Neuberger’s Pim van Schie on CLO mezzanine liabilities

Hello and welcome to Global Capital's another FineMez podcast. I am Thomas Hopkins, Global Capital's European CLO reporter. This week we are doing another CLO special in which we're going to take a look at investment in CLO mezzanine tranches. Helping me to unpack this topic is Pim Van Ski, a portfolio manager at Newburger Berman.

Pim, thanks so much for joining me on the podcast today. Yeah, thank you very much for having me, Thomas. Yes, and it's it's great to have you here and to be diving into all things mezzanine debt related. But uh before we start, perhaps you could just tell me a little bit about your professional background and your role at Newburger.

Yeah, absolutely. Happy to. I'm a senior portfolio manager at Newburger focused on CLO strategies. And so my responsibilities and my team's responsibilities include both the liability side of our CLO platform as well as investing in CLO tranches, including CLO mezzanine debt, which we're focusing on today.

For context, Newberger has a CLO platform of about $32 billion in total in size. We are one of the largest CLO issuers and managers in the market, uh, both in the US and European CLO markets, and a large investor in CLO debt as well, on behalf of a number of funds, but also uh many separate accounts and uh multi-asset fixed income mandates that we we manage for a range of clients globally. Great. Thank you very much, Pim.

And that's definitely sort of put us in the pictures to your sort of diverse kind of experience with CLOs. Um, sort of diving into this you know topic of CLO mezzanine um liabilities, have you been aware of kind of increased demand from investors for these tranches in CLOs in recent years? Absolutely. I think one of the biggest developments in our view in uh in the CLO market the last two or three years has been a big increase in demand and interest from investors globally.

And in particular, I would highlight a lot of new investors coming into the market for the first time. So we and many of our peers, many, many large managers in the market have been educating the global investor base on CLOs, I would say for at least the last 10 years. Coming out of the global financial crisis, as you can imagine, there were some reservations for many investors around structured products in general, or any product that starts with a C and ends with a no. So it's required a lot of education over the years, in our experience, to get investors more comfortable with CLOs as an asset class, explain how they're different from CDOs, for example, explain the historical performance in terms of defaults and credit losses, which has been extremely low over the history of the CLO market.

My experience is that even with all of that education uh over the past 10 plus years, many institutional clients globally remained hesitant to allocate to CLOs until two or three years ago. And we've really seen an inflection point in the last two or three years, and we can see that across our platform, uh, both our funds and uh and other types of mandates, but we also see it more broadly across the CLO market in terms of demand. Yeah, it is extraordinary actually, just that you mentioned the sort of the continued confusion around CDO and CLO, because it's something I've definitely heard sort of from market participants.

Um, but that's interesting to know that that sort of education process has advanced quite a lot over the last few years. And you know, just thinking about this kind of investor base for CLO mezzanine tranches, have you seen that kind of change over time? And you know, are there now more investors say that invest in CLO mezzanine tranches through funds rather than directly in the tranches themselves? I believe that to be the case uh based on our experience.

And and so if you go back five or ten years ago, the investor base, as we discussed, was more narrow. I'd say, generally speaking, more specialist investors that were more often than not investing directly in the CLO tranches themselves, uh, had a team and the resources and the know-how within their organization to make those kind of direct investments in CLO tranches. Where we've really seen the growth is increasingly investors investing in CLOs via managers like Newberger, for example, in fund structures or separate accounts.

And so I think of these as investors that are you're one more step removed from the market. Uh, they don't necessarily have the internal team or know-how or resources to invest in CLO tranches directly. And so they rely on external managers to make those investments and allocations for them. I think it's really uh a characterization or a reflection of the nature of the investor base that has come to the market in the last few years.

So this is a much broader investor base. You could think of pensions, family offices, endowments, foundations, insurance companies, increasingly private banks that offer CLO exposure to their and high net worth and private banking clients. All of those kind of organizations generally just don't have the resources and know how to invest or dedicate to investing in CLO tranches directly. And so they rely on external managers to do that.

You know, we get asked a lot about the reasons for why we've seen such a pickup in interest from more and new investors over the last two or three years. And I would highlight maybe a couple of components that we think have contributed to that interest. The first one would be uh what I reflected on earlier, the the the constant and continuous education from many managers like Newberger, many of our peers in the market of all of their end clients across their organizations. So that certainly has contributed.

But as I mentioned, that education has been happening for over 10 years, and we've really only seen the increase uh or the real inflection the last two or three years. The the other components I would highlight are that it is our experience that investors continue to see CLO markets rebound very well from periods of market volatility. And so we've now had four or five periods of volatility in the last 10 years, meaningful volatility in the CLO market. And each time the market has bounced back very well, credit losses have been extremely limited.

And so investors have become more and more comfortable with the fact that indeed these structures are very well protected against credit losses. The third reason, uh, ironically, I think is the advent and growth of the CLO ETF universe. Um, while that is, you're of course predominantly focused on CLO AAAs, and that that's why we think it has the best use case potentially for clients. It's our belief that just the fact that there are CLO ETFs out there is getting some institutional clients more comfortable with the concept of CLOs really being a mature deep asset class that they should consider in their asset allocation framework.

And then you know the final component, of course, the most important one is just relative value. So CLO debt continues to offer uh very attractive relative value to clients compared to corporate credit at the exact same rating. So even if you look at CLO double Bs today, for example, investors are capturing about 3.5% additional yield for CLO double Bs as compared to double B rated high yield for something that is actually better protected from a default perspective, from a structural perspective.

So that message has resonated with clients as well. So I think all of those four aspects have contributed to the significant increase uh from new investors over the last two or three years. It's interesting, Tim, that you bring up the sort of strong relative value point because obviously just over the last couple of weeks or so, we've seen with European CLO mezzanine spreads, they've gone sort of exceptionally tight. You know, at times we've seen them almost the tightest they've been in around five years or so, I think.

And I wondered with these really, really tight spreads, that's usually an indicator of quite strong demand from investors. And I wondered if you thought that there was a kind of link between the sort of tight spreads and the kind of strong relative value that CLO mezzanine tranches sort of do offer some investors. Yes, absolutely. Um, you're you're quite right.

We've seen very strong demand as we've talked about, and that that has contributed to the tight spreads in the market today, which are tight even despite large issuance volumes. So CLO issuance volumes have been very high the last couple of years, both in the US and European markets at record levels. Despite those issuance volumes, we we've seen uh very tight spreads because of the strong demand from investors globally across the capital structure. Our outlook on this is that even though spreads are quite tight today, as you well pointed out, near the post-global financial crisis tights in uh, for example, CLL mezzanine debt, we believe that spreads are likely to be range bound in a pretty narrow range uh going forward, at least for the next 12 months or so.

Um, and that the bias, if anything, is towards some slight further spread tightening, even though levels are already tight today. And the reason for that is, again, we we don't see any impending change in the strong demand from investors. We still continue to see a ton of increasing uh inflows, interest from investors into the space. And uh on the supply side, we actually believe that we'll see levels of supply issuance volumes in the CLO market decrease somewhat from the record levels of the last couple of years.

And the reason for that is just that you know, it's been well documented for quite a while now. The new issue CLO equity arbitrage continues to be quite challenging, meaning that CLO equity returns for new issue CLOs are relatively tight compared to the historical range. So it's a little bit less attractive to issue a new CLO today than it has been over most of the last 10 years. We think that ultimately will drive somewhat lower issuance volume.

So a little bit less supply, still very strong demand. Uh, we think the market will continue to be very firm from a technical perspective. Just to pick up on something there, Pim, do you think that even with managers increasingly using kind of captive equity funds to print deals, you know, which is I I think maybe part of the reason that supply has been a bit higher, do you think eventually, even though captive equity funds aren't quite as focused on like the day one ARB and things, that we'll see supply sort of tail off a little bit if equity conditions sort of stay where they are at the moment?

Yeah, you bring up a good point. The market has been a little bit distorted by the large amount of captive equity being invested in new issue CLOs, and that certainly, in our view, led to a little bit higher issuance than we otherwise would have or should have seen in the CLO market. Now we have captive equity funds ourselves, so I I'd like to point out that we believe a lot of these captive equity funds actually are are pretty disciplined in how and when they issue uh related to what the new issue equity arbitrage environment looks like at any point in time.

But we do believe that uh even those funds have return hurdles. Um you know, obviously they have end investors, they need to show performance and that over time the captive equity funds uh perhaps will exhibit even more discipline uh with respect to issuance volumes than we've seen so far uh in the market. Absolutely. And returning to thinking about CLO mezzanine investors and what they're looking for in deals at the moment, are they sort of really quite strongly focused on collateral quality at the moment?

I would say absolutely, uh although perhaps still not as focused or focused enough in our view. So there is certainly a lot more focus on quality. I think one of the big trends we've seen in the market this year, or really over the last couple of years, but exacerbated this year with the volatility around software and AI this potential AI disruption of some of the underlying companies in the market. We have started to see a lot more dispersion in performance between the higher quality and lower quality parts of the market, especially, of course, in the lower mezzanine tranches where that is most pronounced.

And we believe that will continue. So, for example, as a firm and as a platform, we've always been focused on uh what we believe is the higher quality part of the CLO mezzanine debt market. And the reason for that is very simple is that we don't believe that in a normal market environment, investors are getting paid a sufficient premium for lower quality CLOMES in the market versus the higher quality. So said another way, the the basis, the spread basis between higher quality and lower quality CLO double Bs or CLO single Bs in the new issue market, for example, in our view is not nearly wide enough.

So it doesn't pay, in our view, to invest in lower quality, wider CLO mezzanine debt tranches, especially uh as we're expecting the the dispersion to increase going forward. So coming back to your specific question, investors are definitely focused on it, but but not focused enough in our view. Uh we still think there is much better value in the higher quality end of the market. And you brought up, of course, Pim, this dispersion in terms of where CLO mezzanine tranches are pricing.

I mean, I know that obviously in the junior MES, so double B and single B, those investors are probably the most sensitive to kind of collateral quality and things. But I mean, are are you seeing some dispersion currently in you know where those tranches are kind of pricing? We are. We certainly are, and the dispersion is increasing.

Uh again, I we think it will continue to increase further. Um, it's interesting because I mentioned earlier, you know all the education that's been done with clients and all the education we've done over the last 10 plus years. I think you're one of the big selling points of CLO debt in general, or in this case, let's say CLO double B debt specifically is the extremely low default rate historically. So, for example, if you look at CLO double Bs uh over the last 30 years, the average annual default rate for CLO double B debt is 0.

04%, which is significantly lower than high yield or loans uh outright, right? That just for context, that is equivalent to the default rate for single-A corporate credit. So objectively, CLO mezzanine debt or a CLO double B specifically have performed very, very well from a fundamental perspective over the last 30 years, including the global financial crisis. So you're one of the big selling points of CLO debt has always been that, well, you may experience potentially volatility in times of of market shocks, but you can be, as an investor, very comfortable from a fundamental perspective that the risk of an actual default or credit loss is very low, especially when you're investing in the higher quality part of the market.

That continues to be the case, but but we have seen a lot more dispersion. And and I think where you're going with that is we've, for example, recently seen a well publicized actual default of a CLO single B tranche in the European market. We've had a lot of questions from clients around that event happening and what that means for the market going forward. Uh, and maybe to give some context around dispersion.

You know, i if you think about the CLO double B market today in the US, for example, uh almost 10% of the market has a MVOC, a market value over collateralization below 100%. So that in plain English means if you take the market value of the underlying loan portfolio, the total market value of that is not sufficient to cover the entire principal balance of the CLO double B charge. Similarly, in Europe, just under 10% of the European single beat market has a market value over collateralization of below 100.

So if you just take that as a data point, that would tell you that likely going forward, we're more likely than not going to see more of these idiosyncratic uh defaults of lower CLO mezzanine debt tranches because of underperformance in the underlying loan portfolios. I would stress though that this should not be a surprise to anyone. This is very well telegraphed by the market value of the underlying loan portfolios already. The default that we did see happen would not have been a surprise to anyone in the CLO market because you can simply look at the quality of the underlying loan portfolio and draw conclusions from that well ahead of those defaults actually happening.

But my point there is that default rates historically have been extremely low. We expect them to continue to be low going forward, but we do think that default rates in CLO Mesdat will be higher going forward than they have been over the 30-year history of the market, just because of the increase in dispersion in the market. Yeah, of course. And I mean you obviously Premier, you mentioned that there's been the sort of that that first sort of impairment to a European CLO tranche uh in the 2.

0 era. But I suppose that does really stand out, that it is the only impairment that there has been since CLOs were relaunched in Europe after the financial crisis. And obviously that was on the bane in 2018, one deal, which we actually covered on global capital. Um one thing I sort of thought I had around it though, is I suppose to some extent, also if investors are being paid sort of 800 or 900 basis points over your eyeball to invest in a single B tranch, a default like this or an impairment like this shouldn't really be completely unexpected, because I suppose that's why you're paid that much.

That's why you have a spread that is as sort of as high as it is to some extent. You know, that there is actually, you know, you are at the bottom of the liability capital, the liability capital stack, and so there is a risk that there might be an impairment, even if impairments are pretty rare in CLOs. Yeah, no, I you you make a great point, and that would be a completely fair uh way to think about it. Obviously, these changes are rated single B and double B for a reason.

You are getting paid a very healthy coupon, in fact, a large premium even over corporate credit with the same rating, in part for the risk that you're taking as an investor. But I would say that we actually ascribe a lot of the coupon or certainly the premium that investors get paid in CLO mezzanine debt versus corporates to things other than the credit risk. And so we we think you know investors primarily are getting paid for number one, a complexity premium. You can also call that a reputation premium.

Number two, a liquidity premium, because the while the CLO secondary market is quite liquid these days, it is not as large or as liquid as the corporate credit market as a whole. And the third part of the premium, we believe, is a premium investors get paid for potential temporary mark-to-market volatility. So I would still argue that the biggest risk investors are taking investing in CLO debt is not credit risk. It is potential mark-to-market volatility in a in a market shock scenario, temporary mark-to-market volatility, importantly.

But you're absolutely right. These these tranches are obviously not risk-free. We should expect over time some defaults. And again, if we just look at market statistics today, we look simply at the market value coverage, the value of the underlying loan portfolios in the market today and how well they cover the tranches, that might lead you to conclude that you know, perhaps between 5 and 10% of lower mass tranches in the US and European market that are currently underwater, some subset of those may end up in a similar fashion as the uh as the Bain default that you referenced.

Yeah, thanks very much, Pim. I'm sorry to say that that's all we're going to have time for, but uh thanks once again for joining me on the podcast. It's been a really, really interesting discussion. I'd like to thank everyone for listening and just please do join us again next week for more discussion of all the latest trends in European securitization.

Goodbye for now.