Structured credit in a diversified portfolio

Hi, I am Jim Smigiel, SEI's Chief Investment Officer, and today we're here to discuss collateralized loan obligations in a total portfolio context. And with me to help us along is Brian Hoffman, SEI's Global Head of Advice and Asset Allocation. Brian, thanks for joining us. Of course, I thought I would start off by talking about CLOs as an asset class because that's really how these things have evolved, and I think maybe investors still when they hear this term, CLOs, are thinking of individual securities, but the reality is there's lots going on in that asset class to help lots of different types of investors improve their portfolios. Can you walk us through that a little bit? Absolutely, and it's, I think very instructive not to view CLOs as this one kind of homogeneous blob because while they're backed by the same pool of collateral, even any individual CLO deal has a tranche that's AAA and resembles the kind of risk and return of high quality sovereign bonds and has an equity tranche that is arguably riskier and we expect offering higher expected returns even than public equities. And so they fit very different roles in a diversified portfolio and can play very different roles. To your point, for different organizations, an insurance company might be very interested in the AAA tranche, right? Because they've got credit quality, they've got risk-based capital haircuts that they have to take on various securities and types of securities depending on their credit quality. And so AAA offers really compelling expected returns because they tend to outspread AAA sovereign debt or even AAA corporate bonds. There's a bit of a complexity premium on this a hundred percent, hundred percent. I think there's a number of reasons why it's reasonable to expect higher returns out of comparably rated CLOs compared to their corporate credit counterparts. Complexity being one of them, some residual kind of global financial crisis related misnomers, right? Anything with the word collateralized, even the things that turned out perfectly fine get painted with a broad brush. A lot of it I think is benchmark constraints. And so you don't see CLOs in the aggregate bond index. So a lot of investors who are more constrained aren't really able to buy them without eating into their tracking error budget. And that's something that creates a constraint on sort of the natural buying market. It is really important to think about the different risk and return characteristics of those tranches, both in sizing your allocations to the various CLO tranches and in funding them. So it would be irresponsible to fund equity tranche CLOs from high quality sovereign debt unless you really need to jack up the risk of your portfolio. It would also probably not be the wisest idea to sell some public equities and buy AAA CLOs because you're going to give up return, if you want to de-risk, fine. But if what you want to do is stay in kind of the risk profile you're in while increasing your expected return, that funding source is going to vary depending on the CLO tranches you buy. It might be high quality sovereigns for the triple A through single A tranches. It might be lower quality corporates or even a little bit of public equity for the lower mezzanine, triple B through single B tranches. And if you're going to be allocating to CLO equity, it makes sense to fund it from full beta public equities. And we think you can generate a similar risk profile with, in our view, higher expected returns that way. Interesting. So maybe let's focus on that end of the capital structure. So the more aggressive side of things. What are some of the interesting characteristics of say, A CLO equity position that an investor would expect to see? So interesting characteristics from maybe a risk perspective, but then also interesting characteristics from a return pattern perspective. So CLO equity is particularly interesting, right? Because the underlying collateral is loans, right? So it's got this floating rate coupon. And then obviously because of the waterfall structure of the CLO, the equity participates first in losses, but the benefits in the event that losses don't exceed expectations or even if they exceed expectations and not buy too much, the payoff to CLO equity can be very attractive and it can be very attractive from a cashflow perspective as well. It plays really nice in the sandbox with other high octane asset classes like private equity for instance, where you've got very high expected risk and expected return from private equity, but the cashflow profile is much more delayed. It takes a long time even to deploy your capital in private equity, you're relying on kind of a capital call schedule and opportunities arising with the manager. And then even once the capital is deployed, we're talking a decade or more in many cases to get money back from those investments. CLO equity, as long as covenants aren't being breached and things are going as expected, is paying distributions consistently. And so if you are, say, an endowment or foundation with a spending need, so you've got a long time horizon, a high risk tolerance, and so you've got a high return target, but you've got to keep the lights on in the meantime, and so you've got operational spending needs. CLO equity can be very attractive from that perspective because it's generating that cashflow without diluting the long-term expected growth of your portfolio. Interesting. So kind of like a reverse J curve, right? You have very front loaded cash flows for equity-like returns as opposed to backloaded cash flows for equity-like returns that we would expect to see with a large private equity allocation.

As it relates to risks. You've mentioned loans are obviously the underlying part of the collateral pool. They're floating rate in nature, so obviously the first thing that jumps out, what's the interest rate sensitivity profile of a CLO? Yeah, so because the collateral is floating rate, generally very little interest rate risk, which is a good thing if your portfolio in its traditional fixed income allocation is sort of overloaded to interest rate sensitivity. It doesn't mean that any CLO tranche doesn't have risk. Obviously they all do to varying degrees, and they all participate at different points in losses, but the risk isn't driven by interest rates so much as it's driven by general economic credit earnings conditions. So it's being driven by the ability of the underlying collateral to pay its interest and principal payments, the equity tranche will lose out first in the event that there are defaults that'll move up the stack all the way to the AAA, which has a lot of subordination. It takes a whole heck of a lot for an equity trust to be impaired for an AAA trust to be impaired. Excuse me. Right, and it's worth pointing out, we're talking about the bank loan pool, the underlying collateral. I mean, this is an actively managed pool. I mean, you might not have managers attached to this pool that are looking to beat an index, but you have managers attached to this pool that are looking to avoid defaults. And I think that's an important part of the structure as well, particularly when we're thinking about it from a risk perspective. So you have no interest rate sensitivity really to speak of. You have a lot of credit sensitivity, obviously, so you're not getting any interest rate sensitivity. You're getting spread duration, and that's really the pure risk that you're taking on, but you're taking on in an actively managed capacity because you have a manager attached to the pool.

And speaking of active management, we talked a little bit earlier about this as an asset class that has evolved. We have ETFs in the market now, particularly at the higher end of the spectrum. There's indices attached to the CLO market now, which is kind of interesting. When you're allocating a client's portfolio, you're certainly taking the ability of that particular asset class to produce excess returns into account. Right? And you would imagine those more inefficient asset classes, emerging market equity, small cap equity, are going to provide the higher probability of outperformance, or at the very least, we would expect them to be more well stocked ponds as it relates to producing excess returns. Where do CLOs fit into that? I think you're spot on. We've got no issue with CLO ETFs. I think they have a time and a place, and particularly for retail investors, potentially tax sensitivity comes into play. There's nothing wrong with a buy and hold passive CLO allocation in an ETF format. There are constraints that apply to CLO ETFs as with all ETFs. So the most obvious would be that they're generally only buying the highest rated stuff, so that's not necessarily a bad thing. It's just limiting. It means you're not going to be able to get as high an expected return as you could get if you moved a little bit lower in the capital structure. Importantly, also, they kind of, by virtue of the intraday liquidity of the ETF structure, have to buy the most liquid issues in the CLO market, which again, inherently isn't a bad thing, but it generally means you're not going to be able to harvest any illiquidity premium. You're not going to be able to get the higher returns that you would expect from something lower in the stack that is less liquid, but still reasonably liquid. We're firm believers as allocators and active strategies, because the fewer constraints we impose on a strategy, the more opportunities there are and generally the higher risk adjusted returns you can expect. And one of the main reasons for that is because of the heterogeneity of the CLO stack, an active manager is able to identify opportunities and say, okay, I think I'm being rewarded in as right now. No, I think I'm being rewarded in equities right now. It's not always kind of a matter of a rising tide lifting all ships. It's not as easy. It might be easy to say, okay, small cap equity looks undervalued, so I'm going to buy small cap equity as a whole. And CLOs, there's sometimes a trade off, right? The debt tranches are providing financing for the equity tranche, so when spreads new issue spreads widen on the debt tranches, that's attractive for those buying the debt. It's less attractive for those buying the equity because they're paying higher financing costs. So an active manager who's able to dynamically move up and down that stack, depending on where the opportunity is, is really valuable for us as allocators.

So we've been talking about the CLO asset class, the beta, if you will. I wanted to transition a little bit and ask you a little bit about Alpha as an allocator. When you look at asset classes, you're not only assessing the characteristics of the underlying, but I think you're also assessing the excess return opportunity set. And I think it's probably fair to say that in more or less, I should say, less efficient asset classes, say in emerging market equity or a small cap equity, we would expect that the opportunity for excess return would be greater. How does CLOs fit into that? I think you're spot on. What we get is the actual return of the portfolio we invest in, which includes the beta and includes any alpha that the manager does or does not generate. Both are important. We feel that in the CLO space, active is particularly important because there's a lot of nuance. Simply painting, as we alluded to, CLOs with this broad brush misses a lot of differential characteristics among the different tranches, and it's not always a rising tide lifting all ships. So you mentioned emerging market equity and small cap. If you have a view on emerging market equity or on small cap, it's fairly easy to say, I'll buy the index and if my view is correct, I'll make money. It's not as easy to say that about something like CLOs because the debt tranches actually provide the financing to the equity tranches. So when spreads on new issue, CLO debt widen, that's really attractive for the buyer of the debt. It's not so attractive for the buyer of the new issue equity because their financing costs just got higher. If you were to say, buy a AAA CLO ETF, or a single A-CLO ETF, and by the way, we don't think there's anything wrong with that. It's got a time in place. It's just maybe a little bit more useful for, say, a tax sensitive retail type investor as opposed to an institutional investor with potentially a longer time horizon and who doesn't experience the same constraints as that retail investor might. And so having an active strategy that is able to move up and down the credit stack based on where that opportunity is, is really valuable for us as an allocator because it means we can harvest all of the different sources of return premium that CLOs bring to bear, including that active management capacity. Excellent. Brian, thanks for that. I think we covered quite a bit of territory today discussing the kind of totality of the CLO universe, the different types of clients that it can be very, very useful for improving their portfolios and the role that active management plays. Thanks for your time and thanks for everyone for joining us today.