Chris Galipeau, Senior Market Strategist of Putnam’s Capital Market Strategies group, recently spoke with Scott M. D’Orsi, CFA, a Portfolio Manager in Putnam’s Fixed Income group on the Active Insights podcast. Scott has been in the investment industry since 1990 and specializes in bank loans, leveraged loans, and collateralized loan obligations. He is part of the team managing Putnam Floating Rate Income Fund.
Chris Galipeau: Let’s start by defining what CLO means.
Scott D’Orsi: A CLO, or collateralized loan obligation, is essentially a highly levered fund. It’s going to be capitalized with about 90% debt that’s structured into multiple tranches (segments of a larger pool of securities), usually five, from AAA down to BB. There’s also an equity tranche of around 10% or less.
CG: Why do people invest in this asset class? What’s the value proposition?
SD: On the whole, CLOs account for 65%–70% of investor demand for leveraged loan products. This level of demand speaks to the performance expectations of the asset class.
Because such a significant amount of the leveraged loan market is held in these highly levered vehicles, the asset class demonstrates a fair amount of predictability. Once capital is funded and the CLO is priced, that capital is held within the fund between six to eight years. This creates a strong buy-and-hold investor base that provides a lot of stability.
Investors can match their risk appetite to CLO tranches, whether they’re traditional money center banks that like to be in the AAA or AA tranches — where risk of losing principal is negligible if held to maturity — or go all the way down to BB and equity risk.
CG: What can make these loans underperform?
SD: These are credit risk instruments, so understanding the forward path and ability of these issuers to service their debt, or pay back these loans, is very important. And the scenarios where we have mass sell-offs tend to be more macro, more global in nature.
But there are certainly downside scenarios entering into recessionary periods. Generally, companies that are not the largest in their sectors are likely to be more at risk in terms of their pricing leverage over customers, or their purchasing power with some suppliers. Understanding management, their business plan, and their ability to track to that plan is very important and a key part of what we do.
CG: When I listen to management teams and our analysts, I hear balance sheets and business fundamentals are great. So my take is, yes, the environment’s a little risk-off and there’s more volatility, but the operating conditions for corporate America, for the most part, are pretty good — net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization), the balance sheet, and cash flow generation. Agree or disagree?
SD: I would largely agree with that. We do not see issues with respect to maturity walls or significant refinance risk for the most part. A lot of companies were able to access the debt markets in 2021, extend out maturities, and add liquidity to the balance sheet. 2021 was a unique year with the unwind of the 2020 impact of Covid-19. One of the critical components of our credit work is understanding where demand might have been pulled forward in 2021 results, and what that might imply for comps into 2022.
One of the hidden cushions to the loan market is we generally do not need a 2.5% or 3.5% GDP environment for loans to hold their value. If we’ve done our credit work adequately, these companies should be able to service their debt even in a more modest environment.
CG: What would you want a financial advisor to walk away from this conversation knowing?
SD: I think the asset class has always demonstrated remarkable resilience. We’ve taken this asset class, one that was almost entirely held within banks underwriting to a zero-loss kind of credit standard, and deployed that approach without really compromising the credit standards by which we monitor that type of risk.
I think once people get through the lack of familiarity, they start to appreciate the value of the asset class. In terms of the sheer number of people moving into retirement age, looking for current income with some confidence around capital preservation, it’s a terrific asset class to generate that kind of performance.
You can listen to the full conversation here.
No assurance can be given that the investment objective will be achieved or that an investor will receive a return of all or part of his or her investment. Actual results could be materially different from the stated goals. Investors should carefully consider the risk involved before deciding to invest. As with any investment, there is a potential for profit as well as the possibility of loss.
Collateralized Loan Obligations (CLOs) are debt securities issued in different tranches, with varying degrees of risk, and backed by an underlying portfolio consisting primarily of below investment grade corporate loans. The return of principal is not guaranteed, and prices may decline if payments are not made timely or credit strength weakens. CLOs are subject to liquidity risk, interest rate risk, credit risk, call risk and the risk of default of the underlying assets. The risks of investing in CLOs include both the economic risks of the underlying loans combined with the risks associated with the CLO structure governing the priority of payments. Investors should carefully consider the risk involved before deciding to invest. Diversification does not assure a profit or protect against loss. It is possible to lose money in a diversified portfolio. As with any investment, there is a potential for profit as well as the possibility of loss.
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