XAI Octagon Floating Rate & Alternative Income Term Trust
Q3 2019 Earnings Call Transcript

Published: 3 Dec 2019

[Kimberly Flynn:]

Welcome to today's webinar for XFLT. My name is Kimberly Flynn. I am a managing director with XA Investments. We serve as the advisor for the trust and we are pleased to join you today to talk about the fund and its performance for the period ended September 30, 2019. I am joined today by Lauren Basmadjian. She is the Lead Portfolio Manager for XFLT. She has been with Octagon since 2001 and she is a senior member of the investment team, a member of the investment committee. So we are very pleased to have Lauren on the call today to talk with you about the fund's performance and to also provide you insight into the market for senior loans and for CLOs.CLOs have been in the headlines this past quarter. So there is a lot to discuss on today's webinar. A few general disclosures as we get started. The presentation today will have performance which represents past performance. Past performance does not guarantee future results. Current performance may be lower or higher than the performance quoted in the presentation. This presentation will be made available on the XA Investments' website for your review at a later point. The presentation today does contain forward-looking statements and we suggest that investors not to place undue reliance upon those forward-looking statements.With that, we will get started and talk a little bit about how the fund is positioned in the market today. So XFLT, the investment rationale for the fund remains true since inception, meaning the fund is, we think, an attractive combination of senior loans and CLO investments packaged in what we think is the best structure for CLOs. This is an actively managed fund featuring the investment expertise of Octagon Credit and there really is no better way to bring this mix of investments to investors in the marketplace. The fund does feature monthly distributions at an attractive rate. It also provides attractive diversification from traditional stock and bond portfolios. The shares are listed on the New York Stock Exchange. We do have a 1099 tax form that is typical for 40 Act closed-end funds and the fund we think is competitive with other institutional investment products with competitive fees. And so together, XFLT really does represent a unique way to invest with Octagon in loans and in CLOs. And this combination is designed to enhance risk-adjusted returns over time and we like the combination of senior loans, CLO debt and CLO equity altogether.If you look at it, comparing of distribution rates, here we show XFLT, which has a current distribution rate of 9.82% as of November 1. We think that the fund has an attractive income profile relative to other asset classes in the marketplace. So on the top, you see U.S. Treasury is yielding 1.69%. At the bottom of the bar chart, you see CLO debt yielding 9.73%. We have highlighted in green the two bars where the fund does invest which is the senior loans. The fund will also invest in second-lien loans and the fund also invested in CLO equity. There is no representative benchmark for CLO equity so we can't show it to you here on the chart. The IRR is for CLO equity are significantly higher than the yield for these representative index shown here on the slide. And that's part of a component of the distribution rate for XFLT. The fund does have an allocation to CLO equity that ranges anywhere from 30% to 35%. And Lauren will talk about the asset mix and how that's changed a little bit from quarter-to-quarter.So XFLT was designed to feature the investment expertise of Octagon. Octagon is a leader in the marketplace for below investment grade credit. They have been managing CLOs and below investment grade portfolios since 1994. The firm has grown significantly. They have $24.9 billion in assets under management. Much of that growth has been in the time that Lauren has been part of the team, having joined the firm in 2001. And we think that the success of Octagon is really a combination of the capabilities and the expertise that you see shown here, meaning their process, their people, their performance. It's really the combination of skills that you want when you are navigating different market environments like today and when you are investing in below investment grade credit. This is a cycle-tested team, having managed through various cycles in the past and obviously XFLT is really the first way or opportunity for individual investors to be able to access Octagon's institutional capabilities in an SEC-registered fund format.Now we will show you just a little bit more about Octagon in terms of the significant growth that the firm has experienced in its history. This shows the asset breakdown in terms of how the fund, the different types of products and asset mixes that they manage. Obviously with $23 billion in bank loans, they also have structured credit multi-asset class credit products and so it runs the gamut. Everything is below investment grade corporate credit focus and the team and Lauren can talk with you about their process is really set up to manage these credit portfolios with a consistent, time-tested process.This fund is unique from other closed-end funds in the marketplace, given its CLO exposure. So I would just like to touch on the CLO marketplace and the growth that it's experienced in the last 10 to 12 years. The market has expanded. It now stands at over $650 billion CLOs in the collateral pools underneath the CLO. They are holding senior loans and they represent about 55% to 60% of the outstanding loan market. And this is compared with loan-focused mutual funds or ETFs which only hold about 12% of the loans in the marketplace. A year ago, this percentage was a little bit higher but we have seen more loans held by CLOs in the last year. There has been a strong amount of issuance on the 2018 and 2019 in terms of CLOs coming to market which is representative of this buyer base of institutional buyers for CLOs that has expanded and it includes ranges from pension funds to insurance companies, long-term asset managers. There really has been a lot of interest in the CLO asset class, all the way from the AAA CLO debt on down to the CLO equity, just depends on people's risk appetite.Now I will turn it over to Lauren and she will talk a little bit more about the fund, how it's positioned our holdings and her market outlook. Lauren?

[Lauren Basmadjian:]

Thanks Kim. Page nine provides a snapshot of the trust as of September 30. The trust NAV decreased to 8.22% from 8.79%, largely reflecting unrealized losses due to the valuation changes for the trust investments and CLO equity, CLO debt and performing loans. The trust asset allocations were relatively stable over the third quarter. Senior secured first lien loans and CLO equity continues to represent the trust's largest asset allocations with CLO equity positions comprising the trust's top 10 holdings.Page 10 provides a quarter-over-quarter summary of the trust's portfolio. As you could see, our asset allocations remained relatively consistent. Portfolio turnover was around 15% in the third quarter, compared to 22% in the second quarter. Third quarter trading activity was focused in the trust performing loan and CLO equity baskets. We purchased about $7 million par amount of equity positions in three CLOs in the third quarter at a weighted average purchase price of 75.6 and there is one sale of CLO equity position in the third quarter. We purchased one CLO deposition as well in the third quarter. And it bears noting that the proceeds from the trust's ATM program and have helped to fund the trust purchases of more accretive CLO equity and debt positions. The weighted average current yield for the CLO equity positions purchased in the third quarter was 19% on a purchase cost basis versus 16.1% for the trust's CLO equity, both as of 6/30. For CLO debt, the current yield for the third quarter purchase was 9.5% versus 8.7% for the trust CLO debt holdings as at 6/30.The next few pages present the trust's top five holdings by asset class. We continue to hold larger position sizes in the CLO equity compared to other appetite. The trust's top five CLO equity holdings share similar investment thesis in that they have attracted capital structures relative to the current market. So the weighted average cost of capital of what we own is L+151. Today, if you were to create a new CLO, you are probably creating closer to L+190 on CLO liabilities. And the majority of what we own have longer reinvestment periods. We like these positions for the current income generation and generally believe that they could benefit from any future periods of softness in the loan market and improving spreads in the loan market as well.Turning to CLO debt. That will be tranches continue to comprise the trust's top five holdings. Spreads on these assets range between 6.10% to 6.75% and the all-in average is 8.76%. Looking at the trust's top five year senior loan positions, the weighted average all-in rate is 7.17% as of 9/30 compared to the trust's entire performing loan portfolio. The weighted average all-in coupon is 6.39% versus 5.66% for the broader loan market. So higher spread loans in this portfolio than the market on average. The trust holdings in bond and equity and opportunistic segments are presented in the other top five box on the bottom page 12. We hold one high-yield position at the end 9/30 which was sold subsequent to the third quarter.Moving on to our loan market observations. Loans have generated strong year-to-date returns of 6.3% through October 31, despite the market facing pressure in recent months following the technical snapback from the loads hit during the selloff in the latter half of the fourth quarter of 2018. November was a positive month with loans returning an estimated 59 basis points inclusive of November loans have returned 6.94% year-to-date. In the context of the ongoing broader market volatility throughout 2019 and heightened sensitivity to risk, we have seen a flight to quality in the loan market. Higher qualities that are BB rated loans have outperformed loans than at the riskier end of the rating spectrum B- and CCC loans, reflecting increased bifurcation in credit performance. Illustrative of ratings bifurcation within the secondary market, BB loans have lost only 80 basis points on a market value basis since early May, compared to 2.97% for B rated loans and 8.94% for CCC rated loans. All told, the gap between the average bid price of BB+ loans and B- loans has widened to 580 basis points as of 10/31, the highest level in years and that compares to 160 basis points differential in the beginning of 2019.Turning to the primary markets. Since March, new issue spreads have decreased by 52 basis points for higher-rated loans, so BB and BB- loans while spreads for lower rated loans, the B categories has widened. In several instances, B borrowers have had to offer lenders improved economic and revised deal terms in order to execute their transaction. The bifurcation trend is partially a reflection of technical factors within the loan market. CLOs which are the dominant buyer of institutional loans have limited portfolio capacity for lower rated assets and must be managed to average ratings of CCC basket. We have seen CLO face increased CCC basket pressure and that's resulted in less of a bid for B- weighted assets and underperforming be B credits have often gap down on earnings that disappointed or industry news that was troubling. While performance dispersion has been the dominant trend in 2019, it does bear noting that the loan market has firmed over the past couple of weeks as earnings season has wound down and we have seen more managers turning cash to working in the B universe. Although LIBOR has decreased, loans continue to offer comparatively high yields as well as some convexity opportunities. The average current loan yield was 6.73% as of October 31, which has ticked down to 6.47% as of November month-end. As of 10/31, roughly 75% of loans were marked below par with many well performing loans trading at discounts. This has actually decreased now to 68% as of month-end of November. Lastly, loans are offering higher yields than high-yield bonds on its average yield to maturity basis despite loan seniority in the capital structure, reflecting particularly strong dynamics in high-yield market. As of October 31, their loans were trading 34 basis points wider than bonds, though the gap has since narrowed to 10 basis points.Continuing on to page 14. U.S. economic growth is decelerating but still positive and the U.S. consumer remains strong. Overall corporate earnings growth continues but with greater performance dispersion among issuers and more ratings downgrade resulting from lower profitability of certain companies versus original expectations, tariffs and other headwinds negatively affecting global growth and some dividend yields as well. On the positive side, after several years of deterioration we are seeing modest improvement in covenants and loan documentation. Low default represents another positive. While we anticipate loan defaults will increase from current levels, we expect the default rates remain below the long-term average in to 2020.On to market technicals. We have been impacted by shifting interest rate outlooks and broader market volatility. Retail alone redemptions have continued over the course of 2019, though at a more modest pace than as the year has progressed. Importantly, the contracting size of the retail fund complex which currently represents about 12% of the loan market should diminish the impact of future outflows. Notably, most of the loan redemptions float into high yields which is not a risk of trade rather outflows were caused by a shifting rate view. If funds stabilize, it could support a more sustained rally on lower rated assets because loan retail mutual funds are unconstrained buyers. They don't have CCC test or rating stuff like CLOs do. Meanwhile CLOs continue to represent the lion's share of loan demand. So new CLO formation totaled $90 billion year-to-date as of September 30 and we are definitely on track to meet projections of over $100 billion of new CLO deals this year. We remain cautious as 2019 comes to a close and anticipated periodic bouts of market turbulence in the months ahead. In a potential weaker growth environment, strong bottom-up fundamental credit research, proactive risk and portfolio management and prudent relative value focus will be paramount to loss avoidance. At current levels, loans offer high current income compared to other fixed-income classes as well as low duration risk. Moreover, we believe that loan's senior priority and secured nature can help portfolios withstand challenging market environments.Page 15 charts historical loan yields and loan default rates. As you can see, the third quarter and yield of 6.62% is above the long-term mediums. Meanwhile, the LTM default rate for loans is well below the long-term average. Taken collectively, these metrics suggest that loans offer compelling value for the assumed risks.On page 16, we review loan repayments and the relationship between repayments and CLOs. CLOs typically generate cash from loan repayments at par. During periods of volatility when loan prices decline, repayments provide CLOs with the capital to buy discounted assets and benefit from possible par appreciation or buy loans at higher coupons which would increase the yield on the underlying portfolio in the arbitrage because the liabilities are fixed. Historical loan portfolio repayment rates averaged about 24% per year therefore providing the CLO manager with a continual stream of cash to reinvest. When credit spreads widen, loan prepayments and amortizations are recycled into higher yielding assets and we are in one of those periods right now where we are able to reinvest at either lower dollar prices or higher spread assets.Page 17 turns to the CLO market and we look at CLO debt performance during the third quarter. Performance amongst debt tranches are mixed. AAA and AA tranches produced positive returns during the quarter while outsize losses in August negatively impacted third quarter returns for BBB and BB notes. Following a weak October, CLO debt performance was strong in November with monthly returns ranging from 31 basis points for AAA to over 2% for B. Increasing spreads and low loan defaults are supportive of healthy CLO performance and 80% of reinvesting CLOs hold less than 1% of defaults in their portfolio. But loan price volatility has resulted in volatility in CLO equity prices which you saw flow through to the XFLT portfolio in the third quarter of this year. In third-quarter, new issue CLO spreads widened across the capital stack. Mezzanine debt, so BB and B spreads widening was driven by elevated secondary supply and volatility seen in the loan market.While we hold the view that current market environment is reasonably supportive for CLO investors, credit risk is escalated and we have seen some par deterioration for managers selling underperforming loans and pressure from downgrade to CCC. Investors remain focused on collateral managers' ability to manage tail risk in the underlying portfolios. As the year has progressed, we have observed ongoing tiering among collateral managers, particularly at the bottom of the capital stack. Tiering occurs in the CLO market as investors' view towards collateral managers are reflected in pricing and trading levels. So more established seasoned managers are generally considered top-tier will see their deals priced and trade tighter to those of smaller or less experienced managers. In the context of increasing idiosyncratic credit issues and loan downgrades, we expect this continued tiering and disparity in CLO manager performance. Lastly, current liability spread level suggest that CLOs offer relative value to broader credit and other structured products as further illustrated on the chart on this page.Over the past couple of weeks, we have seen significant tightening of BB after they reached L+800 level in late October and early November. We believe that level led to more buyers stepping in with new issue BB since tightening to the low to mid L+700 range. The pace of new CLO issuance has been steady year-to-date at just over $100 billion of new CLO issuance and that remains on track to meet supply forecast of about $110 billion to $125 billion for the year, probably closer to the lower end of that range. Meanwhile CLO reset and refinancing activity remains muted compared to prior years due to wider spreads on the CLO liability stack.Secondary CLO trading volumes have remain elevated throughout 2019 although third quarter volumes were a little lower than prior quarters. Looking ahead, we believe new CLO issuance will remain healthy into 2020 though lighter than 2019's volumes. This is driven by existing warehouses that will be termed out into CLOs, new and debut managers with large internal equity commitments continuing to enter the market, CLO equity funds continuing to deploy locked-up capital and continued AAA demand from both foreign and domestic investors. We expect CLO debt spreads will remain relatively range bound. Deals of less subordination or underperforming riskier collateral pools should continue to trade wider, reflecting investors' focus on the collateral managers' ability to manage tail risk. Market value cushions are also lower which will likely cause investor caution towards the asset class.In our view, the current market environment is reasonably supportive with the loan investors as healthy investor demand for across the CLO debt tranches. The loan market conditions are constructive for collateral managers. Few loans trade above par, which allows managers to ramp collateral portfolios efficiently in the secondary market and new issue loans are coming at wider spreads. CLO equity investors should continue to benefit from CLO managers who are able to increase coupon and manage idiosyncratic credit losses and credit risk.Pages 21 and 22 provide further detail on market technicals and credit fundamentals and how the relevant metrics have changed over time. I will say, we have seen a little bit, we have seen leverage increases bring more dispersion in performance of the underlying companies as far as sales growth and EBITDA growth. So the market on a whole on average is growing sales and EBITDA certainly at a slower pace than may have been in the prior quarters.Unless there are any questions, I will turn this back over to Kim.

[Kimberly Flynn:]

Thank you Lauren. We definitely want to save time for questions for Lauren. I have got a couple online. So let me be brief with summarizing the financial statements and a little bit about the secondary market update and then we will do Q&A.On 23, we provide the net earnings report. Here, we are just showing earnings per share and distributions paid. The fund does have an income-based distribution policy. We want to be paying out what we are earning and we strive to do that. The fund pays monthly distributions and you can see the fund's distributions paid over the last 12 months lines up with the fund's net investment income and realized gains per share. And the fund has been active with its at-the-market DRIP program so there is a little bit of disconnect in terms of when the cash comes in and when it's deployed. That issuance through the ATM program is accretive. Shares are being sold at a premium to NAV and is helpful in terms of being able to deploy assets into some of these opportunities that Lauren has described.Net returns. This provides returns since inception and for the quarter-to-date, year-to-date and one year. The net return performance does assume the reinvestment of distributions.NAV returns here are reflective of the NAV decreases to the fund that we have observed. We have seen unrealized losses in the CLO debt and CLO equity positions and those unrealized losses are largely due to model driven valuation changes and so this performance, bear that in mind, the fund is earning its distribution and I think there has been a lot of opportunities for investors in the secondary market as they look at the unrealized NAV losses and we use third-party evaluation. And so we are not driving the valuation and so there are opportunities in the secondary market to the extent that you feel like the fund's NAV is lower than it should be. And so this performance is reflective of where we stand today.In terms of secondary market, the fund does have a current premium of 7.77%. On average, the fund since inception has traded at a 1%-plus premium. We have seen an uptick in volume in terms of average daily trading volume in the last 90 days. It's been about 73,000 shares, which is significantly higher than the average since inception. So we are pleased that the secondary market for the fund continues to grow and be healthy.Another way of looking at the secondary market is just looking at price of NAV. Here we compare price of NAV with the S&P 500. Obviously, it's been a strong bold equity market and you see that in the orange line.I mentioned the ATM program. The fund has been active, having sold 1.8 million shares. ATM proceeds, common proceeds to the fund have been $16.58 million. This ATM or DRIP program has been helpful accretive way to grow the fund in terms of its size and scale. It also allows Octagon to deploy capital into some of the opportunities that we talked about in CLO debt and CLO equity where evaluations are lower than they have been in the past.Now here, our fiscal year ended September 30. We provide the audited financials. I won't take you through the balance sheet or the other financial statements just in the interest of time. So we make those available here. They will also be in the annual report. A couple of highlights just in terms of financial highlights on page 32. We have seen the decline in the net asset value. We have talked about the reason for the decline of the net asset value due to unrealized losses in primarily the fund's CLO debt and CLO equity holdings. We have talked also about distributions importantly being earned through income or gain. And so we just wanted to share that with you. The leverage facility has, we have kept leverage at about 32%. We have been able to add a small amount of leverage to the fund for the quarter in line with the issuance of common shares via the ATM program.Portfolio holdings. This is the full list of holdings. We do provide them monthly with a one month lag. They are posted on our website each month. And so we welcome you to review holdings.

[Kimberly Flynn:]

I think now just in the interest of time, what I would like to do is address a couple of questions that we have had. The first question is for Lauren. The question is, CLO equity has been volatile this year as the proportion of B- rated loans has increased which could stress CCC buckets and impact cash flows. How do you see downgrade progressing given the late stage of the credit cycle and what is your outlook for sustainability of CLO equity cash flows?

[Lauren Basmadjian:]

Yes. I mean that is the topic du jour. We have certainly seen downgrades increasing to CCC. I think on average, the downgrade rate in the market just in general downgrades has been about a little over 5% per quarter over the last five years with a small uptick or an uptick when we went through the energy crisis and that was very industry-specific. So we saw a lot of downgrades coming out of metals and mining and oil and gas. In the third quarter though, we saw downgrades tick to over 7.5%. And we are seeing more downgrades to CCC. We are seeing CCC baskets increasing. On average, we are still in the 4% range that we are looking through to portfolios and CCC baskets are generally 7.5% for CLOs.So what happens when you took that CLO, CCC basket, as you start marking to market the lowest dollar priced loans in your CCC basket and that affects your ask over collateralization rate. We still see pretty healthy cushions in almost of our OC or over collateralization tests the spectrum of CLOs and we are not forecasting a widespread equity shut off anywhere in the near to medium term. But what does concern me is that there have been a lot of new managers that have been created over the last few years. Many have not managed CLOs through cycle and they are very specific complex vehicles.So managing the CCC basket, managing the credit risk within the CLO, I think what you are going to see is more and more dispersion. You are going to see some managers that will never miss the distributions in the next cycle and you will see others that will miss equity distributions. And I think that just gets to the dispersion in one, understanding the underlying credits having a full team that's built out to work through most multiple credit cycles, the resources available to continue to invest in your team, even at times when you are not raising new funds and perhaps AUM is even shrinking and the understanding of how to actually take a CLO through the cycle.

[Kimberly Flynn:]

Thank you Lauren. And operator, do we have any questions on the line or can we make lines open for questions?We do have one more while we are waiting for the operator to open up the lines for questions. We do have another question on the webinar. This question is also about the CLO market. So the CLO primary and secondary market have been somewhat frozen, as a characterization, with reduced volumes and wider bid-ask spreads as investors assess risk. How do you characterize the trends in recent CLO equity performance in November?

[Lauren Basmadjian:]

Well, November still had a decent issuance month, I think with almost $10 billion, so certainly very healthy new issue comparative to historic averages. I will say that we saw loan prices move up in November and for the first time in a while we saw B loan prices move up which should help NAVs as CLO equity and I would expect over the near-term to see a little balance in CLO equity. The other thing that happened in November was after significant widening in mezz, we saw a lot of buyers step in to buy mezz. And for the first time in a long time, we are seeing new issues CLO BB be oversubscribed. And as soon as they launched, we can see the book being oversubscribed by maybe two times or three times. And so generally that was the hardest part of the debt to place in a new issue CLO over the course of 2019. That shows that the market has just oversold and its corrected pretty quickly over the last few weeks. So we see BB bids increase and the spreads come back in from what probably widened to 8.25% for top-tier new issue CLOs down closer to 7.25%, so 100 basis points of tightening in new issue top-tier over the last couple of weeks.

[Kimberly Flynn:]

Thank you Lauren. We have a question just about the ATM proceeds raise and how has Octagon been able to deploy those proceeds into the market? What opportunities are you finding right now?

[Lauren Basmadjian:]

Yes. So we are finding the most accretive opportunity is to be in CLO equity and some CLO BB as well. So the loans that we have been buying which is roughly 50% of the portfolio closely mimic on the type of spreads and yields that already have in the loan book. But for the other 50% that we are deploying which is roughly 15% in CLO BB and 35% in CLO equity, we find those purchases to be very accretive at much higher IRRs or yields than what we had in the existing portfolio. The CLO, the ATM program which I believe started to issue shares in mid-May, really in a way timed the market quite well in that there has been CLO equity selloff pretty dramatically in the third quarter and CLOs BB as well. So we have been able to be in the market and been a buyer at the entire yield with the proceeds that we gotten from both the ATM and the overnight.

[Kimberly Flynn:]

Great, Lauren. Operator, if we don't have any questions, we have addressed the questions on the webinar. And so we will sign off. Thank you very much Lauren and thank you all for joining us today.

[Lauren Basmadjian:]

Thanks.