Michael Vranos has always been comfortable with fallen angels.
Vranos is the founder and chief executive of specialty investment and advisory firm Ellington Management Group, a longtime player in the mortgage securities and derivatives space, including non-agency and subprime investments.
So it’s no surprise that when Ellington took an interest in corporate loans six years ago, Vranos and his team gravitated to the speculative-grade side. It wasn't just the higher returns offered by leveraged loans; EMG's experience (through publicly traded affiliate Ellington Financial) foraging through the bargains in the volatile mortgage bond market of the late 2000s gave the firm a different perspective on the values in the “misrated” debt of some of these borrowers.
The loans’ ratings are not wrong in the sense that ratings agencies erred in their original assessments or downgrades, but are out of line with the loans' current coupons and performance, in Ellington’s view.
“When we took a look at the leveraged loan market, we decided to figure out where there was value and to create portfolios around that value,” Vranos said.
The Old Greenwich, Conn.-based firm established Ellington CLO Management and issued its first CLO in 2017 via Citigroup, under the direction of Vranos and Robert Kinderman, a managing director, partner and head of credit strategies. Ellington (which oversees $7.7 billion in assets under management) now has three deals outstanding valued at $1.1 billion, all of which have unusually heavy exposure to triple-C rated assets – up to 50% of the collateral pool. By comparison, most CLOs limit holdings of triple-C rated loans to 7.5% of their portfolios.
While triple-C ratings indicate a high level of risk, these loans come with terms that Ellington values highly.
For example, 80% have what Kinderman describes as "real" financial maintenance covenants. Ellington also looks favorably on loans that amortize relatively quickly, by 5% to 10% a year, compared with 1% a year for most leveraged loans. Some of the loans it holds also "sweep" more of borrowers free cash flow to pay down principal than is typical in this market.
It's telling that
Vranos and Kinderman recently discussed with their strategy and their outlook on the CLO market with Asset Securitization Report. What follows is an edited transcript.
ASR: What attracted you to the leveraged loan market, particularly with the strategy of focusing on “misrated” loans?
Vranos: Besides perhaps for their rating, the loans that we source look superior to the loans that other managers have been putting into “regular-way CLOs” – our loans are at discount, they’re almost all first-lien, about 90% first-lien, and they are low leverage at high 3s to low 4s on average.
Kinderman: And 80% of our loans have real covenants as opposed to the cov-lite trend in loans.
Vranos: Yes, and that’s one of the most important characteristics. These loans on their own, pre-CLO if you will, looked to us like a great investment opportunity. We find it important to find a great portfolio first, and use the CLO as a source of permanent financing for the loans, and that’s just what we did. We identified the loans and then securitized them through these CLOs.
Kinderman: Our strategy is to find loans that we deem attractive outright, figure out what permanent financing structure works for that loan portfolio, and then own a term-financed position in the portfolio. Our loan PMs don’t think about managing a CLO, they think about managing our loan portfolio as a total return investment portfolio. It’s a very different mentality.
Was there a challenge in sourcing loans last year because of tighter spreads?
Vranos: The loans we source have very little overlap with the loans that are getting packaged into regular-way CLO deals. If you look at the deals we do, there are only a couple of other managers who have a similar strategy.
Kinderman: The competing bids for the loans that we’re sourcing are not other CLOs. Instead, they’re some form of an opportunistic loan fund, or a distressed fund that doesn’t have enough opportunities in distressed, that’s going for mid-nineties dollar-price, high single-digit coupon loans as a placeholder. We’re looking for a set of loans that are entirely different than other managers who issue broadly syndicated CLOs. Simply put, the dynamics are just different.
Where were your opportunities and challenges in the leveraged-loan market last year, particular with the market’s price dislocation in December?
Kinderman: The price action in the fourth quarter was great for us because it gave us the opportunity to prove out our investment thesis. The loans we hold outperformed a mix of single-B and triple-C loans. If you were to look at a portfolio that was 70% single-B and 30% triple-C, those loans were down around 3% in December, and, during the same period, regularly broadly syndicated loans were down 2-3%. Our loan portfolio, on the other hand, was down much less, because it’s not the typical portfolio and didn’t face the same sell pressure as [with] regularly broadly syndicated loans. The loans that came under pressure were larger loans that might have been part of a regular CLO warehouse or held by loan mutual funds.
With this in mind, we were opportunistic in December. There were lots of loans that the market seemed comfortable with – with more leverage, at par, no covenants – loans that were even riskier than what we typically buy. But in December regular-way CLOs and loan mutual funds weren’t buying. Issuers had to sweeten the pot, and as such, the market ended up on our terms – offering covenants and discount dollar prices. When the CLO issuance market shuts down, sometimes we find an opportunity, and this was the case in December.
What are your investors seeking that’s unique from other BSL CLOs?
Vranos: On the equity side, we are much higher yielding and significantly more resilient – we essentially have our LPs lining up for the opportunity to participate. On the debt side, the spread differential of the higher rated debt tranches in our deals can be pretty significant compared to a regular-way, broadly syndicated deal.
Kinderman: Generally, I’d say that that our investors also invest in regular broadly syndicated deals. They are investors who are large enough that they have their own credit analysts doing full diligence on our portfolio. They’re combing through data and recognize that the loans in our portfolio are not as risky as the ratings suggest.
What is the reason for the triple-C cap to be at 50% on your CLOs?
Kinderman: The triple-C bucket is typically dictated by senior and mezz investors. In a number of ways, we could have made our lives much easier by making the triple-C limit tighter. Our initial portfolios are only 25% triple-C, and a lot of those loans are not rated.
Our primary concern is that all of these tests and triggers are so far away from affecting us that we don’t want our loan PMs to even be thinking about what the rating of a loan is or how it’s going to affect some test. Our loan team thinks about what’s the best value and total return, and manages the loan portfolio from that perspective because that’s ultimately going to be best for our equity investment.
Vranos: To that end, let’s talk about returns and yields of the assets. The assets themselves, are on average, in our first three deals, in the Libor plus mid 600s [coupon] range.
Kinderman: If the coupon is in the low 600s and your 96 dollar price performance for your maturity, you’re going to be into the 700s discount margin.
Vranos: The spreads on the assets are very wide, so the fact that we might need more subordination [in our CLOs] from the equity, up to the triple-B, is not a big deal. It makes for a rather safer-looking equity piece, because zero yield occurs at much, much higher [constant default rates] as compared to a regular-way CLO; we’re not fighting over every last penny or having to tranche the deal very thinly.
Are there particular sectors where Ellington finds much of its collateral, or are this mostly company-specific loan purchases?
Kinderman: Some investors assume that in order for us to find the spreads we do on our portfolio, we must be concentrated in sectors like retail and energy. But in fact, our sector concentrations are low. Rather, our portfolio is diverse across industries. It’s a company-specific analysis, but we are also conscious to limit our exposures to challenged sectors like retail. Our largest industry concentration is approximately 1/3 of the limit allowed.
Will the reduced number of expected Fed rate hikes [which could lower demand for floating-rate] impact your loan acquisition plans for 2019?
Kinderman: We think CLO demand is going to be important in terms of what loans end up doing this year. CLO liabilities didn’t widen out as fast as loans did in November/December. Conversely, now that loans have recovered quite a bit, CLO liabilities are still catching up.
We may see a number of deals start to get done now that had warehouses already outstanding from last year; however, given the thinness of the arbitrage in regular deals, it is likely we will see less issuance in the first and second quarter. So we expect that CLO issuance is going to be well below the pace we saw in 2018. We believe that dynamic is more significant for our CLO platform than is the prospect for fewer rate hikes.
Vranos: For us, sourcing loans has not been difficult, regardless of the rate environment. The big story last year, which has less to do with Ellington, was when refinancings occurred, because you saw a lot of [net interest margin] compression on regular-way equity deals; you saw those who refinance can and those who can’t stay in the pool.
So the bout of loan refinancing did not reduce your existing loan opportunities in the secondary market?
Kinderman: Actually, what was hurting regular-way CLO managers last year was a great tailwind for us. If we’re taken out of a loan we own at 95-96 through a refi, ratings agencies likely haven’t looked at that credit in several years. So, when the loan goes to refi, after the refi, it’s given a rating that fits a regular-way CLO. That activity takes us out of the loan that we bought at a discount at par, meaning we can then go find another investment at a discount.
If you assume this aggressive refi behavior continues, that’s a big problem for a typical broadly syndicated deal because of the NIM compression Mike mentioned, but it’s a great benefit for us.
Any additional overview or insight on the 2019 loan market outlook and how it affects Ellington?
Kinderman: Regular-way BSL deals are such a high percentage of loan demand that the dynamics of the CLO liability market – particularly AAA spreads – will help determine the volume of loan issuance, whether spreads normalize, and the terms under which loans are issued. Tighter AAA spreads lead to looser terms on loans.
