Thomas Majewski on CLOs, Private Credit, and Bank Capital Relief Trades
Dec 19, 2023
01:06:54
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Thomas Majewski, founder of Eagle Point Credit, discusses the advantages of Collateralized Loan Obligations (CLOs), private credit, and bank capital relief trades. Topics include CLO resilience in challenging times, impact of rising interest rates, liability structure of BDCs, and preference for CLO equity over senior tranches.
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Quick takeaways
CLO equity offers structural advantages and consistently delivers positive total returns, even in times of market stress.
CLOs provide banks with capital relief and risk management opportunities, allowing them to raise capital without issuing stock.
CLO equity performance during market downturns is impressive due to the reinvestment period, offering value generation and capital raising opportunities for banks.
Deep dives
Overview of CLOs
CLOs are securitizations of loans, typically owned by big American companies. They are senior, secured, and floating-rate, making them resilient to market variability. Even though they are below investment grade-rated, CLOs have consistently delivered positive total returns throughout the years. CLOs take large pools of loans and tranche them into different classes, such as triple A, double B, and equity. CLO equity holders benefit from the reinvestment period, allowing them to reinvest paydowns and default recovery proceeds into new loans, creating value even in times of market stress.
Comparing CLOs to Banks
CLOs offer advantages over banks in terms of capital relief and risk management. Banks are increasingly facing higher capital charges and liquidity concerns. To raise capital without issuing stock, banks use regulatory capital relief transactions, selling risk on specific loan portfolios to investors like CLOs. These transactions provide banks with capital relief while still allowing them to retain a stake in the loans. CLOs, in turn, earn higher interest rates for taking on this risk. The regulatory capital relief market has been thriving, providing opportunities for CLO investors.
Credit Performance and Reinvestment Period
CLO equity's performance during market downturns has been impressive, thanks to the reinvestment period. Even during periods of high default rates and market stress, CLO equity holders were able to reinvest paydowns at discounted prices and generate value. CLOs have historically outperformed their on-balance portfolio and offered a way for banks to raise capital without heavily relying on bank deposits. The credit linked nature of these transactions and the alignment of interests between banks and investors contribute to their success.
Overview of CLO Equity and Cash Flow
In this podcast episode, the speaker explains how Collateralized Loan Obligation (CLO) equity works and how it generates cash flow for investors. They highlight that unlike banks, CLOs do not have retained earnings and instead distribute cash to equity holders through an interest waterfall. The speaker mentions that CLO equity investors typically receive an average of 25% cash on cash return each year. While there are scenarios where cash flows could be diverted for a period, the speaker notes that this is rare. They emphasize the importance of passing protective tests to maintain cash distributions to CLO equity holders.
Credit Stress and Default Rates in CLOs
The podcast explores credit stress and default rates in CLOs. The speaker compares loan yields and implied default rates, highlighting that the market predicts an 8% default rate based on loan recovery rates. However, current data from LCD shows that the default rate is below 1.5% for the trailing 12 months, which is lower than the long-term average. The speaker emphasizes that companies in CLOs have ample debt service coverage and pricing power, allowing them to navigate through rising rates and potential defaults. They conclude that while there may be isolated defaults, a systemic or widespread issue leading to significant losses for CLO investors is unlikely.
Private Credit and Potential Bubble
The episode discusses the private credit market and addresses concerns about a potential bubble. The speaker acknowledges the increasing capital inflows into private credit, but notes that many of the firms involved have a long history of lending and expertise. They highlight that private credit loans generally offer higher spreads than syndicated loans, providing attractive returns. The speaker notes that the liabilities of private credit funds are long-term, and they have steady hands to work through any problems that may arise. They also mention how private credit funds refinancing loans in the syndicated market can benefit CLOs. Despite concerns, the speaker believes a systemic or widespread issue leading to significant losses is unlikely in the private credit space.
Thomas Majewski, founder of Eagle Point Credit, joins Forward Guidance to share his insights from the somewhat opaque world of Collateralized Loan Obligations (CLOs). Majewski explains why he perceives that CLO equity enjoys a series of structural advantages, and he also shares his thoughts on the worlds of private credit and bank capital relief transactions. Filmed on December 11, 2023.
Please note that any past performance discussed in this presentation is not indicative of, or a guarantee of, future performance.
To reference performance and the discussion about Eagle Point Credit Company, please visit the website: https://www.eaglepointcreditcompany.com/
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Timestamps:
(00:00) Introduction
(00:11) What Are CLOs (Collateralized Loan Obligations)?
(19:00) A Look Back At CDOs And 2008
(31:42) Impact Of Rising Rates On Companies' Ability To Service Debt Loads
(40:14) How Would "The CLO World" Handle A Potential Recession?
(43:06) Banks Are Selling Credit Risk (i.e. Buying Insurance) Via "Regulatory Capital Relief" Credit Linked Notes (Are They Similar To Credit Default Swaps?)
(54:15) Private Credit - Golden Age Or Biggest Bubble In The World?
(01:00:13) Liability Structure of BDCs (Business Development Corporation)
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Disclaimer: Nothing discussed on Forward Guidance should be considered as investment advice. Please always do your own research & speak to a financial advisor before thinking about, thinking about putting your money into these crazy markets.
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