XAI KNOWLEDGE BANK ACCESSING INSTITUTIONAL ALTERNATIVES: Factors to Consider When Adding CLO Debt and CLO Equity to a Portfolio Explore CLOs
THE OPPORTUNITY CLOs represent an alternative source of income and benefit from rising interest rates. CLOs (collateralized loan obligations) are a type of structured credit that invest in senior floating-rate secured loans. CLOs have attractive current distributions and performed well through multiple investment cycles with a track record of low defaults. 1 CLOs may provide a natural hedge for interest rate risk because of their floating-rate income and therefore may not directly suffer the same adverse effects from rising rates as traditional fixed income investments. 2 Historically, CLOs have been an institutional investment and largely inaccessible to individual investors. Today, access is possible through closed-end fund offerings. Since CLOs are actively managed, investors may benefit from engaging managers with strong track records and an expertise in issuing CLOs. Past performance is not indicative of future results. See page 9 for a discussion of risks associated with CLO investing. 1 Source: Standard & Poor s Ratings Direct Twenty Years Strong: A Look Back at U.S. CLO Ratings Performance from 1994 through 2013 (January 31, 2014). Please note that this is the latest information available from S&P. 2 Senior secured loans have LIBOR floors, most commonly the LIBOR floor is 1%. Investors in senior secured loans benefit from higher interest payments once LIBOR is above the 1% floor. See discussion of risk associated with recent developments regarding LIBOR on page 9.
The Investment Case for CLOs CLOs may be attractive to large institutional investors seeking to generate higher yields and to mitigate interest rate risks. These institutional investors recognize that the CLO structure allows for active management by a CLO manager who may capitalize on opportunities if credit market conditions change. In addition, when the integrity of the CLO structure was tested during the financial crisis, CLOs proved resilient according to Standard & Poor s research that is discussed later in this paper. Individual investors share goals similar to those of institutions. Both sets of investors seek income and seek to reduce the impact of higher interest rates. 1 CLOs can offer a solution, but they have been difficult for individual investors to access until recently. In recent years, individuals and smaller institutions have gained access to CLOs via closed-end funds, which have certain advantages over private funds for some individual investors, including low investment minimums and Form 1099 tax reporting. 2 In considering CLOs as an investment, it is important that investors understand how they work. CLOs may offer opportunities for yield and attractive returns in different interest rate environments. They may perform well even when interest rates are flat or during a period of rising rates. They do, however, pose risks associated with leverage and periodic illiquidity. Since CLOs are actively managed, identifying and accessing a highly skilled manager is of key importance but may be difficult for the individual investor who only invests in mutual funds and ETFs. For would-be CLO investors, the central question is, How are CLOs managed and what should I look for in a CLO manager? CLOs Invest in Senior Secured s A CLO is a type of structured credit that invests in a diverse pool of U.S. senior secured loans. Senior secured loans, also referred to as floatingrate loans or senior loans, are issued by banks to below-investment-grade corporations. 3 Senior loans have several distinctive and highly attractive features, particularly when compared to fixedrate high yield corporate bonds. First, senior secured loans are floating-rate credit instruments. When interest rates exceed the loan s LIBOR floor, the interest paid increases. By contrast, fixed income is by definition fixed, so when interest rates rise, the value of a corporate bond portfolio is adversely affected. The floating-rate feature of U.S. senior loans is particularly favorable for those who anticipate a normalization of interest rates and a return to higher levels. Secondly, senior loans are senior collateralized assets, which further distinguishes them from high yield corporate bonds. As their name implies, senior loans have the highest priority in receiving payments, ahead of both bondholders and preferred stockholders. In addition, senior loans are typically secured by collateral. Senior loans have very low default rates, averaging less than 2%, 4 and they have a very high recovery rate following default at 81 cents on the dollar. By comparison, high yield bonds have averaged a 4% default rate and a low recovery rate following default at only 41 cents on the dollar. 4 Differences between Senior Secured s and High Yield Bonds Senior Secured s High Yield Bonds Collateral Secured Unsecured Coupon Floating Rate Fixed Rate Covenants Maintenance Incurrence Call Protection Limited Moderate Recovery Prospects High Low Investor Base Concentrated Diverse Secondary Market Volume ~$3 billion per day ~$6 billion per day Source: Citi Research 1 The Federal Reserve expects three interest rate increases in 2017. The Federal Reserve, March 15, 2017. Federal Open Market Committee (FOMC) Meeting, press conference transcript. 2 Closed-end funds are actively managed portfolios and are subject to active management risk. Shares of closed-end investment companies frequently trade at a discount from their net asset value. A closed-end fund may not achieve its investment objective. An investment in a closed-end fund is subject to investment risk, including possible loss of the entire principal amount that you invest. Investments in closed-end funds present certain special considerations and risks not present in making direct investments in securities in which such funds may invest. Investments in other closed-end funds involve operating expenses and fees that are borne by fund investors. 3 Issuers of below investment grade securities (that is, securities below Baa3- by Moody s Investors Service, Inc. or below BBB- by Standard & Poor s Ratings Services or Fitch Ratings) are not perceived to be as strong financially as those with higher credit ratings. These issuers face ongoing uncertainties and exposure to adverse business, financial or economic conditions and are more vulnerable to financial setbacks and recession than more creditworthy issuers, which may impair their ability to make interest and principal payments. Below investment grade securities, which are commonly referred to as high-yield securities or junk bonds, are regarded as having predominantly speculative characteristics with respect to capacity to pay interest and to repay principal. 4 Moody s as of 2015. 1
Understanding the Basic Structure of a CLO CLOs are operated by professional credit managers who actively buy and sell senior loans based upon proprietary research and an ongoing evaluation process. The CLO manager finances its investment in the pool of loans by issuing debt and equity. CLO debt holders have the highest priority on payments while equity holders have the lowest priority. This hierarchy is known as the cash flow waterfall and is explained in greater detail below. In essence, CLO debt is designed to have lower risk than CLO equity, but CLO equity compensates for its higher risk profile by offering the potential for higher returns. The CLO Cash Flow Waterfall Tranches Priority of Payment Losses Total Return First Payment Last Loss Lowest AAA, AA Pools of 2 s 2 A, BBB, BB, B Equity Last Payment First Loss Highest Source: Morgan Stanley Wealth Management GIMA CLO Debt Tranches At the top of the CLO cash flow waterfall are the CLO debt tranches, AAA and AA are the most senior. The debt issued by the CLO to pay for its purchase of the loans is divided into different tranches, each with different risk/return profiles. Each debt tranche is given a credit rating by a national rating agency. The more senior the debt tranche, the higher its priority on any cash payment received by the CLO and the higher its rating. The highest rated tranches, rated AAA and AA, have the lowest current yields but have never defaulted. 1 CLO debt tranches pay a spread above LIBOR. The details of the U.S. CLO debt market are shown below. U.S. CLO Debt Market Overview CLO Debt Tranche Current Weighted Average Life (years) Current Spread (1) (basis points) Current Yield (2) AAA 5 6 127 2.45% AA 6 8 178 2.96% A 6 9 260 3.78% BBB 7 9 400 5.18% BB 7 9 695 8.13% B 7 9 938 10.56% For new and longstanding CLO investors, the case for CLO debt is straight forward. The yield premium compensates for CLOs higher product complexity, lower liquidity compared to corporate bonds and regulatory burden for bank investors. But attractive relative value and its rare losses over the last two decades helped defeat the investment hurdles. Source: Citi Research, Global Structured Credit Focus, January 13, 2017 Source: J.P. Morgan, Credit Strategy Weekly Update: High Yield and Leveraged Research, May 12, 2017 Note: (1) Current spreads represent the midpoint of a range of spreads to indicate manager tiering. (2) Current yields reflect current spreads in basis points over 3-month LIBOR (1.18%) for originally-rated categories. For illustrative purposes only. Past performance is not indicative of future results. 2 XA Investments XAI Knowledge Bank 1 The last comprehensive study of CLO performance was conducted in January 2014 by Standard & Poor s Ratings Direct described in the report Twenty Years Strong: A Look Back at U.S. CLO Ratings Performance From 1994 Through 2013. Past performance is not indicative of future results.
CLO Equity The Residual CLO equity represents a residual stake in the CLO structure and first loss position in the event of defaults and credit losses. CLO equity investors receive the excess spread between the CLO assets and liabilities and expenses. To better understand how CLO equity may generate attractive returns for investors, we can make a rough comparison between owning CLO equity and owning a house purchased with a mortgage and renting it out. For the homeowner, the difference between the rent payments received and the mortgage payments owed is equivalent to the spread. For CLO equity, this spread can be quite wide; when underlying loan payments exceed CLO debt payments, CLO equity may have the opportunity to generate high returns. In a market environment with low cost of debt and returns on senior loans exceeding that cost of debt, CLO equity can produce attractive cash flows. CLOs utilize leverage, further affecting the potential for positive or negative returns, and making it even more important to select a highly skilled manager with extensive experience. We will return to this important topic in the discussion about active management of the CLO on page 6. Integrity of the CLO Structure CLOs have built-in safety mechanisms, which partly explains the historical performance of CLOs. A CLO is subject to performance-based tests that ensure it meets its cash flow distribution obligations. An overcollateralization test confirms the principal value of a CLO s underlying bank loan pool will exceed the value of CLO debt. If the principal value declines below the test s trigger value, cash will be diverted from equity and junior CLO tranches to senior debt tranches. A skilled CLO manager can make portfolio changes to avoid reaching the trigger threshold or to purchase more bank loans. A CLO s debt financing is locked in for the life of the CLO and is therefore favorable relative to bank financing where depositors cash balances will vary and increase the cost of financing. In addition to the structural characteristics that supported performance, the fact that CLOs are actively managed worked in their favor. Because managers can sell deteriorating credits before default, they can maintain a higher asset quality in the CLO portfolio. Source: Syndications and Trading Association, January 14, 2015 Understanding the Drivers of CLO Equity Returns CLO equity is different from the CLO debt tranches. CLO equity holders receive any residual cash flow from the CLO s assets, after all debt tranches have been paid. The equity residual is not rated, nor does it have a set coupon. It is also the first to absorb losses. To compensate for these higher risks, CLO equity offers the potential for higher returns. Typically, CLO equity benefits from both volatility in the underlying loan market which creates opportunities for active management and low-cost financing. CLO equity outperformance is therefore driven largely by a combination of manager skill and market opportunities. When CLO managers pay less for liabilities associated with the CLO debt tranches, CLO equity holders may receive increased profit from the residual cash flow. Additionally, newly issued CLO equity can benefit if credit spreads widen because of a CLO s ability to reinvest the repayment proceeds of its underlying loans. There is further benefit to holding CLO equity. CLO equity investors typically control the fate of the entire CLO structure and may elect to either call or unwind the CLO or capitalize on decreasing liability costs by refinancing the underlying bank loan portfolio and increasing current income. As such, CLO equity investors may benefit from the lower cost of liabilities and see higher levels of cash flows. 3
Overview of the CLO Marketplace The global market for CLOs has expanded in recent years and now stands at $527 billion, 1 with the U.S. accounting for roughly 85% of outstanding issuance and Europe accounting for the remainder. CLOs hold 47% of the loan market, representing nearly half of the $925 billion in senior secured loans outstanding in the institutional market. By contrast, loan-focused mutual funds and ETFs represent only a 15% share of the loan market. 1 As market participants understanding of CLOs has increased, the CLO market s buyer base has transformed from specialized investors to long-term asset managers, insurance companies and pension funds. According to research by Citigroup, asset managers comprised 17.9% of the U.S. AAA CLO market at the end of 2016, a significant increase from 4.4% in 2013. 2 This evolution has been prompted by diminished demand for leveraged structured asset-backed products, the shrinking popularity of hedge funds, and by regulations that prohibit broker-dealers, including Wall Street banks, from operating proprietary trading desks. 3 CLO Debt Historically Outperformed Similarly Rated Corporate Credit Historically, CLO debt has provided higher risk-adjusted returns than similarly rated U.S. corporate credit instruments. CLO debt has also proven resilient to losses from underlying loan defaults through multiple credit cycles. As shown in the chart below, the long-term default rate for CLO debt is less than 1.7% on the BB-rated tranche of CLOs versus a 9.2% default rate for similarly rated 5-year U.S. corporate credit. In addition, no AAA- or AA-rated CLO debt tranche has defaulted since the debut of the asset class in November 1996. 4 The last comprehensive study of CLO debt performance was conducted by Standard & Poor s in 2014, and the results of the research are summarized below. Performance Comparison of U.S. CLO Debt to U.S. Corporate Credit U.S. CLO Default Rate U.S. Corporate Default Rate Sector 1994 2013 5 Year 10 Year 15 Year AAA 0.0% 0.4% 0.9% 1.3% AA 0.0% 0.5% 1.2% 1.7% A 0.5% 0.8% 2.1% 3.2% BBB 0.3% 2.4% 5.3% 7.6% BB 1.7% 9.2% 16.7% 20.5% B 2.6% 21.4% 29.9% 34.1% Source: Standard & Poor s Ratings Direct Twenty Years Strong: A Look Back at U.S. CLO Ratings Performance from 1994 through 2013 (January 31, 2014). Please note that this is the latest information available from S&P. Past default rates are not indicative/a guarantee of future default rates. Includes all U.S. cash flow CLO tranches rated by Standard & Poor s as of year-end 2013. Default rate is calculated as the number of rated tranches that had ratings lowered to D divided by total number of rated tranches. Loss rate is calculated as the sum of losses divided by the sum of issuance amounts. When necessary, market values from trustee reports were used to estimate tranche losses. 1 Thomson Reuters LPC Collateral Leveraged Monthly June 2017. 2 Source: Citi Research. 3 Source: Citi Research. 4 The CLO market can trace its origins to the $5 billion R.O.S.E. Funding No. 1 Ltd. transaction sponsored by National Westminister Bank PLC in November 1996. Source: NYU Stern, Kenneth Kohler Mayer, Brown & Platt, 1998. 4 XA Investments XAI Knowledge Bank
A CASE STUDY: The Financial Crisis Strong CLO Performance Sets CLOs Apart from Other Structured Credit Impressive performance has heavily impacted the growth of the asset class. CLOs are some of the few structured credit products that performed as intended during the financial crisis. The performance of senior debt tranches of CLOs as shown in the chart below, highlights the unique levels of protection and structural resilience that may make them attractive to investors. When senior secured loans held by CLOs were called or refinanced by the issuer during the crisis, the loans were typically paid out at par, and the cash was reinvested by the CLOs in new senior loans for the CLOs underlying loan pool. Opportunistically turning over the loans and reinvesting at higher spreads and lower prices allowed many CLO managers to generate strong returns over this period. How are CLOs different from CDOs and why may CLOs be considered less risky than other types of structured credit? Not all structured credit held up well during the financial crisis. Collateralized debt obligations (CDOs), often confused with CLOs, are a case in point. Other than a similar name and acronym, these two investment products have little in common. Historically, CLOs have outperformed assetbacked CDOs (ABS CDOs) because of active management and the diverse nature of senior secured loans and their underlying collateral. In contrast, the underlying collateral for ABS CDOs are typically static pools of residential mortgages. The default rate of underlying mortgages in ABS CDOs demonstrates that the fundamental collateral is as important as the structure. During 2008 and 2009, the underlying collateral of ABS CDOs not only consisted of mortgages with very high default rates and very low recovery rates, but none of those ABS CDOs is performing today. It is important to differentiate between types of structured credit and understand why CLOs have certain advantages over ABS CDOs. CLOs Compare Favorably to CDOs Collateral CLOs Senior secured loans CDOs Asset-backed security tranches Management Active management Static securitizations AAA 20 Year Cumulative Default Rate AA 20 Year Cumulative Default Rate 0.0% 35.4% 0.0% 43.4% Source: Moody s Investor Services, Special Comment: Default and Loss Rates of Structured Finance Securities: 1993 2015. June 1, 2016. For illustrative purposes. Past performance is not indicative of future performance. Investments in different asset classes have different types of risks, which may provide higher returns but also greater volatility. See below for a summary or risks associated with these asset classes. Investments in different asset classes have different types of risks. In general, equity securities tend to be more volatile than fixed income securities. In addition to the general risks associated with credit instruments, CLOs and CDOs are structured credit securities and often involve risks that are different from or more acute than risks associated with other types of credit instruments. The credit quality of CDOs depends primarily upon the quality of the underlying assets and the level of credit support and/or enhancement provided. CDOs are subject to risks associated with the possibility that distributions from collateral securities will not be adequate to make interest or other payments; the quality of the collateral may decline in value or default; and the complex structure of the security may produce disputes with the issuer or unexpected investment results. 5
Active Management May Generate Attractive Returns for CLO Equity Investors The CLO manager actively manages the diversified portfolio of loans in the CLO. When the leveraged loan market experiences volatility, a capable CLO manager may capitalize on such volatility by minimizing credit losses and purchasing assets at discounts to par. Doing so can enhance current income for CLO equity and increase total return through capital appreciation. Hence, CLO equity may benefit from volatility or severe dislocations in the loan market, especially when the CLO is managed with great skill. A specific benefit of active management is a CLO manager s ability to refinance by calling the CLO debt two years after inception if interest rates decline. Active management is an important driver of historical CLO equity performance. Unlike passive investments, the manager of a CLO can find new investment opportunities in times of market stress and may refinance at advantageous rates in times of market calm. CLO Life Cycle: Current CLOs typically have a 12-year final maturity and an expected life of 5 8 years. 1 Throughout the life of a CLO, the CLO manager has different responsibilities. During the warehouse period, the CLO manager uses financing to acquire assets in advance of the close. Life of the Typical CLO 1 Pre-closing Month 1 to Month 6 Warehouse Period Underwriting bank provides CLO manager with financing to begin acquiring assets in advance of CLO closing. Equity investors provide first loss capital during the warehouse period Post close, the ramp-up period occurs. In this stage, the manager issues CLO debt in order to repay the initial warehouse loan and acquire additional assets. During the non-call and reinvestment period, the CLO manager can add significant value by managing the underlying collateral of loans. The manager can also refinance the CLO debt by using cash flows from the portfolio to reinvest at advantageous current prices. During the amortization period, the CLO manager will use cash flows to pay down outstanding CLO debt in order of seniority. Closing Post-closing Month 1 to Month 3 Month 4 to Year 4 Year 5 to Maturity CLO comes into legal existence Ramp-Up Period Post-closing, proceeds from CLO debt issuance used to repay warehouse and purchase additional assets Non-Call Period Post Year 2, the equity investor(s) may direct original CLO liabilities to be refinanced (prepaid at par) and replaced with new liabilities in order to reduce interest expense Reinvestment Period Collateral Manager permitted to actively trade underlying assets to maximize value and ensure portfolio remains in compliance with collateral quality tests Principal cash flows from underlying loan/bond assets used by the Collateral Manager to purchase new assets Amortization Period A portion of cash flows from asset amortization, prepayments/repayments, and sales are used to pay down outstanding CLO debt in order of seniority 1 Source: Octagon Credit Investors 6 XA Investments XAI Knowledge Bank
Identifying Highly Skilled Managers Is Key to Successful CLO Investing Given that CLOs are dynamic structures, investors will benefit from identifying skilled CLO managers. In addition to identifying CLO managers with team continuity and experience through several market cycles, investors may benefit from identifying CLO managers with deep, fundamental credit expertise and CLO structuring expertise. Specifically, a quality investors seek in a CLO manager is a long track record of issuing CLOs. Such a track record enables investors to assess how that manager performs in various market cycles. CLO managers who have long-standing relationships in the CLO market and are in the pulse of the market tend to be more successful in the CLO marketplace. Their extensive industry network can enable greater access to some of 2016 Top U.S. CLO Manager League Table (By volume) CLO Manager CLO Volume (Dollars in millions) the scarce and increasingly coveted CLO equity tranches as well. In today s marketplace, CLO managers are governed by risk retention rules that provide additional safety to investors. These new rules, implemented following the 2008 financial crisis, require CLO managers to have some skin in the game and invest their own capital alongside investors. Since managers now shoulder some of the risk inherent in a CLO, market observers such as Fitch Ratings anticipate a reduction in the number of CLO managers going forward. 1 The result may be an industry with higher standards for the CLO structure, in which management will be condensed into the hands of quality firms whose interests are better aligned with those of their investors. Number of Deals Market Share 1 Credit Suisse Asset Management $2,891.00 4 4.0% 2 GSO Blackstone $2,789.22 5 3.9% 3 Octagon Credit Investors $2,235.75 4 3.1% 4 Voya Investment Management $2,141.55 4 3.0% 5 Sound Point Capital Management $1,950.00 3 2.7% 6 Carlyle Investment Management $1,915.15 4 2.6% Given CLOs complexity, fund managers need strong credit, structuring and legal expertise to take advantage of the opportunities in each tranche. Investing in CLOs is best done in an illiquid structure that prevents the manager from having to sell assets at unfavorable prices to meet redemptions. As with all investments, manager selection is critical. CLO managers credit analysis and ability to mitigate losses can be important drivers of returns. Source: Morgan Stanley, CLOs: An Asset Class for HNW Investors, March 2017 7 Ares Management $1,831.10 3 2.5% 8 Prudential Investment Management $1,673.17 3 2.3% 9 Golub Capital $1,653.27 4 2.3% 10 KKR $1,630.25 3 2.3% Source: Thomson Reuters LPC, December 2016 1 Source: Fitch Ratings, March 5, 2015, Risk Retention Rule Will Hurt Small U.S. CLO Managers 7
Next Steps for Investors Investors who are looking for an income-generating strategy with robust structural protections may want to consider CLOs. Not only have CLOs historically experienced fewer defaults than comparable U.S. corporate credit, their structure may enable them to benefit from rising interest rates. Although investors have had limited access to CLOs in the past, allocations to the asset class are now possible through closed-end funds. CLOs are more accessible, thus permitting investors to diversify their portfolio, and capitalize on CLOs income and return potential. An individual investor can approach the CLO asset class either tactically or strategically. For those taking a more tactical approach, the floating-rate nature of CLOs may offer a sensible alternative to stocks and bonds in anticipation of rising interest rates. The safety of the underlying loan market might be another compelling reason for investors to allocate to CLOs. Long-term strategic investors view CLOs as a viable choice due to the income potential and portfolio diversification from traditional stocks and bonds. The critical next step for investors is to identify highly skilled investment managers with demonstrated longevity in the CLO market; a proven track record of issuing CLOs and successfully investing in CLO debt and CLO equity. 8 XA Investments XAI Knowledge Bank
Benefits and Risks of Investing in CLOs KEY BENEFITS Income CLOs provide the opportunity to capitalize on excess returns in the loan market, creating potential for attractive income. CLO debt holders receive LIBOR plus a spread, which varies by debt tranche, while CLO equity holders benefit from attractive dividend payments and the potential for high total returns from the residual. Rising Interest Rate Hedge CLOs may offer a natural hedge to rising interest rates with little to no duration risk. As LIBOR increases, CLO debt increases its distributions. CLO equity is more nuanced; once LIBOR has risen above a specified floor, the spread paid to equity holders increases as interest rates rise. In contrast, interest rates on traditional fixed income investments are locked and adversely impacted by a rising rate environment. Alpha CLO managers seek to generate alpha for CLO equity investors by capitalizing on fluctuating markets and identifying new investment opportunities through the credit market cycle. Structural Integrity Strengths of the CLO structure include stable financing and various credit enhancements that protect debt holders. Low historical default rates demonstrate the overall credit strength of CLOs as well. KEY RISKS CLO investing poses new and different risks than stock or bond investing. CLOs are leveraged investments that may be volatile and may be illiquid in certain market environments. Additionally, the underlying loans of a CLO are senior secured, below investment grade credit and they carry the possibility of default, a risk that increases as the credit cycle progresses. CLOs often involve risks that are different from or more acute than risks associated with other types of credit investments. Generally, there may be less information available to investors regarding the underlying investments held by CLOs than if investors had invested directly in credit securities of the underlying issuers. The market value of CLO securities may be affected by changes in the underlying collateral, including shifts in market value or changes in distributions, defaults and recoveries, capital gains and losses, prepayments and the availability of new investment opportunities, prices and interest rates. The use of leverage in each subordinated tranche may magnify the adverse impact of changes in the value of the assets, defaults and recoveries on the assets, capital gains and losses on the assets, prepayment on the assets and availability, price and interest rates of the assets. The activities of CLOs are generally directed by a CLO manager. A CLO investor is generally not able to make decisions with respect to the management, disposition or other realization of any investment, or other decisions regarding the business and affairs of that CLO. CLO equity (also referred to as the residual or subordinated notes) is junior in priority of payment and are subject to certain payment restrictions generally set forth in an indenture governing the notes. CLO subordinated notes generally do not benefit from any creditors rights or ability to exercise remedies under the indenture governing the notes. The subordinated notes are not guaranteed by another party. Subordinated notes are subject to greater risk than the senior notes issued by the CLO. CLOs are typically highly levered, utilizing up to approximately ten times leverage, and therefore subordinated notes are subject to a higher risk of total loss. There can be no assurance that distributions on the assets held by the CLO will be sufficient to make any distributions to CLO subordinated notes. Relatively small numbers of defaults of instruments underlying CLOs may adversely impact the returns to CLO subordinated notes. CLO subordinated notes are illiquid investments and subject to extensive transfer restrictions, and no party is under any obligation to make a market for subordinated notes. At times, there may be no market for subordinated notes, and an investor may not be able to sell or otherwise transfer subordinated notes at their fair value, or at all. Investments in CLO subordinated notes may have complicated accounting and tax implications. Regulators in the United Kingdom have called for LIBOR to be abandoned by the end of 2021. There is currently no definitive information regarding the future utilization of LIBOR or of any particular replacement rate. Abandonment of or modifications to LIBOR could have adverse impacts on newly issued financial instruments and existing financial instruments which reference to LIBOR. Such developments could lead to significant short-term and long-term uncertainty and market instability. It remains uncertain how such changes would be implemented and the effects such changes would have on CLOs, the loans held by CLOs and financial markets generally. CLOs typically provide that in the event that LIBOR is no longer available the CLO administrator shall calculate a replacement rate primarily through dealer polling. However, there is uncertainty regarding the effectiveness of the dealer polling processes, including the willingness of dealers to provide such quotations. In addition, the effect of a phase out of LIBOR on senior secured loans, and the underlying assets of CLOs, remains unclear. Benchmarking CLO Performance In the past three years, J.P. Morgan and Palmer Square have launched a suite of CLO debt indices to benchmark performance. As of the third quarter, there were no established indices for benchmarking CLO equity performance. Research departments at Wells Fargo, Citi Research and J.P. Morgan provide in-depth CLO market research coverage and track CLO issuance and CLO performance in the marketplace. J.P. Morgan CLO Index (CLOIE): The CLOIE was the first U.S. CLO debt index. This index tracks floating-rate CLO debt securities in 2004 present vintages. Additional sub-indices are divided by ratings AAA through BB, and further divided between pre- and post-crisis vintages. CLO 2.0, or post-crisis vintage, consists of deals issued in 2010 and later. The CLOIE utilizes a market-value weighted methodology. Index inception was July 15, 2014. Palmer Square CLO Debt Indices: The Palmer Square CLO Senior Debt Index (CLOSE, includes AAA- and AA-rated senior tranches) and the Palmer Square CLO Debt Index (CLODI, includes A-, BBB-, BB-rated mezzanine tranches) are broadly distributed daily benchmarks for U.S. dollar-denominated CLOs backed by broadly syndicated leveraged loans. CLOs are investment vehicles which primarily issue debt securities in individually-rated tranches, from AAA- to BB-rated, divided according to levels of seniority pertaining to principal and interest payments. Palmer Square indices include CLO debt issued after January 1, 2009 subject to certain inclusion criteria. Index inception was June 1, 2015. 9
Glossary Alpha Measure of the excess return of a manager or a fund relative to the return of the benchmark index. CLO Collateralized Obligation is a type of structured credit. CLOs typically invest in a diverse portfolio of broadly syndicated senior secured loans. CLOs finance this pool of loans with a capital structure that consists of debt and equity. CLO Debt CLO debt represents senior and mezzanine debt or liabilities of a CLO structure with tranches from AAA down to BB. Interest earned from the underlying loan collateral pool of a CLO is used to pay the coupon interest on the CLO liabilities. CLO debt investors earn returns based on spreads above 3-month LIBOR. CLO Equity CLO equity represents a residual stake in the CLO structure and first loss position in the event of defaults and credit losses. CLO equity investors receive the excess spread between the CLO assets and liabilities and expenses. Collateral Collateral is a property or other asset that a borrower offers as security for a loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to attempt to recoup its losses. LIBOR A benchmark rate that some of the world s leading banks charge each other for short-term loans. LIBOR stands for London Interbank Offered Rate. Senior secured loans and CLO debt investors earn returns based on spreads above LIBOR. Senior loans have LIBOR floors, which ensure that investors receive a guaranteed minimum yield on the loans in which they invest, regardless of how low the LIBOR benchmark rate falls. Senior Secured s Debt obligations (also commonly referred to as senior loans or floating-rate loans ) issued by a bank to a corporation that holds legal claim to the borrower s assets above all other debt obligations. Senior secured loans have floating rates that typically fluctuate according to LIBOR. Tranche Tranches are pieces, portions or slices of debt or structured financing. Each portion, or tranche, is one of several related securities offered at the same time but with different risks, rewards and maturities. CLOs are typically structured with debt tranches from AAA down to BB. Disclosures This material has been prepared by XA Investments LLC for informational purposes and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2017 and may change without notice as subsequent conditions vary. Past performance is no guarantee of future results. This material is intended for informational purposes only and does not constitute investment advice or an offer or solicitation to purchase or sell any securities, XAI funds or any investment strategy nor shall any securities be offered or sold to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by XA Investments LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by XA Investments LLC, its officers, employees or agents. This material may contain forward-looking information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any time period. The instruments and strategies described herein are not representative of the investment strategy of any fund. Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. Investments made by a fund and the results achieved by a fund are not expected to be the same as those made by any other fund, investment objective or policies. There is no guarantee that any investment strategy will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of XA Investments LLC. DECEMBER 2017 ABOUT THE AUTHORS David Adler is an economic analyst and author. His work focuses on illiquidity and behavioral economics. For the CFA Institute Research Foundation, David wrote The New Economics of Liquidity and Financial Frictions published in December 2014. David has an MA and BA in economics from Columbia University. He serves as a Senior Advisor to XA Investments LLC. Jennifer Pruett has over 20 years of experience working with institutions and intermediaries representing both traditional and alternative strategies. She graduated from Williams College and has a BA in History. She is a Director at XA Investments LLC and is responsible for sales and business development. 321 North Clark Street, Suite 2430 Chicago Illinois 60654 1.888.903.3358 xainvestments.com 10 XA Investments XAI Knowledge Bank