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CEFA: Welcome to CEF Insights, your source for closed-end fund information and education, brought to you by the Closed-End Fund Association. Today we are joined by Matthew Smith with the Closed-End Fund Association who will lead the discussion with Nishil Mehta, Managing Director with Carlyle and Portfolio Manager for Carlyle Credit Income Fund, New York Stock Exchange Ticker CCIF. Carlyle became the investment advisor for CCIF in July of 2023, which coincided with a change in investment strategy for the fund from mortgages to a focus on collateralized loan obligations, also known as CLOs. Carlyle has significant expertise in CLOs as one of the largest CLO managers in the world. Matthew and Nishil, we look forward to your discussion.
Matthew Smith: Nishil, we’re happy to have you with us today. Thank you so much for being a part of this.
Nishil Mehta: Thank you, and I’m happy to join the panel today to discuss CCIF and the Carlyle platform.
Matthew Smith: Perfect. Well, let’s dive right into it. Nishil, as we mentioned, Carlyle has specialized expertise managing and investing in collateralized loan obligations. Could we start by discussing what some of the key characteristics of CLOs are and also the advantages and risks with these investments?
Nishil Mehta: Sure. So a CLO is a diversified pool of 200 to 300 first lien senior secured loans to large companies with an average EBITDA of $600 million, an average loan size of approximately $900 million. The underlying loans in a CLO have a first lien on assets with payment priority over bonds and equity. That provides downside protection, resulting in a historical recovery rate of 63%, relative to approximately 44% for high-yield bonds. Because loans have a first lien on assets and are floating rate, they’re a stable asset class and have only experienced three years of negative returns in the asset class’s 24-year history. The U.S. loan market today is approximately $1.4 trillion in size, in line with the size of the high-yield market, and CLOs only purchase performing loans from mature companies. There are no distressed CLOs or venture CLOs. To finance the purchase of loans, the CLO manager issues debt with approximately 65% of the financing rated AAA resulting in low-cost financing.
The financing and CLOs are differentiated as the financing is locked in for a 12 to 13-year period and cannot be pulled. There are no market value-based triggers that could result in forced liquidations and periods of volatility either. CLO equity receives the residual cashflow from the income produced by the underlying pool of senior secure loans, net of the cost of the financing. CLOs are actively managed vehicles where a manager or CLO manager can actively trade the portfolio over the CLOs three to five-year reinvestment. Advantages associated with the CLOs include a sizeable market with a multi-decade track record and enhanced diversification. The U.S. CLO market today is approximately 1 trillion in size, representing over 60% of the buyer base of the 1.4 trillion U.S. leverage low market. CLOs have performed well through multiple cycles over the past 25 years, including the financial crisis and COVID due to the stability of the underlying loan asset class and the stability of the CLO financing.
Since the financing is locked in for 12 to 13 years and there are no market value triggers, a CLO can take advantage of periods of volatility by purchasing loans at a discounted price. CLOs are well diversified with each CLO holding 200 to 300 individual loans. Additional diversification requirements include the largest company exposure limited to 2% with the average exposure of less than 0.5% of a portfolio. Industry diversification with the largest industry limited to 12 ½% to 15%, and a 7 ½% limit on low rated loans or CCC loans, which possess a high likelihood of defaulting. What’s interesting is the average overlap across CLOs from different CLO managers is limited to 25% to 30%. So as a result, a portfolio of CLOs would typically have exposure to thousands of loans resulting in significant diversification. Similar to other credit asset classes, the biggest risk for CLOs is default risk, and more importantly losses in the underlying portfolio.
CLO equity is the first loss position in a CLO and therefore, bears the risk of defaults in losses. The annual default rate for the LSTA Loan Index is approximately 2 1/2%, which is about a full percentage point below high-yield bonds. At Carlyle, we use our internal credit expertise to complete bottom-up fundamental analysis on the underlying loan portfolios to seek to minimize defaults and losses. An additional risk includes failing coverage tests that CLOs are subject to. These metrics are measured quarterly to protect the CLO structure from potential collateral deterioration. If a coverage test fails, cash flows are diverted from the waterfall, away from the CLO equity to purchase additional loans until the tests pass again. CLO managers actively monitor these tests and communicate to the respective trustees through reporting.
Matthew Smith: Great, that’s really helpful as we lay the foundation here. Moving forward now, could you discuss a little bit about your CLO equity investment strategy?
Nishil Mehta: Sure. So CLO our equity strategy is to generate attractive risk- adjusted returns supplemented by high current income. We are typically targeting CLOs managed by CLO managers who we believe to be the highest quality, mostly with ample time remaining in the reinvestment period. Many of these portfolios appear to us to have attractive cost of capital. With active management and time left in the reinvestment periods, managers can capitalize on period to volatility to improve portfolios or reposition them. We may target small allocation to CLOs with shorter time left in the reinvestment period if we can source high quality collateral pools that we believe can generate higher returns. Now, Carlyle leverages its in-house expertise to manage the strategy, including Carlyle is a global platform with over 30 years of investing across numerous asset classes and over $350 billion in assets under management.
We leverage a “One Carlyle” approach through the firm’s 750 investment professionals and insight from our chief economist. Carlyle is also one of the world’s largest CLO managers with over $50 billion in assets under management and a 25-year track record across various market cycles. In addition to being one of the world’s largest CLO managers, Carlyle has a 15-year track record of investing in third-party managed CLOs as well. We also have a team of over 30 credit research analysts across the U.S. and Europe dedicated to the coverage of over 700 leverage loans. This deep bench of credit research analysts allows us to complete the bottoms-up fundamental analysis on each of the 200 to 300 loans typically seen in a CLO. In our view, our industry leading position and extensive track record is a key differentiator versus our peers.
Matthew Smith: Great. Nishil, what is your process to evaluate the CLO universe and make specific security selections for the strategy?
Nishil Mehta: Yeah, so we have a data intensive investment process that is highly automated leveraging Carlyle’s in-house expertise. Our investment process includes 13 steps, which is broken down into four main categories. One is economic trackers, so we have three separate economic trackers including leveraging proprietary data from the approximately 290 companies owned by Carlyle’s private equity group and financial statements from the 700 leverage loan issuers and Carlyle-managed CLOs. The second step is our CLO manager diligence. Since these are actively-managed vehicles, we spent a significant amount of time underwriting CLO managers, and we have a multi-step CLO manager evaluation process, including a quantitative ranking system based on 96 unique performance factors and a 30 to 40-page diligence presentation that we create to evaluate the CLO manager’s platform, strategy and performance and it’s inception. The third category are investment templates. We maintain automated trackers for the CLO secondary market.
We maintain relative value trackers, CLO primary trackers and investment committee memos to underwrite and price all investment opportunities that we see. Then lastly, portfolio management. We maintain automated weekly, monthly and quarterly reports to track the performance of individual CLO positions and the entire portfolio. Inclusive of the 13-step CLO investment process, we focus on four key areas to complete our bottom-up fundamental analysis. Those four key areas include sourcing and trading. Our scale, global reach and industry relationships enable our team to access a comprehensive origination network that is well positioned to source attractive investment opportunities. Second is manager diligence, which I just walked through. Third is collateral review. We complete detailed analysis of the underlying loan portfolios based on the credit level views from the team of 30-plus industry-focused credit research analysts, categorizing each underlying loan, depending on the industry expert’s view of overall risk.
My team can gain an in-depth, real-time market insight into the underlying collateral of each CLO position that evaluates, enhancing my team’s ability to dynamically monitor the risk. We also customize default scenarios and cashflow projections based on our credit research analyst views on the underlying portfolios. The fourth area that we focus on is CLO structure and documentation review. As one of the largest CLO managers globally, with over $50 billion in assets under management, we have the expertise to develop and manage complex CLO structures and documentation. We conduct a thorough review of CLO structures and each deal is evaluated on its projected returns and ability to withstand losses in the underlying leverage loan collateral. Each CLO is also governed by a 200-page indenture, which is highly negotiated and customized. We have a head of documentation who was previously a lawyer at a global law firm to review the legal documents for each CLO.
Matthew Smith: Great. Nishil, as you know, the Federal Reserve seems to be near the end of its rate-hiking cycle. Inflation has slowed but remains elevated and economic growth has been resilient. We also have significant geopolitical tensions that have contributed to volatility as well as the upcoming U.S. presidential elections this fall. Where do you see the fixed income markets currently and what is your outlook for 2024?
Nishil Mehta: Yeah, and this is a question we get often. So we observed a powerful rally in fixed income markets in the last two months of 2023. As inflation continued to decline and as a result the market pivoted its interest rate expectation. As a result, most fixed income markets ended 2023 at year-to-date tights. Now, we’re currently observing a partial reversal of the fixed income market rally in the beginning of 2024 as the markets reassess interest rate expectations. However, in senior secured loans and CLOs, we’ve seen a continued rally for the first month-and-a-half of the year. These oscillations and the market’s interest expectations and the geopolitical attentions and the upcoming elections we think will create pockets of volatility, creating opportunities to make investments at attractive prices. Our chief economist, Jason Thomas, is anticipating a soft landing based on the proprietary data we are receiving from the portfolio companies owned by Carlyle. However, we expect the economic growth will decline in 2024 from the resiliency observed in 2023.
Matthew Smith: That’s helpful. Specifically for the CLO market, what is the impact of greater volatility in the broad interest rate environment?
Nishil Mehta: Yeah, so market expectations can change pretty quickly. We’re just seeing that recently. The market was anticipating rate cuts starting as soon as March of 2024, but I think the expectation of rate cuts in March has quickly dissipated. We believe there’s potential for a higher for longer rate environment, which can pressure borrowers of the senior secured loans since the loans are floating rate. However, we believe the average borrower in the senior secured loan market can withstand the current interest rate environment. The average interest coverage ratio and the approximately 700 leveraged loan issuers in Carlyle-managed CLOs remains healthy at approximately 3.1x with only 4% of the companies with the interest coverage of less than 1x.
Given the uncertainties in interest rate movements and the decline in economic growth, we expect the current default rate of approximately 1.5% may return to the historical averages of 2% to 3%. We predict that defaults and restructurings will be driven by stress and distress issuers with limited options to address near-term maturities. As a result, we’re constructing defensive portfolios with CLO managers that have a track record across multiple cycles and CLO portfolios that we deem to be more conservative based on a fundamental analysis of each loan.
Matthew Smith: Nishil, is CLO equity currently an attractive asset class or are investment opportunities more security specific?
Nishil Mehta: Sure. So CLO equity has historically provided attractive risk-adjusted returns, including high cash-on-cash yields. The average net return for CLO equity over the past 10 years is 12.4% compared to 12% for the S&P 500. The returns for CLO equity are front-end loaded through quarterly cash distributions. Since 2003, excuse me, 2013, the average quarterly CLO equity distribution for deals in reinvestment period is approximately 4% quarterly. The elevated cash-on-cash yields are not materially impacted by movements in interest rates as the underlying loans are floating rate based off SOFR and the financing in CLOs are also floating rate based on SOFR as well. With the returns for CLO debt increasing over the past two years due to the elevated base rates, the required rate of return for CLO equity has increased as well. The expected returns for CLO equity has increased to mid to high teens versus a low teens that we’ve historically seen and we saw a couple of years ago. We are generally targeting CLOs with a considerable time left in reinvestment, which allows the CLO manager to actively manage the portfolio during periods of increased defaults and downgrades.
Matthew Smith: How does CLO relative value compare to that of corporate bonds?
Nishil Mehta: Sure. So CLO debt, which we view as more comparable to investment grade and high-yield corporate bonds trades anywhere from 90 cents on the dollar to par based on ratings, credit quality, time left in reinvestment and other factors. However, CLO debt tranches have historically provided a higher annual return and higher yield than corporate debt with lower historical impairment rates, which results in higher Sharpe Ratios. Lower rated CLO debt tranches, primarily CLDDS also benefit from the convexity upside, similar to the opportunities we’re seeing in investment grade and high-yield corporate bonds.
Matthew Smith: Understood. What are the most significant risks in the current environment?
Nishil Mehta: Credit and default risk in the underlying loan portfolios remains the most important risk, and specifically, we’re focused on the tails as the average borrower remains fairly healthy. The underperforming companies may struggle in an environment of slowing growth and potentially a higher for longer interest environment, and therefore, struggle to refinance upcoming maturities. In these environments, we really benefit from being part of the larger Carlyle platform, including being part of one of the world’s largest CLO managers. Through our credit research analysts and loan portfolio managers, we can identify and assess these tail risks in the portfolios.
Matthew Smith: Absolutely, and with this current environment in mind, how is your CLO equity investment strategy currently positioned?
Nishil Mehta: Our CLO equity portfolios are diversified by positions, CLO managers, and vintage resulting in exposure to numerous managers and thousands of underlying loans. Using our extensive and data-intensive investment process, we have invested in CLOs that meet the following criteria: high-quality CLO managers with experience in investing across various market cycles; defensive portfolios constructed to navigate a higher for longer interest environment; and CLOs generally with ample time left in the reinvestment period so managers can take advantage of periods of volatility and actively manage the risk in the portfolio.
Matthew Smith: Excellent. Nishil, how do you see an allocation to an actively-managed strategy focused on collateralized loan obligations best positioned in an income-oriented investor’s portfolio?
Nishil Mehta: We believe the attractive quarterly distributions of CLO equity is an attractive current income opportunity for investors. CLO equity can also contribute to portfolio diversification as it has historically exhibited a low correlation to S&P 500 compared to other asset classes. We believe CLOs are also well positioned to navigate all interest rate environments with lower impairment rates relative to similarly-rated fixed income asset classes.
Matthew Smith: Nishil, this insight is fantastic, and we thank you so much for taking the time to share your thoughts on CLOs and share more about Carlyle’s strategy with us today.
Nishil Mehta: Thank you.
