XAI Octagon Floating Rate & Alternative Income Term Trust (NYSE:XFLT) Q4 2022 Earnings Call Transcript

XAI Octagon Floating Rate & Alternative Income Term Trust (NYSE:XFLT) Q4 2022 Earnings Call Transcript March 2, 2023

Robert Chenoweth: My name is Robert Chenoweth, Product Specialists at XA Investments, and I will be your moderator. In today’s webinar, we will provide a Fourth Quarter Update for XFLT and take questions from the audience. Before we begin, there are a few disclosures I’d like to make you aware of. The information discussed today does not constitute investment tax, legal, regulatory, or accounting advice. This information should not be considered as an offer to sell or buy any security. Investors are advised to make an independent review before purchasing or selling. Investments carry a risk of loss and past performance does not guarantee future results. All right. So, a couple of housekeeping items. Registrants will receive a link to the replay following the webinar, I’ll send that to the e-mail you provided when you registered.

You can also resource additional information on our website at xainvestments.com under the Knowledge Bank tab. We will be taking questions today. We may not be able to answer all the questions that come in, so please feel free to reach out to us after the webinar, we’ll share our contact info towards the end. So speakers, today, we are joined by Gretchen Lamb from Octagon Credit Investors. Gretchen joined Octagon in 1999 and is a member of Octagon’s Investment Committee and serves as a Senior Portfolio Manager Across CLOs and oversees the firm’s structured credit investment strategies. We are also joined today by Kimberly Flynn. Kim is a founding partner and Managing Director at XA Investments, responsible for all product and business development activities.

Previously, Kim was Head of Product Development at Nuveen, leading their Global Structured Products Group. So, as I mentioned, we have prepared questions and topics to discuss on our webinar today. They’ll be relevant to XFLT and the bank loan and CLO market. These topics will all correspond with the slides in our presentation, which you will have access to along with the replay. So, I’ll give a quick review of Octagon Credit investors, and then we’ll hand it over to Kim. So, Octagon has focused on below investment-grade credits since 1994 with assets under management of $33.8 billion. Their investment process is rooted in fundamental credit and relative value analysis. They are an experienced team with a track record exceeding 25 years and they’re a leading institutional credit investor.

So, with that, I’ll hand it over to Kim for a review of XFLT. Kim?

Kimberly Flynn: Great. Thank you, Robert. We ended the year 2022 with total managed assets just shy of $400 million. The fund today stands at about $410 million in total managed assets at about $2.44 in common assets and that’s in large part due to the scaling and the continued growth of the fund in the secondary market. The fund has trade at a premium, allowing us to continue growing the fund and creating scale efficiencies. The average daily trading volume, 172,000 shares this is a sign of kind of the overall health and wellness of liquidity in the secondary market. So we’re pleased to see volumes remain high for investors. Regulatory leverage, we did end the year at 42% leverage, so slightly higher than where you’ve seen the fund.

We’re typically in the range of about 38% to 42%. We have a fairly attractive leverage structure with various sources of leverage, and it allows us to borrow cost effectively, and it allows us to have flexibility in managing the fund, given the long-lived assets, particularly the CLO equity in the fund. So we’ll talk more about leverage in a moment. I just want to point out NAV ended the year at $6.27. The NAV of the fund is depressed right now, given some of the unrealized losses associated with the — just the pricing of CLO equity in the marketplace. We’re also going to talk about what that means for shareholders. But that is why the NAV is lower today than it was a year ago. We continue to pay regular steady monthly distributions at a rate of $0.073 per share a month.

Right now, distribution rate on NAV is about $13.97. The fund is quite diversified, 462 holdings. Even the top 10, if you look at the table there, represents about 12.5%. As you would expect, with CLO equity positions being a little chunkier, but we’re still very diversified with only 12.5% of the fund in the top 10. The asset mix, we can turn to the next slide and you’ll see that Octagon has done a great job of thinking about opportunities in these different opportunity sets in the first lien loans, CLO equity and CLO debt. So you will see things move around a little bit from quarter-to-quarter. At the end of the fourth quarter, Octagon was seeing increasing opportunities in the CLO debt marketplace, and Gretchen will talk a little bit more about that.

The allocation ended the year at 14% CLO debt 35% CLO equity and first lien loans, 45.6%. We’ll move on now and talk about net returns. This is really important in terms of our performance to think about €“ it’s not just the net investment income that the fund is generating. When we go through periods where CLO equity and CLO debt positions, the price of those securities are marked down, those unrealized losses that are associated with valuation changes, they show up in the NAV performance of the fund. And those are not — there’s a difference between unrealized losses associated with valuation changes and obviously realized losses, which would be a permanent hit to NAV. So we ended the quarter NAV was off 1.53% for the year. NAV was off 12.87%.

We did start to see price move ahead of NAV in the fourth quarter, the price return quarter-to-date was 10.09%. It didn’t — it wasn’t able to offset the overall one-year decline in price and we did see a price return of negative 19.96%. But we have continued to see in the first quarter of 2023 improvements to both price and NAV for XFLT, so continuing on that trend that started in the fourth quarter. As of last night, the closing NAV of the fund was 660 and the closing price was 676, which represents about a 2.42% premium. Let’s move now and talk a little bit about the secondary trading market. Typically, the fund does trade at a premium on average of about 3.36%. On the 24th, the fund did dip to a slight discount of negative 0.45%. But as I mentioned, the fund is now trading at about a 2.4% premium again.

Let’s move and talk a little bit about price and NAV relative to the overall broader equity market, we’ve observed this as their is market volatility and investors become concerned as they did in 2020 when the S&P 500 declined and then in 2022 with a lot of the uncertainty the war in Ukraine and inflation concerns, we did see the S&P 500 decline the fund was not immune from that. The NAV declined, as I was mentioning on the prior slide, you can see the green line, which shows the NAV of the fund. We have started in the first quarter to start to see NAV move right in the right direction, moving back up. But it is lagging. I think we’ve seen the equity market run back up a little bit. And so that pace is a bit faster than we’re seeing NAV recovery, talking with experts in the space, I think there’s still some concerns about recession and concerns about the overall health and wellness of the economy.

So we may have to be patient with some of the NAV and price recovery. Let’s move on now and look at just — as you know, I mean, unless you lived under a rock you know this, which is that the Fed has been raising rates and even into February where the Fed raised by 25 basis points. So this has impacted the fund, and the fund is a floating rate fund. The securities that we invested in all floating rate, we also have the benefit of liabilities. The bulk of our leverage sources are also floating rate, which means the cost of leverage on our credit facility has increased as we observed increases in LIBOR and SOFR. So the nice thing about the floating rate nature of this portfolio is that it can keep pace with some of the changes in the environment with respect to rates.

So we’ll move on. We can take questions with respect to that and the impact on the fund at a later point. As I mentioned, we’re really happy and pleased with the continued strength in the trading volume. 2022 is kind of a funny year, one thing I’ll mention is that, the volume that we’ve observed in XFLT often comes a little bit more sporadic in the last six months than it did in years prior, where it was a little bit more steady or smooth trading from day to day. So now, we see bigger trading days in XFLT, where there’s a lot of volume and a lot of trading in the shares of the fund. Those are days in which the funds at the market program is active, so it’s still reflective of the overall volatility in the market. We’re seeing that show up in the day-to-day trading volume.

It doesn’t necessarily appear in the averages that we’re showing. But if you were to be a buyer and a seller, you would obviously see some of this — the differences day-to-day in terms of the nature of the trading volume in the fund. So now, I’ll just talk a little bit about the scale of the fund, and then I’ll end with a mention of the diversified leverage sources. But we have continued to grow the fund over the course of time. And we’ve done this through accretive transactions, benefiting shareholders, the fund does have an active at-the-market program, which allows the fund to drip shares out in an accretive way, and we’re able to deliver some cost efficiencies as the fund has continued to grow in size and scale. And also, with the growth of the fund, and if you move to the next slide, one of the benefits of this enhanced scale is having more I guess, diversity or different sources of leverage.

In the last year, we issued convertible preferred — and so the fund has three sources now, a credit facility with SocGen at an average cost in the fourth quarter of about 11%. We also have retail preferred shares that actually trade very well in the secondary market, they trade at par. Those retail preferreds were issued at $6.50 and then the convertible preferreds, which have an average cost of about 6%. And the benefit of having varied sources of leverage is that we can reduce the overall cost of leverage in the fourth quarter, the average cost of leverage was about 5.54% and we’ve talked about this previously, XFLT is uniquely positioned in the marketplace, because it does invest in CLO debt and equity, but it has a healthy portion of the fund invested in first lien and second lien loans, which is what allows us to secure that credit facility and borrow more cheaply.

So we’re happy with the asset liability mix for the fund. We continue to be thoughtful about managing leverage. In the quarter, it is important to note, you can see this comparing the final two columns that as rates have risen, the average cost of leverage in the fund have increased significantly, specifically the bank borrowing row, you see that the average cost in Q3 was about $341 million and the average cost in the fourth quarter was $511 million So, we have seen those leverage costs move up. That’s true for us. It’s true for competitor funds in the marketplace as well. So — and in this case, the XFLT fund does have the benefit of the asset liability match being better, given the floating rate nature of the securities within the portfolio.

That’s what I plan to cover with the group. And Robert, I’d love to turn it back to you.

A – Robert Chenoweth : Great. Thank you so much, Kim. So we will get started with our prepared questions, and audience, please feel free to submit questions of your own as well. So Kim, we’re going to start off with you and if you could give us a review of the XFLT financial highlights for the quarter.

Kimberly Flynn : Sure. I just wanted to mention that every quarter, we do publish our quarterly financials. We’ve got the unaudited interim financials for the 12/31 period posted on our website at xainvestments.com. So you’ll see the detailed financials there. When we post the replay will also just point out the financials, so that you can take a look at those. I’ll give you the highlights and then walk you through a few of the points that are relevant for this quarter. And let’s just start with a couple of the highlights. We were — as I mentioned, the ATM was active. We did issue about 144,000 shares of common stock. And the ATM has actually been a bit more active in Q1 2023 as we’ve seen volume increase. So we expect that to continue.

Distributions have been steady, total monthly distributions paid to common shareholders and the rate of that distribution is about $0.073 and no change in recent months to the distribution rate. For the quarter ended 12/31, net investment income was $0.26. We did have some small realized losses. I mentioned the unrealized losses associated with some of the pricing changes of $0.16, total gain from investment operations was about $0.10, the ratio of net investment income to average net assets was 0.16%. Interesting to note, as I was just given some of the volatility in the marketplace, we wanted to share with you all the current yields for the securities within the funds portfolio. And right now, as of 12/31, CLO equity, the yields were close to 30%.

CLO debt was about 12.2, loans were about 11.3, opportunistic loans that is, and then senior loans at 9.34, and bonds at about 7.7. These are the yields that we’re showing here. These are not the net IRRs. We’re always very thoughtful about anticipating potential future loss. And so net IRRs are going to be lower than any current yield that you would see in the marketplace, but this gives you a sense of the repricing of these securities in the market and the yields have gone up as the prices have declined. I’m going to point out a few things in the financials themselves, if you’ll bear with me. Now in the statement of assets and liabilities, we ended the period with total investments of about $385 million of total assets were about $395 million and net assets to shareholders once you back out the leverage facility and other forms of leverage and expense.

The net assets for common shareholders, is about $224 million. If you look at the statement of operations, this break’s down the funds, investment income, and at the end of the statement of operations, you get a net investment income of about $9.26 million. We do itemize the realized losses on investment securities in the quarter and the unrealized losses associated with valuation changes. I will make mention of there were a number of positions in the portfolio that the fund sold at a loss, but when we look at the IRR for the holding period of those investments, the IRRs were positive, given the income or distributions received from those investments. And so happy to take questions to the extent there are any. Now, if we look at the statement of changes in net assets, as I mentioned, net investment income was $9.26 million and the total distributions to shareholders importantly, because I know a lot of our investors are distribution focused.

We did cover the distributions from net investment income and distributions represented about $7.8, as I mentioned, net investment income was about $9.26. So we did end the period with an increase in net assets applicable to common shareholders. One thing I wanted to mention on the financial highlights. There’s a lot of good information there that compares the year-end going back all the way to 2018. But one thing I wanted to point out is the expenses and we talked about the benefit of the funds growth is that we’ve been able to reduce some of the fixed cost as a percentage. And so you see the funds expenses declining from 2019 to 2021. And then you start to see in 2022, an uptick in the expense ratio, and you might wonder why that is. And that’s what we were talking about earlier with respect to the changes in interest rates and leverage costs have moved significantly higher in the last year as rates have moved higher.

And so that does show up in the expense ratio, and we wanted to call that specifically out for your attention. Now, the operating expenses of the fund have declined as a percentage and are expected to continue declining as well given the fund scaling. Now, we’ll keep you informed and updated on any changes in leverage costs in periods to come. So, Robert, I’ll turn it back over to you.

Robert Chenoweth: Great. And we’re coming right back at you, Kim, with a two-part question here. So how have loans and CLOs performed in this rising rate and inflationary environment versus more traditional fixed income investments? And how does the floating rate structure affect performance?

Q&A Session

Kimberly Flynn: Okay. So this is a good question. And it’s really €“ for 2022, just that time period, thank you, Patrick and Robert for putting up the slide. This is really a relative performance story. And so when we say that the floating rate assets and specifically, we’re showing here the loan index have performed better than traditional stock and bond investments, the Morningstar leverage loan index was down. It was a negative 0.6%. And so we feel like that’s pretty terrific, given the decline and the negative performance that we observed from stocks and bonds. 2022, it’s just a year where people were questioning their traditional 60-40 allocation. I don’t think investors were questioning their loan allocation or their CLO debt and equity allocation.

And these floating rate assets are poised to perform relative to other fixed rate assets in a superior way. The full rate nature of the assets is going to benefit the fund in terms of increasing yields as rates move higher. So we continue to like loans, CLO debt and CLO equity relative to other asset classes. Now there is uncertainty. There are concerns about the credit markets, overall. A lot of €“ we consider that as well when we look at the asset mix. And when we look at €“ we talked about the net IRR calculations that we do. So we’re trying to be very thoughtful about how we manage the fund in this sort of rising rate environment. And I think that other investors continue to view loans is a way to participate in an inflationary or a rising rate environment

Robert Chenoweth: Great. Thank you very much. Gretchen, we’ve got a question for you. It’s a two parter as well. The markets have been dealing with slowing economic growth, rising rates and recession concerns. Can you give us some insight into how the loan market performed amid these conditions in 2022? And what about CLOs, can you give us an update on their performance in Q4 and where CLOs are trading now?

Gretchen Lam: Sure. Happy to. Good morning to everyone. 2022 was an interesting year in that it was one of only three years in the last 26, where the broadly syndicated loan market generated a negative annual return. Though as Kim referenced, it was just fairly negative at 0.6%. It is worth noting that loans still outperformed, as Kim discussed, most other credit and equity asset classes and in some cases, by quite a wide margin. Thus far in 2023, we’ve seen a really nice rally across assets, loans, CLOs and high yield. Loans are up 3.5%, CLO BBs are up over 4% year-to-date. And nonetheless, even after this rally, we’re still seeing yields and spreads well above historical averages really across the CLO stack and within loans as well.

Yields on CLO tranches look particularly compelling, when compared to corporate bonds, but loans as well, with yields just shy of 10% also look quite compelling. We are seeing, as Kim mentioned, BB yields right around 12%, with total returns higher once you incorporate the accretion of the purchase discount, which currently CLO BBs were seeing trade in the secondary market at $0.85 to $0.90 on the $1. CLO equity, we’re seeing in the secondary market, projected purchase yields of 17 to 20-plus percent, which again is meaningfully wider than historical levels on average.

Robert Chenoweth: Great. Thank you. So, another question for you, Gretchen. So we saw earlier the allocation for XFLT and — XFLT can invest across multiple asset classes. So how do you think of the relative value in CLO debt, CLO equity, loans and high-yield bonds?

Gretchen Lam: Yes. I mean, XFLT’s ability to invest across the risk spectrum within loans and CLO tranches, as well as high-yield corporate bonds, really allows us to take advantage of relative weakness or strength across those areas in order to maximize income for the fund. A couple of areas worth noting. We have increased, as was referenced, the exposure to CLO BB tranches in the last year or so. The allocation sits at about 14% as of year-end. And we think the value here is particularly interesting, both in terms of the yield, as we’ve discussed, as well as future convexity or pull-to-par opportunity, which both creates upside, as well as supports the NAV and the fund. Second, I would mention high yield bonds. We have, as you can see, very little exposure to corporate bonds today, about 2.5%, plus or minus.

And this is an allocation that, as the rate picture develops, we think could be a real opportunity in 2023 to increase exposure. And the idea here is really to capture price discount without reaching for credit risk. Even if the coupons and the current yields are a bit more modest than we might see in loans or CLO tranches or certainly see low equity. We are — just given the movement in rates, we are currently seeing BB-rated corporate bonds, so relatively higher quality in the spectrum of below investment-grade corporate credit. We’re seeing those bonds trade in some cases, in the low 80s and even into the $0.70 on the $1 range. And this is really, in most cases, a function of the duration, interest rate duration of these assets and less so because of specific credit risk.

And lastly, CLO equity, while we do think yields in the 18-plus percent range are attractive, we are being very, very selective in the assets that we source. And we’re also, as Kim referenced, we have looked at rotating out of less well-positioned CLOs. Quality is really key here in our minds. And we think that’s appropriate particularly for CLO equity where as investors in that tranche, we are the first loss position of the structure.

Robert Chenoweth: Great. Great answer. That makes a lot of sense. Thank you for that. So Kim will go to you next, two questions here. How is XFLT performed relative to its fund peer group? And XFLT has traded at an average of approximately 3.4% premium since inception, although we did see a bit of a discount in Q4, what do you attribute XFLT’s superior trading performance to?

Kimberly Flynn: Sure. If you go to slide 18, I’ll talk with you about a few of the differences in terms of how XFLT was designed. In the marketplace today, there are several CLO focused closed-end funds. We note the tickers and the materials, but ECC, EIC, OXLC, OCCI. So those are the funds that are also investing in CLO equity predominantly and then some of them also invest in CLO debt. Now XFLT, I think, is because of our strategic mix of the portfolio allocation being about half loans and half CLO debt and equity, the fund has designed — it’s performed as designed. It’s performed the way we would expect it to. The fund was — the objective is to seek attractive risk-adjusted returns over time, over multiple market cycles.

The fund celebrated its fifth anniversary in September of last year. And we’re pleased with how it’s doing. It is uniquely positioned. And so while we don’t compare head-to-head if investors want a fund that’s more heavily allocated to CLO equity, there’s a number of really great options. Now XFLT, it has a couple of strategic advantages, which is what we’re pointing out here. One is leverage costs. We’ve talked about the advantage of being able to borrow more cheaply. Now we have both the floating rate credit facility and fixed rate preferreds giving us flexibility and reducing overall cost of leverage. Now preferred securities that are used to leverage CLO equity-focused funds, those preferred securities that are being issued in the market, if they were being issued would be issued in the 7% or 8% range.

So much higher costs anticipated for sourcing preferred leverage with the overall rate environment that we now find ourselves in. Now XFLT has transparency. We have a daily NAV. We have third-party valuation sources. We’re not doing this in-house. We have market and other experts helping provide valuation on the investments in the fund. Now the fund also does not have a performance fee. A number of the competitor funds use an income incentive fee, XFLT has a flat management fee. Now, the distribution rate for the fund has been about 13.86%, and that is reflective of the portfolio allocation that that mix of loans, CLO debt, CLO equity, which you’re going to find the distribution rate to be a bit lower than the competitor funds, which are focused on CLO equity.

Now, from a premium trading perspective, the fund has done well. 5.6% relative to some of the competitor funds. I think that largely has to do with some of the NAV differences and as we talked about the last 12 months have been a very volatile market period. So — and nobody buys a fund like this based on the premium. People are buying these funds for access to CLO debt and equity access to active management by Octagon and access to an income or distribution stream that’s attractive relative to other investments and we do think that XFLT is an attractive option.

Robert Chenoweth: I would agree with that. Thank you very much Kim. Gretchen, we’ll go to you next. How has the financial performance of loan borrowers trended in the fourth quarter of 2022?

Gretchen Lamb: Sure. One thing that we continue to see in late 2022 and expect to continue in 2023, and we’ve talked about this in previous calls, is greater variance in the performance of loan borrowers across the universe. And specifically, we’re likely to see more borrowers underperforming or experiencing declining profits year-over-year. And this, in turn, is driving more variance or dispersion in the performance of portfolios of loans sitting in CLOs. We recently ran an analysis for over 400 loan borrowers and we looked at 3Q of last year performance results. And what we saw is that year-over-year EBITDA growth was an average positive 8%, which sounds great. But if you drill down — if you kind of peel back the onion, you find that almost 40% of those borrowers actually saw negative EBITDA growth on a year-over-year basis.

And we would anticipate that dynamic likely continues into 2023 where even as growth decelerates we see more dispersion and more — a greater percentage of borrowers actually seeing negative profitability on a year-over-year basis than we had in 2021, for example. One clear indication of this performance dispersion is the heightened level of loan downgrades by the rating agencies over the last year. In 2022, about 16% of loans held within CLOs were downgraded and a full quarter of those downgrades were 4% were downgrades to CCC. Now, the good news is, though, that the actual increase in CCC holdings within CLOs was only 1% to 1.5% in 2022, despite the fact that 4% of the loan market was downgraded newly to CCC in the year. And in other words, CLO managers were able to avoid the broader market CCC downgrades through a combination of better credit picking versus the market, selling some CCC exposures over the course of the year.

And lastly, of course, benefiting from upgrades out of CCC rated loans to higher ratings. So as we look forward, clearly, the pace of downgrades and the increased number of underperforming loans and borrowers. We expect will continue, but we have seen thus far, CLO managers have been able to kind of outperform the broader loan market in regard to those statistics.

Robert Chenoweth: Great. So keeping on the topic of management, Gretchen, what do you think good loan managers have done well in 2022? What did they do well?

Gretchen Lam: Yes. 2022 is really a year where good managers distinguish themselves by being positioned more defensively by not owning large positions in underperforming or defaulting credits. We like to say that now is the time where you stand out by not owning the docs. Good managers are closely watching their CCC exposures. They’re closely watching their B3 or B minus loan exposures in observing historical performance of some of the best CLO managers out there, they typically experience loan defaults at a rate of half to one-third of the broader market-wide default rates, and we’re hopeful that €“ that expertise kind of flows through over the course of 2023 in terms of avoiding risk and defaults. Also worth noting, we’ve begun to see in 2022, managers really look to their high-yield bond buckets that are permitted in most CLOs. CLOs issued in the last few years typically have the ability to buy up to 5% of assets in corporate bonds.

And this is a really important tool in the CLO manager tool chest, which allows managers to trade out of risk loans, often meaningful discounts to par and really replace that par loss by trading into high-yield bonds, which in the current rate environment are often trading at similar discounts to par. And in this way, managers can really reduce credit risk in exchange for duration and as a result, mitigate CLO par losses, which, of course, is a — it’s a good thing for CLO debt investors and long-term a good thing for CLO equity investors. And we think that this will be a strategy that we’ll continue to see managers utilize in 2023 as well.

Robert Chenoweth: Nice. Thank you for the insight there. I appreciate it. We’ll go to Kim next, Kim. So we understand that mark-to-market volatility is one of the key risks to investing in CLOs — can you explain this and describe the impact to XFLT’s NAV return?

Kimberly Flynn: Sure. So I think when we conducted the road show, the initial sale of XFLT in 2017, this was one thing that we really tried to reinforce with financial advisers because you do need to be an owner of CLO debt, CLO equity through a market cycle and be able to tolerate some of these declines in NAV that are due to or reflective of the declines in market price for these types of investments. When there is economic uncertainty, you would expect to see CLO debt zero equity be priced lower than it had been before. And so this is what €“ when I was talking about in the financial highlights, the unrealized losses, that’s how they appear in the financials because we have a daily NAV for XFLT. It provides a lot of transparency, but it also shows up real time when there is economic uncertainty and the third-party valuation agents are marking these assets down, it’s in this environment when you don’t want to be a fore seller.

You do not want to be selling these investments. These are cash flowing investments, and you want to be able to hold them and that’s why I think the XAI and Octagon team were very thoughtful about the structuring of the fund. It’s why you see competitor funds structured as listed closed-end funds because in this vehicle, shareholders have the benefit of the liquidity in the secondary market, but it doesn’t come at the expense of having to sell assets to provide liquidity. And so the portfolio remains intact €“ and that is better over the long run for investors. You would not want to be selling these assets at depressed prices and so it’s really, really important. We talked about it the initial fund raise. And as we continue to expand the audience and the investor base for this fund, I think it serves a really important reminder in 2022 has been a period where you look at the NAV and you look at the price follows the NAV, and the NAV is reflecting the valuation of these securities, which is much, much lower.

You buy a fund like XFLT for its regular steady monthly distributions, high levels of attractive levels of cash flow. And so that’s €“ I think these funds are thought of as income vehicles and should be considered as such. But it’s also important to think about holding this type of fund or a vehicle for a longer period of time. And so that helps you reconcile when you do go through periods of time like 2022, when the funds stated NAV is much lower even though the fund continues to generate attractive cash flow-based distributions. So this is something we wanted to highlight this quarter, just to call it to people’s attention and kind of help them reconcile the high levels of distributions that the fund is making with this €“ and this is always going to be an issue with this asset class.

And there can be moments in time when these assets get marked down and then hopefully subsequently will be followed by a period of recovery in the market prices of these securities. But €“ so that’s what we wanted to share, Robert, with the audience today.

Robert Chenoweth: Great. Thank you. And just a reminder to the audience, we’ll share our contact information here in just a bit, you can always reach out to us from our website. Happy to follow-up or give more detail on any of these questions. All right. We’ve got a few questions left. Gretchen this one’s for you. The most recently calculated 12-month loan default rate is 72 basis points and expect it to rise, are we headed back to the long-term historical average of 2.6%?

Gretchen Lam: We do expect the default rate to move up this year, ended 2022 at 72 basis points. Today, it sits at about 1% as of the end of February, which in the context of history is still quite low, though obviously has crept up over the course of last year. Looking at a number of stress indicators in the market, we think 2023 might shake out in the 3% area for defaults. We currently see about 7%, 8% of the loan market trading at prices below $0.85 on $1. And we do think it’s reasonable to expect that somewhere between one-third and half of those loans are at very high risk of defaulting over the next 12 months. So that’s how we get to our 3% number. Clearly, a decelerating economy and much higher interest rates will create headwinds for loan borrowers over the course of the year.

But I would note that there are some mitigate such as the rather liquid corporate balance sheets, very modest maturity wall in the loan market. And the fact that many borrowers have at least partially hedged out their floating rate exposure to fixed rate, which will minimize for those borrowers, the impact of rising rates on their cash flows.

Robert Chenoweth: Great. So a follow-up to that question, Gretchen, is defaults are likely to rise. So how can CLO managers offset the impact of loan defaults in the current environment?

Gretchen Lam: Yeah, it’s an interesting question. I think it’s important to distinguish between two different things that often hit the market at the same time; loan defaults and trading price volatility. Loan defaults, in other words, realized credit losses are never a good thing for CLO equity. Price volatility, however, has historically been accretive to CLO equity cash flows over the medium to long-term. And here’s why. First, volatility generally results in higher loan coupons, which allows for the net interest margin on the loan pool to increase since your — the spread on your liabilities is fixed. And this, of course, benefits CLO equity distributions. And second, volatility often causes loan prices to fall, which allows CLOs to buy loans at sometimes meaningful discounts to par, thus offsetting the impact of any credit losses.

And to put some of that in context, last year, the market prepayment rate was about 14%. So that’s below the average over the long-term, which often is the case in periods of heightened volatility. But 14% is still pretty meaningful in terms of the impact that it can have on the structure itself. If you were a CLO manager and you took those prepayment proceeds, and you reinvested them in loans at a price of $0.96 on the dollar, which last year would not have been a heroic fee based on the trading price of loans over the course of the year. You effectively built par sufficient enough to offset almost 1.5 percentage points of defaults and the losses associated with those defaults, assuming a 60% recovery. And that’s pretty meaningful. And on top of that, CLO equity will, of course, benefit from, as we discussed, the increase in the spread on the loan portfolio.

And looking at 2022, for example, we saw, on average, across the CLO universe, about a 10 basis point increase in the asset spread within CLOs over the course of the year. Now the key in an increasing default environment is finding CLO managers that can effectively navigate a default cycle and limit defaults and limit loan losses while still taking advantage of higher loan spreads and cheaper, more discounted loan prices in the secondary market.

Robert Chenoweth: Great. Thank you very much. Okay. I’m going to ask you one more prepared question, Gretchen. And then I’ve seen a common question come in from the audience. We’ll hit that one real quick, and then we’ll close it out. I know we’re coming up to time. So Gretchen, just quickly on the prepared question, your outlook for the loan and CLO markets going forward?

Gretchen Lam : Yes. I mean, look, there’s no denying the fact that the macro environment is challenging, inflation is high, rates are high, economic growth is decelerating, defaults are ticking up. Worth noting though that CLOs have seen environments like this before, many, many times over the course of the last three decades, and they have exhibited resiliency through these cycles. It is — this volatility really creates opportunity for funds like XFLT and for CLO collateral managers whose deals XFLT is invested in.

Robert Chenoweth: Great. Awesome. Okay. So I’ve seen this question come in a few different ways from the audience. So this will be the last one here, Gretchen. Approximately 40% of outstanding CLOs are ending their reinvestment period in 2023 and how might this affect the CLO market this year?

Gretchen Lam : Yes, it’s a great question. It’s one that we get pretty regularly. I would note that while the percentage of the market that is ending its reinvestment period in 2023, it’s 40%. The exposure within XFLT across the CLO equity book to deals that are ending in the next 12 months is less than half that. We very consciously sought to extend out the weighted average life of the equity in our book today, that sits at about 2.6 years. But importantly, beyond just looking at the average, I think it’s important to look at really the exposure to deals that specifically are coming up in the next six to 12 months, and we’ve worked hard to minimize the fund’s exposure to those types deals. To get back to the broader question, though, 2018, five years ago, was really a bumper crop for CLO issuance, with most CLOs being issued with a five-year reinvestment period.

2018 was also a year when liability spreads were extraordinarily tight. They were at post Great Financial Crisis tights in fact, which was great for CLO equity, still is good for CLO equity. And those liability levels have been in the money effectively from the standpoint of the equity, meaning that they are tighter, cheaper than today’s market prevailing liability costs. And that means that, those 2018 deals have not, over the course of the last five years, been reset or refinanced. And they are now five years later, coming up on the end of their five-year reinvestment period. It is, I think, very important to remind folks that the end of a CLO reinvestment period does not in and of itself create any forced selling whatsoever of loan assets.

What happens at the end of the reinvestment period is that, managers are effectively restricted or, in some cases, entirely prevented from using loan prepayment proceeds to buy new loans. So, instead, these prepayment proceeds which, again, last year was about 14%, looking at the entire loan market. These proceeds are used to pay back — to repay CLO debt liabilities, the debt financing and the structure, in order of seniority across the tranches. So CLOs will pay back their AAA tranche, which, of course, is the cheapest tranche first as the fund naturally delevers the arbitrage. Because you’re paying back your cheapest debt, the arbitrage will erode over time, which at some point, incentivizes the CLO equity investors to just call the deal, redeem the fund, the CLO manager is compelled to sell all of the loan assets held within the fund, use the proceeds to repay all the remaining CLO liabilities and anything left over is distributed to CLO equity.

However, particularly with these really cheaply financed 2018 vintage deals, the distribution stream can remain quite robust for the benefit of equity investors. And we think, again, particularly with these 2018 vintage deals, equity investors might decide to just kind of let it ride for as much as one, two, even three years before finally deciding to call the CLO. So to get back to the original question, what happens in 2023 with so many deals ending their reinvestment period? Not necessarily anything, other than those deals ceasing to be active loan buyers in the market. We happen to be able to view that, these funds will naturally prepay, naturally wind down for some time until the loan market rebounds from current levels. And when that happens, whether that happens in 2023 or 2024 or and any point in between, we do anticipate that some of those deals will end up being redeemed and called and will go away, will cease to exist.

And some of the — those deals will probably the cleaner ones that have incurred fewer losses. And have cleaner loan pools, will the CLO equity investors in those deals will look to reset them? and extend them out at a time at which loan prices have moved up and CLO liability financing is at tighter levels than it is today.

Robert Chenoweth: Excellent. And that we’ll take care of that. Gretchen, thank you so much for all of your insight today. Of course, we enjoy it every quarter, and Kim, thank you for your time and your insights and thoughts. We appreciate it. And of course, everyone for attending today. I will send out replay information. You can access that on our website at xainvestments.com as well as other value-add materials. Feel free to reach out to us any time for more info and follow us on LinkedIn for more firm announcements such as webinars and other events. So, enjoy your day, and thank you again. We appreciate it.