseph Roth   04:39

Correct. You have a lot of different vetting a lot of different parties involved. And again, it’s this is the process that that’s you know fairly standardized over the years.

Greg Mausz   04:48

OK so, another compare and contrast. The senior loans the CLOs as compared to other kind of debt structures.

Joseph Roth   04:57

Sure, so one of the things that that often comes up in a discussion about CLOs is how does how do CLOs differ from other types of structured credit products. And we believe that one of the most important differences is the collateral that CLOs own. So, we mentioned the very beginning, senior secured loans to large businesses in the US, that’s what CLO own. if you look at other types of products that are in this broader category of structured credit. You could find pools of subprime mortgages, which have a completely different credit profile. They used some similar technology and structuring but they have a very different fundamental risk profile attached. So, one of the key principles of CLO investing and why it works why it has worked through downturns is that the collateral it’s a certain credit quality that other products don’t have.

Greg Mausz   05:52

And that’s great because investors if they want higher credit quality, they can kind of access that through the CLO structure. Or if they want higher yield, they go down the risk scale and get that. But how do retail investors really access the CLO market?

Joseph Roth   06:08

Sure, so historically retail investors didn’t really have a lot of access to invest in this asset class. And it was limited to institutional investors either at the new issue market on a primary basis or through the secondary market. Today the way retail investors can invest in CLOs is through 1940 act closed end funds, either traded or non-traded interval funds or BDC’s to a lesser degree.

Greg Mausz   06:35

Right well lots of different ways, that’s perfect. So, if you’re working in on constructing a portfolio. Kind of where do you see CLOs fitting into the retail investor portfolio?

Joseph Roth   06:47

The most important characteristic of CLO investing from our perspective is the income orientation of the investment strategy. So, it’s really an income product designed to deliver high current cash flow to investors. So we see it fitting into the income part of the investor’s portfolio. Generally, in within an alternative allocation, typically an alternative to fixed income or traditional fixed income.

Greg Mausz   07:15

Well thanks for sharing how they fit into the portfolio. But I’m just curious what are the kind of income or dividend ranges that these funds are paying these days?

Joseph Roth   07:23

So, for junior CLO securities that securities that are junior and the CLOs capital structure, we typically see an 8% to 10% annualized distribution yields right these funds.

Greg Mausz   07:37

Well Joey, thank you for coming here today and walking us through CLOs.

Joseph Roth   07:41

Thank you. Appreciate it, Greg. Thanks a lot.

Greg Mausz   07:43

And thank you for watching. For more information about alternative investments, please visit adisa.org. Thank you.

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