Trading in leveraged loans pales compared to the high-yield market, and in complex collateralized loan obligations (CLOs), whose managers have become major purchasers of leveraged loans, it's even less. High-yield bond trading exploded with the introduction of electronic trading platforms, and Octaura is betting on leveraged loan and CLO trading--enhanced by detailed data and analytics—rising similarly.
Now supported by seven major financial institutions, Octaura has added 16 dealers and 110 buyside investors as customers since its launch in April 2023, according to Vitaliy Kozak, co-founder and chief product officer of Octaura.
Octaura launched leveraged loans around the same time as Versana, which shares many of the same bank investors and seeks to enhance leveraged-loan data to facilitate trading. It has also built long lists of agent banks and institutional-investor customers, affirming the demand for electronic trading over today's highly manual processes.
Kozak and Howard Cohen, Octaura's head of sales, recently spoke to Asset Securitization Report about trends and developments in the leveraged loan and CLO markets, and the potential impact of electronic trading.
ASR: Why do you think leveraged loan issuance is up significantly this year despite high interest rates?
Kozak: Default rates rose above 3% when interest rates increased to 5%. That sounds bad, but people expected defaults to reach as high as 6%. That didn't happen, and now a majority of levered loans are trading above par and spreads have tightened. Given the favorable environment, issuers are looking to extend maturities, lock in tighter spreads, and get more favorable covenants.
Cohen: And because loans are very customizable, borrowers can call the loan, typically after a year, and reissue if spreads tighten further.
ASR: Will this continue?
Cohen: If you look at loan inflows and CLO creation, demand for loans continues to outweigh supply. One caveat is that because borrowers are leveraged there will be pockets of risk and more defaults.
People expected defaults to reach as high as 6%. That didn't happen, and now a majority of levered loans are trading above par and spreads have tightened.
ASR: What indications do you have of that starting?
Cohen: We've had 120 downgrades year-to-date, when it's usually closer to 80; we're averaging two-to-one downgrades to upgrades. So behind the scenes, it feels like that's starting to happen, albeit on a small population—we have 1300 borrowers posted in our market alone. Investors on our platform are keen for more information and collating it more efficiently to understand what's happening on a macro basis as well as in the loan space.
ASR: What insights can they gain from Octaura?
Kozak: On loans we focus on execution quality and provide liquidity scores and guidance that can provide insight into when and how to trade. A lot of customers trading loans take a view on credits, and that can't be replaced. With more electronic trading and better data and analytics, a lot of CLO managers are using artificial intelligence to optimize CLO portfolios and maximize returns to their equity investors. Once an optimization strategy has been determined, Octaura can help with seamless execution of, say, buying 20 loans and selling 20, and identify the best day and time to execute, to maximize liquidity and minimize execution costs.
When I was a trader and I had less information for a specific tranche, I bid as wide as possible to account for the unknowns. Octaura's analytics allow traders to better price risk.
ASR: How does that work for trading CLO tranches?
Kozak: Liquidity is less of a concern, so those investors are looking for data and analytics. An investor seeking to buy a BB tranche wants to know what's in the loan portfolio, the CLO's liquidity and NAV, and our loan trading platform provides that fundamental data and analytics. Because we've previously scored the loans, for example, we can say if the pool liquidity is above average, so the investor doesn't have to discount as much in liquidation scenarios, because the CLO will likely trade at those prices.
ASR: Why are large banks supporting the electronic-trading platform?
Kozak: First, the customer relationship. Secondary-market trading supports a bank's franchise, and without it customers are less likely to mandate the bank for warehousing loans, financing or securitizations. BWICs (bids wanted in competition) typically take 90 minutes to conduct; at Octaura we're aiming to bring that to 30 minutes and soon 15. Banks can better service their customers, and speeding up trades enables them to use their capital more efficiently.
ASR: How does Octaura address loans' bespoke nature, especially in cases where it has hindered trading?
Kozak: A key goal is to combine electronic trading with today's advanced data analytics. Natural learning processing (NLP) extracts key paragraphs from the indentures, cloud computing can run many scenarios overnight. So rather than standardizing transactions to speed up trading, we use technology to price the bespoke risk more efficiently. We don't think the market wants standardization; it wants transparency. You can read a 100-page loan document in five seconds instead of 20 minutes, and you can price the risk appropriately.
ASR: Why did Octaura build the loan-trading platform first?
Kozak: Improving loan liquidity and building analytical tools will benefit the CLO derivative product. In addition, loans are not securities, so onboarding is faster and easier.
We don't think the market wants standardization; it wants transparency.
ASR: How will electronic trading change the loan market?
Kozak: The outstanding volume of the leveraged loan market is $1.4 trillion, and historically it has traded around $800 billion a year. The closest parallel market is high yield, but it's a security and so much more liquid and trades closer to $2.7 trillion annually, with about 30% trading electronically. That's a really big gap, given it's basically the same underlying issuers and credit. So the loan market is not nearly as big as it could be.
ASR: Why does such a small amount trade electronically?
Kozak: It's operationally difficult to settle loans—it takes 24 days on average. And because about half of the loans are private, it's more difficult to access those documents. And lastly, the data analytics are not very advanced, unlike the securities markets.
It's even more extreme trading CLOs, where last year only $200 billion traded in the secondary market [in an overall market of $1.2 trillion]. The average trade size is less than $1.5 million, and we're hoping to solve that problem by providing loan-specific data analytics. People want to trade CLOs not on CUSIPS but on loan characteristics—I want to buy high-quality BBBs from these managers, with subordination between 10% and 13%, and deploy $100 million to buy those loans in a day. The only way to do that is by trusting data analytics that are consistent and high quality.
ASR: CLO ETFs have experienced significant growth this year. Will that continue?
Kozak: Probably not under the current construct, with low secondary-market volume and trade size. But if those problems are resolved, CLO ETFs could make up a substantial part of the market, because that asset class's high yields and relatively low volatility make their risk-adjusted return very attractive.
Cohen: A year ago, we didn't have any CLO ETFs as customers and now we have most of them, because our workflow is much more efficient. If a CLO manager must redeem 150 different loan facilities, it's inefficient to send out emails to multiple dealers for each loan.
ASR: How could electronic trading change the leveraged loan and CLO markets?
Kozak: We think about this all the time as part of our pitch … if electronic trading picks up, spreads will compress, creating winners and losers. In the investment-grade (IG) bond market, 50% of trades are electronic, and the sell side makes more money than ever before, because it's more liquid and the return on capital is very high. The top sell side and buy side firms in the loan market today may be different in three to five years, but those that adapt to the changes will probably be trading more and making more money than they do today.
