Podcast: CLO Market Pulse with Ian Gilbertson

Stewart (00:02): Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley, I'll be your host. Hey, welcome back, it's great to have you and thanks for joining us. We've got a great podcast for you today, the topic being CLOs and we're joined by Ian Gilbertson, CLO Portfolio Manager and Co-Head of US CLOs for Invesco. Ian, thank you for being on, I can't wait to hear about this asset class and thanks for taking the time.

Ian (00:49): Yeah, happy to be here, Stewart.

Stewart (00:51): So, before we get going too far, and this is a very important asset class for insurance companies, there's a lot to talk about there. But before we get going too far, where did you grow up and what was your first job, not the fancy one, and a little bit about how did you find your way to CLOs?

Ian (01:10): Sure. So, growing up, I was a military brat growing up actually, father was in the Air Force so family moved around a bit. I spent time in upstate New York, Colorado, Maryland, New Hampshire, got to really see the country that way. And really, my first job out of high school was, fortunate enough, not to have to have worked tirelessly through high school, my parents definitely discouraged me from having to earn a living so early that I was able to really wait until college and it was IT. I found myself in IT early on, fascinated with technology, was interesting as ... I always found myself as interested in gadgets and then I thought I was the tech guy until I went to school at University of Michigan, met a bunch of my engineer friends and realized I have no tech skills at all, so it's all relative.

Stewart (02:04): It's really funny you say that because I started the same way at the University of Missouri at Rolla. And I was like, "I really like tech," and I majored in computer science but no one told me what the math requirement was and I was like, "I just like computers and whatever." And I was like, "Oh, I need to find another field." And it turned out that I was a lot more comfortable with statistics than I was with calculus and so finance just came naturally. So, it's interesting how we get here. I mentioned at the top of the show, CLOs are an important part of a lot of insurance company's investment portfolios but we also have folks who listen that aren't necessarily have a ton of experience. And so, I'd love to start off by just asking you if you can define what a CLO is, what am I actually buying and what risks am I exposed to?

Ian (03:06): Yeah, sure thing and it's good to level set the entire audience to start off here. So, CLO stands for collateralized loan obligation and what that really is, basically, to me, when I explain it at Thanksgiving every single year to the same relatives, it's just a pool of assets that are corporate debt obligations, somewhere in the range of 200 to 350, of senior secured loans. And so, it's actively managed because the collateral manager is really trading that portfolio over the life of the CLO and looking to invest in these corporate borrowers that are sub-investment grade. So, typically, single B, double B rated leverage loans and the pool is then leveraged by going out to borrow debt capital from certain investors that are looking for particular ratings and risk tolerances.

So, you have different investors who will participate at the top of the capital structure, different investors who are in the middle and certain investors who really like the bottom of the capital structure.

Stewart (04:19): And can you tell us a little bit more about your role at Invesco and how your firm, what the overall approach is to the CLO space?

Ian (04:31): Yeah. So, as you mentioned, I'm Co-Head of the US CLO business here at Invesco. I run that business with my colleague Elizabeth Clark who's out of our Chicago office and honored to be just part of a team that's really dedicated to the CLO business for over three decades. Invesco has been managing senior secured loans since the '80s, 1989, managing private CLO structures into the '90s. We issued our first broadly syndicated CLO in 1999 and then we actually started investing into the debt tranches of other manager's CLOs as early as 2001. But today the Invesco loan platform has grown to about $44 billion in AUM and just under $20 billion of that AUM is in the CLO strategies.

So, originating and managing Invesco CLOs is an integral part of the loan platform, that's a core business to the Invesco organization. But with over 130 different CLO managers, there, an important part of my job is really trying to differentiate ourselves and explain to investors what makes the Invesco CLO platform different. And it's really three key pillars of our investment philosophy that differentiates us. First, it's defensive positioning of our collateral. Second, it's owning the large liquid portion of the broadly syndicated loan market. And then, third, it's really seeking to capitalize on market dislocations with, we have a top tier group of analysts and a trading team that's private side focused and really dedicated just to loans.

Stewart (06:03): That's super helpful. So, CLOs have gained popularity with insurance investors. I suspect part of this is driven by the performance of the asset class and what I mean by performance is loss experience, which is my understanding, and I don't want to put words in your mouth here, but this asset class has performed very well. What do you think is driving this growth and where do you see the most demand? And I'll add to that, are there areas of concern for you?

Ian (06:38): Yeah, sure. The growth has actually been pretty remarkable over this time. You look back over the past several years, you go back 10 years ago and the CLO market was just under $400 billion and, now, you look at the US and European markets, it's over $1.3 trillion in total size. The US market making up the majority of that, that's close to $1.1 trillion of that. But break it down into the different parts of risk within a CLO capital structure and I think that also helps drive the growth. You look at the top of the capital structure which is the AAA portion and AAAs make up the majority of a CLO capital structure, it's about 65%. CLOs have really remained the only scalable way to get a highly rated floating rate asset and they offer compelling yields and, given some of the elevated interest rate volatility that we've experienced, AAA CLOs have really been in an appealing way for investors to deploy capital who are seeking that low rates duration and that good price stability.

So, banks in particular have found this really appealing when you look back on performance of treasuries, investment grade bonds, that long duration fixed rate assets, CLOs have offered the compelling alternative to really diversify your holdings. And as you mentioned, the performance has really been strong. So, if you look over the past 10-year average return for just that AAA portion, it's been about 3.25% but it's also been pretty remarkably stable. The Sharpe ratio of 0.71 over that 10-year period, that's really, I think, given investors a lot of confidence that, if they haven't spent time looking at CLOs, it's something that they should be looking at. And then you look at that floating rate nature. So, go back to 2022 when rates spiked and most of fixed income portfolios were in the red, you had positive return. For AAAs in particular, it was over 1% and, even today, now you have a still pretty decent yield at about 5.5% for AAAs.

So, new participants have been looking to add CLO exposure and it's really been enticing for them to see that stability, that diversification effect but then, looking at the past history, AAA CLO notes have historically never experienced a default even when you go back to the GFC and so that true tested structure is really been one of the drivers of the growth.

One other thing that's worth highlighting just in growth recently has been private credit CLOs, sometimes referred to as middle market CLOs. So, these are similar to the broadly syndicated loan CLOs that make up the majority of the market but they're backing loans to companies that are middle market or smaller, call it EBITDA of $100 million or less and sometimes significantly less than a $100 million. So, while BSL and private credit CLOs, they both have the same technology to them, it's that private credit CLO is more, I think, benefiting from the growth in private credit as a funding source, whereas, the broadly syndicated loan CLO is more manager looking at the arbitrage of the spread on the assets and the spread on liabilities.

Stewart (09:55): And it's interesting that, when you talk to my friends that are CIOs, one of the things that comes up is how do we implement this or how do we integrate this or how does this fit into our portfolio? How are you seeing insurers integrate CLOs and are there particular vehicles that are more favorable than others?

Ian (10:20): Yeah. So, insurers have remained a core part of the CLO market for over the past decade and it's really one that, if you name the key participants, insurers are towards the top of the list. You look at NAIC and, according to their statistics, it's over $250 billion of insurance companies held CLOs in aggregate. So, that means insurers own about a quarter of all outstanding CLOs. And even more interesting, when you break that down into the particular tranches of debt, there can be some of these that insurance owns upwards of 50%, that belly of the stack as I refer to it, it's that AA down to BBB tranches. So, AA down to BBB, that's really where insurance spends a lot of time or finds a lot of value.

Now, that said, CLOs still account for a relatively small portion of insurance general account, it's only about 3-4% but suffice to say that banks, asset managers, pension endowments and insurance really make up the bulk of the holder base there. So, the growth in insurance exposure in CLOs, it's received a little bit more regulatory attention lately. NAIC has introduced some stress tests specifically for CLOs in the past several years to help monitor that more closely within the industry's exposure. We had the NAIC increase the risk charge for that residual interest in CLOs, that's also known as the CLO equity position that went from 30% to 45%. Now, this is a temporary change as the NAIC is working towards a longer-term solution but clearly a focus for them for that lowest portion of the capital stack, what they deem the highest potential risk and making sure that insurers don't get ahead of themselves there with exposure.

But additionally, NAIC is planning to move from a ratings-based determination of capital charges to a model-based framework and we've actually seen some recent data come out from them on some of the modelling that they're doing, they're being very transparent on a lot of these moves and giving a lot of time for the insurance industry to react. So, all that uncertainty, it's had some movement over the past couple years, most notably, we've seen insurers are preparing by moving up the capital stack. So, it's very common to see insurance participating right now and call it that A tranche up to the AAA and that's a move that we've seen pretty handedly over the past couple of years.

Stewart (12:50): And it seems that ... We've had others on, we had Kerrie Meares on who's going to be back on in November to talk about some of these issues and it seems as though that insurance companies don't have a lot of exposure to that residual tranche, that equity tranche. Is that fair? I think most of their exposure is investment grade BBB or above. Is that accurate or am I misstating something here?

Ian (13:19): No, you're exactly right. The vast majority, over 75% is in that A on up and it really feels like regulatory body actually getting ahead of a situation that could have occurred if we were ... Go back to 2018, 2019, we were in a yield seeking environment and it's just natural in that environment for a potential buyer. I now have a portfolio of AAA, I'm comfortable there, work my way down to AA, work my way down to A and eventually you might have some smaller insurers that were participating in the equity tranches. You don't see it as much from, certainly, the large life insurance participants as well.

Stewart (14:00): Yeah, it's interesting, there's definitely a deterrent there. It's almost like that level of capital charge makes that asset difficult for insurance companies to own. And you bring up a great point, I think that the regulatory folks and the NAIC staff do a really good job of being super transparent with what they're trying to do and they interact with the industry as well. So, they've got a tough job and I think they do their very best to get it right.

Ian (14:31): Yeah, of course. Now, you had mentioned how people are participating, one thing that I'd want to mention is just the emergence of ETFs which has been a big growth area for the CLO market in general but also just very recent. You think of CLO ETF AUM, currently, it's at about $18 billion but those year-to-date flows represent almost $10 billion of that. Invesco is actually involved here, we launched the Invesco AAA CLO Floating Rate Note ETF, that's Ticker ICLO back in 2022. Our product focuses on senior portion of the CLO liability stack, a requirement of 80% of that to be AAA rated but reception of the product has been strong. It really is the first time that many of the buyers have access to the market in general. And ETF, you think of mom-and-pop retail investors, that's not necessarily the case. Even smaller regional banks, insurers, really sophisticated institutional investors are now able to gain immediate diversified exposure to CLOs without having to go out and build the team or get resources and get those systems in place.

Stewart (15:39): Yeah, it's interesting. I would have thought that those exposures are for the smaller carriers but that's not the case, the larger carriers are players there too based on information that I've seen. And it's a good alternative for insurance companies that you can leg your way in and you can manage your exposure and you've got liquidity considerations there so that all makes sense to me. When you're talking ... And you mentioned at the top of the show that the portfolio of loans is actively managed and I'd like to know a little bit more about that aspect. If you can share with me what areas of the loan market do you like right now and are there areas that you're cautious on?

Ian (16:30): Sure. So, the active management really comes from being able to manage that pool of the 200, 300 obligors. So, Invesco has a pretty unique perspective here in the CLO market, we're a sizable CLO manager as well as we're an investor into other manager's debt tranches. So, I spend my days talking to other managers, analyzing their positioning, their trading history and then evaluating where we'd like to be positioned in our own portfolios. And generally, I'd say, you go back to 2022, 2023, it was risk management mode. Leveraged loans were experiencing headwinds from supply chain disruptions coming out of COVID, then material, labor, other cost inflations and then finally you had that higher interest rate environment which meant interest expenses were increasing for many of these borrowers. Public rating agencies were taking note of some of these headwinds and we're on the tail end here of a pretty decent downgrade wave.

So, you look at the leveraged loan market alone, we saw $45 billion of net downgrades in 2023. So, during the past 18 months, the focus has really been on managing that BBB/B- risk and it's trying to identify within these structures what's that next potential CCC downgrade from an earnings miss. So, maybe it's not priced in right now or you're looking at your interest coverage ratios and you're seeing what could potentially cause that CCC downgrade. But good news is it feels like a lot of that is priced in right now. You've got about 5.5-6% of the CLO market that is CCC rated right now and those are trading in the low 80s, those loans but we've actually seen the percentage of CCCs ticking down in the past couple months and we have over 40% of the loan market trading above par.

So, it's almost like this tale of two cities that the identified CCC risk for the over levered capital structures are, on one end, that's somewhat identifiable and then, on the other side, you've just got the par performing loans that are very well bid from some pretty record issuance that we've seen from CLOs in 2024.

Stewart (18:37): That's super helpful, and thank you for that explanation. The question I guess I have is somewhat of a broad one. In your mind, where are we in the credit cycle right now and how is that impacting how you think about CLOs?

Ian (18:56): So, over the past two years, we've really been focusing our portfolio management just on rates. And now that we're in a declining rate environment, it's become really topical to think about how CLOs perform in a declining rate environment. Generally, I think CLOs are well positioned as loan fundamentals should benefit from the lower interest burdens that we just talked about, it also bodes well particularly for the bottom of the CLO capital stack, that BB in equity position. So, while your carry income might be slightly reduced, CLO spreads actually remain pretty attractive across most of the similarly rated comparable assets within fixed income. But also, equally as important I guess is the question on how CLO structures have performed and where they are in that cycle as well.

So, you go back and you look at 2022 and 2023 volatility, you had CCC's peaked about 100, 200 basis points higher than where they are currently and so CCC exposures have been coming down. But also important in the CLO structure is this idea of over collateralization. So, what we do is we focus on that junior OC cushion, the junior most lowest part of the capital structure and how much over collateralization there is there typically on the BB tranche before you actually get your first dollar of impairment on that junior debt. So, we continue to see healthy cushions there, it's about 4.2% currently, so that's saying that you would have to have 4.2% credit loss before you started to see that first dollar impairment on that BB, that lowest portion of the capital structure.

And so, with the improvements that we've seen over the past couple of months, it really just feels like 2022, 2023 can be another example of an economic period similar to COVID or similar to the 2015, 2016 energy crisis where CLOs essentially bend but don't break and just showcase the structure's ultimate resilience.

Stewart (20:57): And I'm going to just take a sidebar here and just say, when you're talking about overcollateralization, in a structure like this, that is your credit enhancement, right?

Ian (21:09): That's exactly right, yeah.

Stewart (21:10): Can you just talk about that? Because, as I mentioned, we have people who listen that aren't necessarily expert in this area and I think that explanation might be helpful.

Ian (21:20): Yeah. And CLO market wants to make it more complicated than it needs to be so there's going to be terminology that you can use interchangeably. So, credit enhancement, the par subordination, the overcollateralization, we're essentially just getting to the idea of you have the ability to purchase more assets than the debt that's outstanding. And so, the CLO structure is really made in a way over its life to be able to handle a certain level of credit loss and that credit loss comes from a couple of different ways. It can either be trading the portfolio, you're carrying all of these loans at par but, if you trade out of a loan at 99 or 98, there's a mild level of credit loss there. You obviously have defaults where you invest 100 cents on the dollar but ultimate recovery is only 60 or 65 cents on the dollar. And then there is the potential for some CCC haircuts that can be either temporary or those work their way through overcollateralization tests and can become permanent but those are the way that the overcollateralization tests really work.

Now, when we talk about the structure and the technology, what's really nice about CLO as a whole is it has this cash flow diversion mechanism where the OC tests are there for a reason. On a monthly basis, you're taking a snapshot of how much collateral you have versus the debt and cash flows that are going out to equity can actually be diverted to de-lever the structure, repay the highest portion of the capital stack that AAA's and hopefully come back into compliance with the OC tests.

Stewart (23:05): And just generally and if there's duress, the lower tranche is going to ... Some of the cash flows that was originally intended for the lower tranche are going to be diverted to support the more senior tranches which is how you get this credit enhancement in this structure. I realize that that's very basic for some folks but it's important for others and I just wanted to get out there.

Ian (23:30): Yeah, no, it's worth highlighting. Thanks for pointing that out

Stewart (23:33): So, I'm a certifiable bond geek and, whenever you hear performance that's been really strong for a long period of time, me and my spidey senses start going ‘what's going on?’ What's coming down the path? Is there something that I'm not seeing? So, when you're speaking to clients, are there particular risks that are top of mind and, if so, how are you addressing those?

Ian (24:00): Yeah, sure. We were actually just down at an industry conference last week, the ABS East Conference in Miami. Tone of the conference was very constructive for CLOs, conference was very well attended, over 6,000 participants. Now, that's not all CLOs but we had a full slate of meetings with investors and investors seemed really poised and ready to put money to work in the space. Now, I think the questions that we had been receiving are there's been a shift in the issuance of gross issuance to actual just refinancing of the existing portfolios. CLO market has the ability to refi a capital structure lower or reset the capital structure so you have a certain life of the deal, a five-year reinvestment period, you can now reset the structure to go for another five-year reinvestment period. So, a lot of the questions were revolving around what our plans are for our existing pipeline of CLOs.

A lot of investors were also asking just, "Hey, gut check me on how I'm thinking about fundamentals for next year. Does that make sense to you? What are your thoughts on potential for downgrades, defaults, CCCs?" Those are all still questions that I think people are analyzing but at their various tranche levels. But with that said, there definitely felt like a lot of interest in future issuance.

Stewart (25:26): That's really helpful. And that brings me to my last question for you before we get to some fun ones on the way out the door. Given the current economic environment, what is your outlook for the asset class over 2025 and as far as your crystal ball allows you to see?

Ian (25:43): Yeah, my crystal ball, I've been trying to sparkle it a little bit shine here every single day.

Stewart (25:47): Yeah, mine's murky too, don't feel bad.

Ian (25:51): Yeah. I think CLO market is poised to continue to benefit from some of the strong growth and performance we've seen over the past several years. Now, I think the pace of growth is going to slow a bit and that's partly because of the market technicals that we just talked about. Market participants have been very busy with refinancing and resetting their existing CLO structures so, while that new money isn't necessarily going to be growing the overall size, it's still a focus for investors to have to process these refinance activities and that's going to continue into 2025. We've seen amortization and call volume of deals pick up as well. So, you've had gross issuance in the broadly syndicated portion of CLOs be about $115 billion for call it the first three quarters of the year. But actually, net supply, after another $65 billion of amortizations, another $35 billion of called volume, it's actually relatively light, it's only $11 billion of net issuance for the first 9 months of the year.

AAA market, actually, since that's the portion of the capital structure that sees majority of those amortization payments, they're actually net negative for the year. So, that trend we also expect to continue into 2025 where that slowdown in the overall growth in the market stability at a very comfortable level. We've seen interest in CLO equity pick back up in 2024, that's both the return of third-party capital players who moved up the capital stack to junior mez back in 2022 and 2023, they're looking to get more involved in CLO equity again as well as the growth of captive equity funds. So, CLO managers, they've been raising their own financing for the issuance of their own CLO platforms and that should help drive further issuance into 2025 as well.

Stewart (27:44): I've gotten quite a good education on CLOs today, Ian, I really appreciate you sharing your expertise with our audience today. I've got a couple of fun ones for you on the way out the door. I was in front of a group of students recently who were seniors predominantly majoring in finance and I asked, "How many of you have a job lined up for May of '25?" And about, I don't know, maybe a quarter of the hands went up and then three quarters ... I think sometimes people don't really ... You don't know how hard they've been looking and whatever else. But what advice would you give someone in that classroom who wanted to get into finance, who might be interested in structured finance in the way that you've come into it? Is there anything that, any advice that you'd give a person who's starting out in their career today?

Ian (28:36): Yeah, sure. Going back to that time period, I feel like, over past several decades, it's trying to think of what's important to success to get to that level that I'm sure all of these students are shooting to attain. I think it's important to just listen and then be empathetic. Younger me I know would've appreciated that advice if it was having a conversation to talk to somebody with a different perspective and then incorporate that into some of the thoughts and going forward in your whatever path they might be looking at.

Stewart (29:10): That's awesome. And now, the final fun one. So, lunch table of four, you're one of the guests, you have three, you could invite up to three others alive or dead. Who would you most like to have lunch with?

Ian (29:24): This is a funny question because I feel like I've heard it in the, oh, who would you want to interview but it feels like that is only one person. I like how you phrase it where it's a group of people because it's almost like you want to hear the interaction of everybody.

Stewart (29:38): Yeah. Yesterday somebody threw out, they threw out Henry Kissinger and then the other person threw, it was two people on the podcast, Tina Fey and I was like, "Wow, okay." But you don't have to invite all three but you've got three guests so who would you pick?

Ian (29:58): I don't know if it's just the love seeing a car crash conflict side of me that would want to get an entertaining group together, maybe I'm also just reading the Hamilton biography that inspired the Broadway show but I think I'd like to get Aaron Burr and Alexander Hamilton at the table. I guess I would have an extra seat so maybe Thomas Jefferson as well and then just see if we could really settle it without having to count to 10.

Stewart (30:26): Wow, there you go, very cool. I've really enjoyed having you on. I really appreciate the education, I feel like I know a lot more about CLOs than I did when I started 30 minutes ago and thank you so much for being on.

Ian (30:39): Oh, great! Thanks, Stewart, for the opportunity.

Stewart (30:41): We've been joined today by Ian Gilbertson, CLO Portfolio Manager and Co-Head of US CLOs at Invesco. If you like what we're doing, please rate us and review us on Apple Podcasts, Spotify or Google or wherever you listen to your favorite shows. My name is Stewart Foley, we look forward to seeing you next time on the InsuranceAUM.com podcast.

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