Episode 8

June 30, 2021

Three CLO questions for Kim

Steve sits down with Kim Frazier, Managing Director and Portfolio Manager at Crescent Capital Group, to discuss CLOs, LIBOR and bank loan market valuations.

Steve Peacher: Hi thanks for listening in, this is Steve Peacher I’m President of SLC Management, and this is our latest edition of “Three in Five.” And I'm excited to have Kim Frazier with me. Kim's a Managing Director and Portfolio Manager at Crescent Capital, who, among other things, oversees their CLO business and manages those portfolios. So, Kim, thanks for joining today.

Kim Frazier: Sure great to be here, I appreciate the invitation.

Steve Peacher: So, we're talking about bank loans today, which, of course, are the underlying asset class within CLOs, so Kim the market, the loan market is heavily influenced now by CLOs. Do you think that's a positive for the bank one market or negative, all things considered?

Kim Frazier: Sure, yeah you're correct CLOs now represent 70% of the bank loan market, that's up from 45%1 10 years ago so meaningful increase, and we think that's a long term positive for the loan market for a few reasons. First CLOs are locked up, sticky capital with a typical CLO having a reinvestment period of five years and a final maturity of 12 years, so fairly long tenured vehicles. As such, they're not susceptible to retail outflows that could create pressure to sell the underlying loan assets. On the contrary, CLOs are often positioned to be a provider of liquidity to the loan market during periods of volatility, as CLO managers will look to buy loans at a discount to par and you saw that happen last year, for instance, during the heights of the Covid crisis. So, for those, you know, two primary reasons we think CLOs actually helped to provide stability to the bank loan market and exert a positive influence their long term.

Steve Peacher: You know, one of the attractions of loans, maybe, especially in this environment where interest rates are concerned, is that loans are tend to be floating rate based off LIBOR. Of course there's a big switch in the market from LIBOR to a new standard which is complicated. So how is that being dealt with in the loan market, how are new loans being priced and how is this going to evolve as the market moves away from LIBOR?

Kim Frazier: Sure, that's it that's a great and very topical question, certainly. So, what's clear is that one month and three month LIBOR will end sometime after 2021. The expected replacement rate for some time now, has been SOFR, although a few other candidates have been in play as well. But it increasingly it does appear that SOFR you know, which is based off of overnight treasury repo rates is the most likely replacement. SOFR will require some sort of spread adjustment, because SOFR is a risk-free rate and does not have the credit risk embedded that the current library rate does some work to be done there. But just in recent news we learned just last week that SOFR maybe available as soon as the summer. The relevant regulators appear to be coalescing around supporting SOFR as the recommended replacement rate for LIBOR, so it does seem as though we're moving closer to a resolution. For now, it's sort of stay tuned you know this topic continues to evolve, you know, on a weekly and monthly basis we expect to hear more news over the summer. And, in the meantime loan documents and CLO documents have added fallback language, which provides guidance and rates to be used in the event that LIBOR becomes unavailable and an official replacement has not been confirmed.

But that's not our expectation, we do expect that that are an official replacement will be confirmed, but there is a fallback language in loan and CLO documents to deal with that unexpected event should it occur.

Steve Peacher: Third question, third and final question. Bank loans are kind of first cousin of the high yield bond market. Different structure, a lot of the same issuers and I think the markets look at each other in terms of gauging relative value. So, as you look at the market valuations today for bank loans and compare that to the high yield market, you know what's your impression evaluation, do you think loans are cheap or rich relative to how you?

Kim Frazier: Yeah, I think it's hard to argue the bank loans are cheap right now. You know, certainly relative to historical levels and relative to some other alternatives as well. Nonetheless, you know, we do believe that loans are attractive when compared to many of the other fixed income alternatives for a few reasons. One is you think about the broader macroeconomic backdrop, the reopening of the economy, that's supportive of taking credit risk. Looking at the loan market specifically you know fundamentals are healthy we're seeing rating agency upgrades outpace downgrades by meaningful amount this year. We're seeing the default rate fall off pretty quickly, I think more quickly than many of us expected. So, certainly those things are supportive of taking credit risk and then additionally as you think about bank loans by virtue of the floating rate nature, they have the added benefit of no duration. So, if you think about an environment in which rates are rising are expected to rise, we think bank loans are fairly uniquely positioned to deliver an attractive return to investors. So I would say, well, it is very difficult to argue that the bank loans are cheap, you know, relative to historical level certainly, we do still think they fill a need for many investors in the portfolio and are worth adding.

Steve Peacher: Well, certainly at the beginning of the pandemic no one would have felt that fundamentals, a year later, would be as strong as they are now to support those valuations so. As you know, I think, Kim I'd like to ask one kind of out of the blue, wacky question at the end here so quickly, I don't know if you know anything at all about cryptocurrency. I'm confused about it personally, but if you had to say will Bitcoin, which is trading somewhere around $40,000 today, do you think five years from now, that Bitcoin is going to be worth more or less than it is today?

Kim Frazier: I would have to go with it being worth more and I will tell you that's not based on any fundamental analysis, so contrary to what I do in my in my day job focused on CLOs where everything is based on fundamental analysis. You know the cryptocurrency trade, you know there just seems to be so much momentum driven by the younger generation and people moving away from, you know, traditional sort of banking and other institutions. But I think it's hard to evaluate it on the basis of traditional fundamentals and metrics. This seems to be more of a momentum driven trade. The wisdom of the crowd – “wisdom” I use in quotes – driving security prices more than anything, so if I was betting I would place my money on cryptocurrencies generally in Bitcoin specifically being higher five years from now.

Steve Peacher: All right, there you go a Bitcoin bull and we'll look for the next the next CLO back by Bitcoin. Thanks again for taking the time and thanks everyone for listening to this episode of “Three in Five”.

¹ https://www.bloomberg.com/news/articles/2021-05-28/structured-weekly-global-clo-outstandings-approach-1-trillion

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