Interesting, Short Read on CLOs

Gary Hargreaves posted a short article on the Sandbox page relative to CLO exposure by a few companies that I follow to some degree so I am just posting the link for others that may have missed Gary’s post. The article is 6 weeks old, but still may be of interest.

The article is short and not detailed for the most part, but it does highlight some history and touches on Oxford Square (OXLQ), Prospect Capital (PSEC) and Saratoga Investment (SAR).

The bottom line is be cautious with what you own–dig a little deeper to find out who owns equity ‘tranches’ of CLOs (the riskiest tranches)–don’t chase the juicy yield some of the common shares pay, without understanding some of the risks.

Here is the article in the BDC Reporter

16 thoughts on “Interesting, Short Read on CLOs”

  1. CLO equity is essentially 10x leveraged exposure to loans with an average rating of B (+/-). Funding costs (and others costs like manegement fee) are quite high leaving limited cushion for the equity piece.

    Some of these CLO equity BDC’s buy an asset already 10x leveraged and put additional leverage on top of that !!

    Back in 08/09 most CLO equity pieces were marked down to 0-10 cents on the dollar. Maybe this will all work out fine, but I don’t see any risk premias in any CLO preferreds that justify even considering bying them…In honestly I was shocked when I learned that there were vehicles leveraging CLO equity 🙂

    1. CLO preferreds are like owning a senior tranche of the CLO. Well before there is any impairment to A rated tranches, the CEF’s asset coverage will likely drop to below 200%, the fund will be liquidated, and preferreds will be paid out at par with proceeds. The biggest risk is that liquidity is poor with CLOs, especially in a distress situation but even then, it shouldn’t be a problem to get 50 cents on the last mark in a liquidation. There’s a reason CEF preferreds typically come with high credit ratings.

      Obviously, you hope that the CEF won’t be in a position to have to liquidate (essentially a bankruptcy) but the asset coverage covenant is what makes these way less risky than the CLO equity that are the margin collateral.

      What’s funny is that I can buy CLO preferred common stock at E-trade and then leverage that 4x with margin. I think Etrade is taking the bigger risk with that margin customer than I am with PRIF-E.

      1. CLO’s are the definition of bad liquidity. They normally only trade based on bwic’s. Bad days = no bids…

        Wish I could look up one of the charts from 08 showing how fast you could go from par+ to virtually nothing. But if you combine highly leveraged PE bank loans with huge leverage in the CLO structure, a big drop is entirely possible.

        Not in any way claiming that the preferreds are as risky as equity pieces, but your compensation is also different.

        1. “Wish I could look up one of the charts from 08 showing how fast you could go from par+ to virtually nothing. ”

          Yeah, it would take an October 2008 type scenario before you would see damage to the high tranches of CLOs. In that type of scenario, even the A tranches would be toast. However, if PRIF existed in 2008 (and was in CDOs which are the equivalent risk of today’s CLOs), probably they would have had the margin call in March 2008 when Bear Stearns happened. PRIF would liquidate and pay out preferreds at par before Fall 2008 rolled around. That’s the benefit of a quasi super senior position in the capital stack.

          That said, I’m not betting that the next recession is another once is 75 year financial crisis. I think we’ll have something more like the slow motion stagflation collapse like the 1970s due to Fed monetization of debt and MMT.

          Once that starts getting priced in, the right move will be to rotate from fixed income to gold. But we have some time before that.

        1. jda,

          I’m not super familiar with OXLCO’s prospectus but yes, I believe the asset coverage covenant works the same way. While OXLC has the higher yield and shorter term, my problem with it is 1) you’re already tight on asset coverage. According to Tim’s spreadsheet, asset coverage is only at 214%. So another 14% lower and this CEF is in default. 2) NAV has been dropping like a rock (much more than PRIF). I think OXLC has too much exposure to energy and retail in their CLOs which have been the worst performers.

          Tim’s sheet says PRIF currently has 400% coverage but I don’t think that’s been updated for their ATM program and the E series issuance. Also, PRIF has a stated goal of issuing more preferreds until coverage is only 300%.

          1. Landlord–their ATM facility has made tracking difficult on PRIF, but now they have supposedly ended that program so maybe I can get a better handle on it. They do have 1 additional term preferred registered, but it has not been sold. I remember a year or two ago they used little leverage–and coverage was 800-1000%, but the term preferreds just keep coming.

            1. Tim, I think it’s a lock that PRIF will be issuing more preferreds and that coverage will drop to their stated goal of leverage. So, I base my analysis on an assumption of only 300% current coverage to be conservative. Of course, they could lever up to their goal by losing NAV instead of issuing preferreds LOL!

              From the most recent report:

              “Priority currently has $130.2 million of preferreds outstanding resulting in a ratio of 0.33x preferred to common
              equity as of June 30, 2019. Our goal is to target approximately 0.50x debt plus preferred to common equity over
              time.”

              1. There’s a lot to dislike about PRIF’s manager (the same crooks who manage PSEC) but the below underweighting is one thing they got right:

                “We continue to be underweight both the retail and oil & gas industries due to the underperformance seen in both
                markets. At June 30, 2019, Priority’s exposure to the oil & gas industry was 2.23%, compared to 3.86% exposure to
                the retail industry. We have evaluated our oil & gas and retail exposures with our collateral managers, and we continue
                to monitor our positions in these sectors.”

              2. Yes I agree Landlord. If there is personal benefit to them they will leverage to the hilt. When I reviewed their financials their NAV was the steadiest of all similar companies–got to love those level 3 assets I guess.

                Disclosure–I have a taste of the PRIF-D issue.

            2. I got out of my PRIF’s a few months ago, because of all the issues. I also got out of RILY this spring when they issued their 7th or so debt issue.

              Revenue has been increasing, but their Expenses and costs are increasing at same rate. Their debt is about as much as the equity as well. It is if they don’t want to crush their stock price, so they issue debt. I dont track them, but my gut says they are in too much of the distressed businesses and that is too much risk for me.

  2. One of the more interesting things I’ve seen about CLOs/bank loans lately is the vast amount of carnage in this space is in energy and retail loans. Energy/retail are a big part of the reason why CLOs have sucked wind lately. So, the key is to own CLOs with minimal energy/retail exposure. PRIF has avoided energy/retail from the beginning and I believe it’s one of the reasons their NAV has been far more steady than other CLO funds like ECC (either that or there are shenanigans with their third party valuation service).

    Whatever happened to the new preferred PRIF was going to issue? That seems to be the overhang on PRIF-E which I think is a good value here prior to ex-div.

  3. thanks for the article. I find BDC’s interesting, but there is not a lot of info out there, so in order to get a good feel for them, I’d have to individually dig into each financial statement vs. getting a good review from most new outlets on the sector.

    Are CLOs the same as CDOs ? One is debt, the other is a loan which is essentially debt, so how does this differ from senior bank loans ?

  4. For the record, the BDCReporter is a subscription site and the only investment letter I’ve ever subscribed to. The site offers a great deal of free info as well including his Twitter feeds that are the most up to date info he has on BDCs and the companies they’re invested in… Interestingly, for someone who’s 100% committed to researching BDCs, NIcholas Marshi’s present overall view of the industry at this stage seems to me to be one of caution which I like. He’s far from a biased drum beater for the BDC industry and is constantly showing concern about the increasing risks the industry is taking by assuming so much more leverage at this stage of the cycle thanks to the increase abilities for them to do so because of SBCAA’s lowering the bar, i.e., allowing BDCs to increase leverage above the original 1940 Act mandates. He sees the increased leverage as most likely being far more beneficial to the managers than the shareholders. If you’re interested in the BDC field, THE BDCReporter is highly recommended and a different breed than BDCBuzz who frequents SA more..

    1. As a follow-up about the BDCReporter, here’s part of an in depth comment they shared with subscribers about the impact of a Ch 11 filing on Nov 25 of Bumble Bee Foods on the portfolio of one specific BDC with Bumble Bee’s debt on its books – without sharing the detailed specific analysis they provided they went on to say:

      “What’s Important

      We bring these troubled loans to our readers attention as part of the BDC Reporter’s broader focus on credit performance in the BDC sector.

      It’s a truism but credit is Job 1 for every BDC/lender and we seek to evaluate just how well each management team performs over time.

      Like talking about death or your finances, this is a subject that BDC managers prefer not to dwell on.

      We imagine that some managers would rather not discuss credit troubles at all.

      All the more reason – given that credit results are the key component of BDC success or failure – for the BDC Reporter and BDC Credit Reporter to shine more of a light on the subject.

      Lessons Learned

      It’s not just a matter of toting up the impact on the P&L and balance sheet after a realized loss has been booked – as we often do – but learning about the underwriting process of the BDC managers involved, and what outcomes look like.

      Any long time investor in the space will agree that while credit problems are a natural part of leveraged lending, there are wide variations in performance over time.”

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