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Victoria Zhuang

With Octagon Credit Investors’ parent company Conning recently being acquired by Italian insurer Generali, joining the European CLO market seems a logical next step.

It’s a move that Octagon is poised to make as early as next year, according to CEO Gretchen Lam. Octagon is currently the largest US BSL CLO manager without a European presence, according to 9fin data.

9fin sat down with Lam to discuss Octagon’s plans to open a CLO shop in Europe, how CLO managers are responding to the continued dearth of loan supply, and where she sees value as a CLO investor today.

1. CLO spreads have tightened considerably this quarter. Is there room to go tighter?

I do believe spreads can go tighter. First, the technicals are very strong. Even though we've seen roughly $50bn of new triple-A tranches issued year to date, we've also seen a similar amount of triple-A’s amortized or redeemed. So, we’re seeing flat net supply paired with robust demand from other triple-A accounts. There has been about $6bn of flows into CLO ETFs, of which about $5bn has been triple-A purchases, and there have been other buyers of triple-As that are active in the market and are looking to increase their net exposures.

And then secondly, you have currently - and likely for an extended period of time - very high SOFR base rates, over 5.3%. That certainly supports the attractiveness of the triple-A tranche on the basis of its all-in yield, which today in the new issue is around 6.75%.

The flip side to those two points is that we've seen a high volume of resets in the market recently, and the level at which triple-As make sense for a reset might not work for a new issue.

2. With 60% of the loan market above par, how challenging is it to ramp a CLO portfolio in today’s market?

The secondary market is the most efficient and effective way to source loan assets because the buyer receives economics after T+7 days. So that's always the path of least resistance for ramping a CLO, but sourcing in the secondary today means you are probably going to pay 100.375, or 100.5 for many of those assets.

As a result, ramping up a new CLO portfolio today requires an increased reliance on primary loan market sourcing, and you can source good assets there, it just takes time. Are they at coupons that we saw a year or 18 months ago? No, but there are some transactions coming to market that are compelling, where we like the credit risk. There's just not enough of them given how tepid new issue volumes have been.

What that means then, for a manager seeking to ramp a new issue CLO, is that it's just going to take more time sourcing loans in the warehouse in order to make it an attractive trade for the manager and equity.

It is not the most challenging ramp environment I've ever seen, but it is more challenging than it was in 2022 or 2023.

3. Loan repricings and refinancings have accounted for most of this year’s issuance and some have come to market with spreads as low as SOFR+175bps. Are CLO managers able to partake at these levels and if so, are there concerns over WAS limits?

Over 20% of the loan market has repriced in 2024, and the overall impact of those repricings is probably 10 plus basis points; that will increase as we continue to see additional repricings come into the market. That spread compression will absolutely impact equity distributions and overall equity returns, unless managers can offset spread compression with tighter liability spreads via CLO resets.

We haven't seen reinvesting CLOs at risk of hitting their weighted average spread tests. As a manager, we've been able to operate within WAS tests in our reinvesting CLOs, and we started the year certainly with more than sufficient cushion. Certainly over time, if we continue to see repricing at the pace that we have over the last few months, it could become a more front and center challenge.

4. With downgrades of loans in CLOs rising and the loan market bifurcated, how are managers handling the risk of tripping OC and triple-C tests?

The silver lining of the entire loan market moving up in price is that risk assets have also moved up. That certainly is helpful in reducing distressed or risk positions.

On the other hand, while it may be less painful to sell risk positions in the current market, it's much more difficult to mediate the losses that are incurred. It seems like 90% of the loan market trades above 99.5, and the other 10% you probably don't want to own.

Swapping into higher quality, lower coupon bonds is a nifty and helpful tool in the CLO manager's toolbox to effectively swap credit risk for duration risk in a way that minimizes or at least mitigates the loss to par when selling risk assets.

5. With that in mind, are CLO managers increasing their allocation to assets other than first lien loans, i.e. bonds and second lien loans?

We are absolutely seeing managers increase exposure to bonds. Per Bank of America, exposures of bonds in CLOs is up about $1.5bn year-to-date and we are seeing that as a means to reduce triple-C and other risk assets, and at the same time, mitigate or minimize the impact to par in CLOs.

We haven't seen much issuance of new second lien loans in the broadly syndicated market. Much of that issuance has gone into the private credit market in recent years, and so we have not observed increasing purchases of second lien loans across the manager universe.

I would caveat, though, that investors may observe an increase in second lien buckets as a result of liability management transactions where a priming loan has been issued. This would cause what was previously a first lien loan to move to a second lien. But that is not a result of an actual purchase of a second lien loan.

6. As a CLO investor, as well as manager, where in the capital structure are you finding the best value currently?

I think double B's are still very compelling, given where the current yields on that tranche sit today. In particular, in the last couple of weeks with the very high level of CLO issuance in the market, sometimes some of these tranches, whether that's a double B tranche or another tranche, get lost in the mix at the time when they're coming to market. (9fin’s US CLO pipeline has 30 resets and 8 new issues).

There's just a lot of competition for eyeballs. Sometimes you can take advantage of the fact that a tranche here or there isn't getting as many eyeballs as perhaps it otherwise would. It's not necessarily a function of a manager or the credit risk, there's just lots of deals in the market and so that tranche will price wide.

7. We’ve seen massive inflows to CLO ETFs this year with Janus Henderson’s triple-A ETF crossing $10bn in AUM, although the total size of CLO ETFs is only $12bn. How are ETFs affecting the primary and secondary markets?

They have provided very strong technical support. They're getting these flows daily. There's urgency to put that money to work, and that's led to spread tightening across all tranches, but in particular, triple-A’s given that's the lion share of where these ETFs are investing.

Also, two of the largest traditional buyers of triple-As, banks and insurance companies, are predominantly buy and hold investors. Now with ETFs, you have this large buyer of AAA’s, which is subject to daily liquidity, and that will have implications.

Right now we're seeing, at least as a CLO manager, the positive implications of that. Spreads are tightening because these funds are seeing positive flows, but what happens when the view on rates changes and we see outflows? That likely creates some volatility. That volatility may create an opportunity in the future, but, in the triple-A tranche, that is a shift from what has been the historical dynamic.

In the loan market, over the last decade, we've seen periods where outflows from ETFs, mutual funds and other retail funds have caused broad volatility across the entire loan market, despite being a minority player.

If you look at the fourth quarter of 2018, for example, ETFs and mutual funds saw significant outflows which had a significant impact on the loan market. Particularly the most liquid part of the loan market because those were the assets that those retail funds could easily sell. It was pretty disruptive and it was an opportunity for CLOs to buy those loans that the retail funds were frantically selling.

8. Octagon is the largest US BSL CLO manager that doesn’t have a European platform. Is this something in Octagon’s future?

Yes, it is. Octagon is one of only two managers among the top 20 US managers that does not have a European presence currently. It is natural for us to expand into Europe, given our US position and our new ultimate owner — Generali, an Italian insurance company. We’re hopeful that we will be in the market in 2025. Specifically, as it relates to CLO management, we will look to hire a portfolio manager and an investment team on the ground in Europe.

9. Outside of work, what’s one new thing you’re challenging yourself to do this year?

I am challenging myself to put down the phone and be more present and really, fully engaged, whether that's with my family or with my colleagues at work. Unfortunately, I think that's a challenge that many of us struggle with. So, I'm trying to do my part by putting the damn phone down.

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9Questions — Gretchen Lam, Octagon Credit Investors — Targeting 2025 for European debut

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