Earnings Transcript for XFLT - Q2 Fiscal Year 2023

Kimberly Flynn: We're going to start the presentation with some general disclosures, the presentation is intended for educational purposes and is not meant to recommend an individual security, investments discussed may or may not be suitable for the audience today. Neither XAI or Octagon is acting as an adviser to the audience members and audience members should consult their own investment adviser prior to making any investment decisions.

The information presented here does reflect proprietary research and the materials include forward-looking statements. And so investors should not place undue reliance upon those forward-looking statements.:

We're pleased to be with you, we really welcome your questions. We'll take questions from the audience and we can answer them as we go. We'll also put live questions to Gretchen and to Steven. So please use the Q&A box at the bottom of your screen, typing your question. And just in case something occurs to you later, we're always available. Please contact us at xainvestments.com, our 800 number is located there, and we look forward to speaking with you.:

Today, I'm joined -- my name is Kimberly Flynn and I'm joined by my colleague, Steven Perry, who runs product management for XFLT. And we also have with us Gretchen Lam who is the portfolio manager for XFLT. Gretchen serves on the Investment Committee at Octagon and she also serves as portfolio manager for a number of CLOs, separate accounts and commingled funds. So it's a pleasure once again to be back in front of you. I'm going to put questions to Steven and Gretchen in a moment.:

We're going to cover some introductory materials for those that are new to the webinar. If you're new to the fund, you may not be as familiar with Octagon Credit. Octagon, they are credit experts focusing on below investment-grade credit since 1994. They have $34.7 billion in Assets Under Management as of the end of June this year. The firm does use a disciplined process in terms of their evaluation of credit. They have a very cohesive cycle-tested investment team, and they have a track record going back more than 25 years. And they're known in the marketplace for their investment expertise in loans and CLOs and XFLT, which is obviously traded on the New York Stock Exchange was Octagon's first strategy to be made publicly available. So that's a little bit of background on Octagon.:

We've got some planned questions and if this doesn't address what you're interested in, please enter your question into the Q&A box. We'll get to these prepared topics in a moment. I just want to cover a few updates for the group. So let's go to Slide 7.:

Financial highlights. My colleague, Steven Perry, will cover this in a moment so we'll go to the governance slide. This is a new slide. We just wanted to make you aware of the shareholder actions and the number and frequency of board meetings. Your board for XFLT has met 7 times in the last 12 months. And we're going to include this governance overview in future webinars just so you can stay in the loop on future corporate actions and potential transactions.:

As you know, XFLT has grown over the last two years largely through our at-the-market program. We also have convertible preferred shares, which do convert from preferred into common, another way of growing the funds share base. Our trustees, the Chair of the Board is Greg Dingens, and he is joined by Scott Jones, Phil Franklin and Dani Cupps. And these four independent trustees have served the board since inception and continue to act on behalf of shareholders, in exercising their duties as independent fund board members.:

Just in terms of a couple of corporate actions to cover with the group, Octagon did put out a press release in July just announcing that their parent company Conning, was recently announced that there's a pending acquisition by Generali Group. That transaction is scheduled to close in the first half of 2024. Also, in April, the fund did make a distribution increase, the annual shareholder proxy was filed in May, and the Annual Shareholder Meeting was later on June 8. Scott Craven Jones was reelected by shareholders at the most recent shareholder meeting.:

So that's that, what I'd like to do now, if we could, is talk a little bit about the state of the fund in terms of its investments. We always like to give an overview on Slide 9, just where the fund sits today at $427 million, total managed assets. Actually, the fund is a little bit larger due to some of the share growth as of today, but as of 6/30, we were at $427 million. And we've seen in the last few weeks, continued NAV appreciation and price appreciation. So go to our website at xainvestments.com for the latest managed asset and NAV and price information.:

As you've seen from us in prior webinars and prior quarterly disclosures, the top 10 holdings for the fund is comprised of CLO equity. The top 10 represents about 12% of the overall weight of the portfolio. The fund does continue to be well diversified in terms of its asset mix. We're going to talk in a moment just about the opportunities that Octagon sees in the loan market, in the CLO debt market and also the CLO equity market and how the funds portfolio composition may vary or change over time. This is a source of value add in terms of the positioning of XFLT in the marketplace. XFLT is really the only listed closed-end fund that has this asset mix, and it differentiates the fund from its peer group.:

The fund is often compared to senior loan funds, which typically have 80% or more in senior loans. The fund is also compared to the subgroup within that loan category of CLO equity-focused closed-end funds. And XFLT sits in the middle of these two groups with this diversified asset mix, including significant allocation to first lien, second lien loans and also sort of a half and half mix of loans and CLO exposure with the other half of the portfolio being in a CLO debt, CLO equity. :

Kimberly Flynn: So that's what we wanted to cover in terms of setting the table. I'd love now to go to the first question, which is for Gretchen. If we could go to Slide 10, let's look at the composition of XFLT's portfolio over time, and maybe, Gretchen, if you could share with us why this strategic mix is important, and what is Octagon like about the ability to invest in these various asset types?

Gretchen Mae Lam: Sure, happy to. Kim, as you mentioned, XFLT is unique among many of the closed-end fund peers and that the fund can invest across corporate loans, high-yield bonds, CLO debt and CLO equity, and really shift allocations across these assets based on the most attractive relative value at that point in time. Today, about 45% of XFLT's assets are invested in both first and second lien loans, about 32% in CLO equity and 16% in debt and about 4% in high-yield bonds.

And as you can see on Page 10, in 2023 and really throughout the back half of 2022, we've increased our exposure to CLO debt in particular. Last year and over the course of this year, CLO debt was in our view, extremely attractive on a relative basis versus loans and CLO equity, really because CLO debt offered both very high current yields over 12% and also could be purchased at a very meaningful discount to par, which allowed for both additional -- what we call Pull to Par upside over time, and in the earlier parts of 2023, we were modeling out returns for many of our BB purchases in the high teens on a total return basis.:

In most markets, high teens is CLO equity-like return. But in the case of CLO debt, generally has less risk versus equity due to the structural subordination of the BB tranche versus CLO equity. That thesis has really played out over the course of 2023, as BBs have outperformed both the returns of the broad loan index, they've outperformed loans by about 2 percentage points and even have marginally outperformed CLO equity in the year-to-date period.:

Now today, as we look at the various asset classes. And as the prices of BBs have rallied over the course of the summer, in our view that relative value is really starting to shift away from CLO BBs and toward CLO equity. And so as we move forward over the back half of 2023, you'll see us continue to kind of tweak those allocations in a way that we think really benefits the equity holders in XFLT and allows us to maximize both total return and income. :

Kimberly Flynn: Thank you, Gretchen. We'll come back to you in a minute. Steven, if you could talk about the highlights for the quarter. And then in addition, I'd love for you to talk about the growth of XFLT's common share base over time and different methods for growing the fund.

Steven Perry: Yes, absolutely. And I want to ask a technical microphone check here, Kim. Can you hear me alright?

Kimberly Flynn: Yes, you sound great.

Steven Perry: Awesome, my headphones die on me, so I just wanted to confirm. So for the second quarter, XFLT has seen a very strong issuance of the shelf registration statement or the at-the-market program with nearly 3.4 million shares, new common stock issued for net proceeds of approximately $22.2 million. We've seen very strong volume this quarter, stronger than prior quarters, and we like to view that as a sign of good secondary market support and the health and wellness of the fund for investors to get in and out of the fund as they need.

Also notable for the quarter was the increase of the distribution rate by 16.44% to $0.085 per share from the prior $0.073 per share. As we're looking back at the prior quarter, two of those distributions were at that $0.073 rate, with one of them being at $0.085 subsequent to quarter end, there have been two declarations at the $0.085 rate.:

I also want to highlight the weighted average current yields of the various asset classes in the portfolio, it's important to note that this is on the marked price of the positions as of 6/30. CLO equity yielding 23%, debt 13%, loans close to 10% and the bonds of 6.74%. So I'll turn to another slide here to continue going through the quarter and the performance. I wanted to talk a little bit about XFLT net returns.:

For the quarter, NAV returned 4.85%, and price returned at 7.9% versus the benchmark of 3.3%. One year total return is relatively close to the benchmark with NAV being at 10.33% and price being 9.65%. And then if we turn our attention to the 5-year and since inception, very close to benchmark and the price outperformed a little bit on a 5-year basis. I'll keep going, Kim, on a couple of other slides.:

We'd like to present the premium and discount history for the fund here. Current premium as of Friday's close was 1.97%. We've seen a little bit of rounding of the net asset value of the fund recently. But inception to date, average premium is 3.3%.:

Moving on, we also like to compare the fund, give you a view of the price and NAV performance and use the general equity markets as a backdrop. As you can see, with the green line, we've seen that little rally in NAV come up over the last month, 1.5 months. And we've also seen that rally in the equity markets despite the last week or two, a little bit of a downturn there.:

I'll keep moving on to some of the volume activity that we've seen since the increase in the distribution, we've seen XFLT's volume grow. And along with that growth, we've seen the common share base grow, we've seen volume grow. And again, I said it before, but we like to view this as the ability for investors and shareholders to get in and out of the fund as they need. Last 30-day volume as of August 18 was 292,000 shares traded per day, and you can compare that to the Since Inception of 123,000 shares per day. We're seeing a lot of growth in the fund, we're seeing a lot of interest from investors in activity. So we like to show this just to show the health and wellness.:

A couple more slides. Obviously, substantially all of the assets in the fund are floating rate instruments. So it's no surprise that as the Fed has raised the benchmark rates, the assets in the fund have earned more just from the base rates increasing. And so we like to present this slide against 3-month LIBOR, Fed funds rate and SOFR. A lot of people may recall that LIBOR cessation happened in June 2023, so we may see the LIBOR line drop off this chart, but SOFR is the widely accepted new base rate for a lot of the instruments in the portfolio.:

Finally, Kim, you mentioned this. We have seen the asset growth continue over the quarter, and we saw a lot of activity in the -- of the -- at-the-market program, continuing to drive scale efficiencies for the fund. The fund has fixed costs where as the asset base grows, it spreads those fixed costs out amongst the shares, driving costs down for investors. And Kim, I'll turn it back to you for the questions. :

Kimberly Flynn: Sure. I think what I'd love to hear a little bit more about is you mentioned that XFLT has benefited with base rates moving higher, but XFLT is a leveraged fund so can you talk about the kind of the current state of leverage and the impact of rising rates on the fund's cost of leverage?

Steven Perry: Yes, absolutely. Good question, good point. The cost of leverage for the fund has gone up as base rates have also gone up. XFLT has two types of leverage

The credit facility is a base rate, a SOFR base rate plus a spread. And so as the base rates have increased, we've seen the average cost of the credit facility increase. Over the past quarter, we actually did see the cost of the credit facility surpassed the convertible preferred costs, which are priced at 6%. With the asset mix in the fund, loans and CLO debt, CLO equity, because of the loans, lenders are willing to give credit and allow the fund to borrow -- bank borrowings with the credit facility, which a lot of the CLO equity funds don't have access to. The loan funds do if they choose to use leverage. And so since we've seen that bank borrowing, rate increase over the quarter, the funds also gone to use the convertible preferreds as leverage, those are a fixed rate of 6%. And so the fund was able to draw 6% leverage, we've continued to use that in conjunction with the retail preferreds, those are at 6.5%. And so we continually look at the cost of leverage, what the best way to utilize the structure of the leverages for shareholders, we have those conversations.:

If I draw your attention to the bottom left of the screen, that's the preferred stock overview. As talked about, we have the 2026 Retail Preferreds. There's $39.9 million outstanding of the retail preferreds. They trade close to par, and then there is the 2029 Convertible Preferreds which don't trade in the secondary market. On the bottom right, this is public information, you see the retail preferred share ownership. We see a lot of institutions have interest in those and those are the positions that they currently have. :

Kimberly Flynn: Great. Thanks, Steven. Let's turn now for a little bit more focused questions on the market environment. So I'm going to turn this question to Gretchen.

Recession fears eased a bit in the second quarter as inflation came off of its peak, and GDP remained resilient. How did the loan and CLO tranche markets reacted? And where are loans and CLO debt, CLO equity trading today? :

Gretchen Mae Lam: We've spoken in past quarters about the very high level of dispersion of performance across the 1,300 or so borrowers in the broadly syndicated loan market where some borrowers have done quite well, and others have really struggled in their financial performance. That elevated dispersion has continued, but what was different about the second quarter is that for the first time in some time, as the macro view has become less negative or some might even say more positive, risk really rallied in the loan market in the second quarter.

In fact, if you look at recent months, the CCC rated loans have outperformed the broader loan index by a fair margin, and that hasn't happened since late 2021. If you zoom out to the full year 2023 through today, CCCs have rallied in price by 5 points, while BB rated loans have moved up in price only 1 point. So we've talked about the difference in trading price between CCC rated loans and BB rated loans being very wide, and it still is, but we are seeing that basis starting to compress. Today, there's an 18-point price difference on average between a BB-rated loan and a CCC-rated loan. At year-end 2022, that number was almost 24-points. So starting to come into more -- described as more normalized levels.:

Nonetheless, even as they rallied in recent months, loan and CLO tranches are trading at levels that certainly reflect many of the challenges that currently persist in the economy. Loans are still trading at discounts to par, the index is at [ 94.2 ] as of 6/30. And this is even as loan prepayments have picked up a bit in recent months. And as a reminder, these loan prepayments are really a big benefit to CLO equity as those par prepayment proceeds can be reinvested into new loans at discounted prices.:

CLO BBs, at least according to the JPMorgan CLOIE Index, stood at about $0.86 on the dollar as of the end of June. And CLO equity, we see trading at yields in the 16% to 20% range and in some cases, even higher. So still very compelling trading levels really across loans, CLO debt and CLO equity, both in terms of future price upside, future price convexity as well as in terms of current yields. :

Kimberly Flynn: Understood. Gretchen, could you talk a little bit about the underlying performance of the loan borrowers and what that looked like in the second quarter? And then given that performance, what does that translate into CLO performance?

Gretchen Mae Lam: Sure. So we've spoken about over the last 2 to 4 quarters or so, revenue and profit growth have both been positive though decelerating sequentially. And while believe it or not, not all companies have actually reported second quarter numbers yet, we do believe that to still be the case, once all of those numbers are in for the second quarter. So that's good. We're still seeing revenue growth, we're still seeing EBITDA growth.

We are seeing, again, dispersion of performance across the market across those 1,300 borrowers. So what does that mean for CLO managers? As we look back, really for the better part of the last 1.5 years or so, managers have outperformed by avoiding the left tail of the risk distribution. That's really been the winning strategy over the course of 2022 and the first half of 2023. As the year continues, we expect that managers who will continue to outperform will do so by certainly avoiding losses but also by selectively taking risk. We still want to see them actively manage those riskiest loans and their CLOs. We still want them to be nimble in identifying deteriorating corporate performance early, so that they can reduce exposure to those loans. But we also want to see them take risk in a thoughtful, disciplined way.:

And one important note here, it is very difficult for managers to do just that, to do what we want them to do to be nimble once the reinvestment period ends in a CLO. Once that happens, the CLO prohibits really the active trading, we want to see them do in the current environment. And for this reason, we have continued to reduce exposure in the CLO equity that we own in XFLT, we reduced the exposure to deals that are beyond their reinvestment period, and we will continue to seek to do that even as the CLO market, an increasing percentage of the CLO market goes beyond its reinvestment period. :

Kimberly Flynn: Gretchen, another question just about loan borrowers. Are there any problem industries or are any industries underperforming or outperforming things that we should be aware of that are more industry-specific?

Gretchen Mae Lam: Yes. It's been really interesting because in the last year or so, financial underperformance hasn't been strongly correlated to sector-specific factors. In past cycles, we've seen years where 80% of loan defaults were from one sector, retail or oil and gas, for example. That is less the case this year. Weak performance appears to be far more idiosyncratic and kind of specific to that borrower.

Having said that, we are seeing weakness that I would say, is more prevalent in some sectors. Healthcare had been struggling over the last year or so, hit with higher labor costs and in many cases a limited ability to pass on those higher costs due to federal or state reimbursement frameworks, real estate and specifically commercial real estate-related borrowers have seen certainly weakness, especially those exposed to the office sector.:

And lastly, telecom, I would say, seeing some weakness that's prevalent across the sector. And that's really a function of -- it's a modestly underperforming topline but just as much really caused from the burden of high CapEx needs, coupled with already full debt loads which have been particularly challenged as rates have risen.:

For outperformers, we've really seen steady performance from software and business service providers, which, in many cases, have benefited from a recurring subscription revenues and ability to raise prices without pushback from their customers. And believe it or not, we've seen strength in many of our building products companies, everything from light manufacturers to those that are used in products that are used in cabinetry, for example, really as new homebuilding has remained pretty darn resilient over the course of the last 1.5 years or so.:

As we look forward to the back half of 2023 and into 2024, our expectations for loan defaults are relatively unchanged versus those expectations that we had in the earlier part of this year. On an LTM basis, the LSTA is calculating 1.7% loan defaults. And by the way, this generally excludes distressed exchanges in that number. We do anticipate that this creeps up to, call it, 3% to 3.5% by year-end, which is consistent with the 6-month run rate that the pace of defaults that we're seeing over the last 6 months and also consistent with the level of CCCs in the market and the level of the percentage of loans trading below $80 or $85 as an indicator of future defaults.:

At this point, looking out into 2024, we would expect a similar rate of default in that 3% to 3.5% range, maybe a tinge higher, but at this point in the same general ZIP code in 2024 is 2023. :

Kimberly Flynn: Great. Steven, back to you. Can you talk a little bit more about XFLT and how it compares to the different peer groups. XFLT is uniquely positioned so I think it's helpful for this audience to understand the differences and some of the benefits of how the fund is positioned.

Steven Perry: Yes, absolutely. As you spoke about earlier, XFLT is in that unique bucket where it's roughly 50% loans, roughly 50% CLOs. Oftentimes, we get compared to the CLO focused closed-end funds. There's about four other ones in the marketplace, maybe about five coming up. And there are a few main differences.

The first one I'll highlight is the leverage cost. Because of those loans, XFLT's leverage is mainly at this point on the credit facility. As of 6/30, the average cost of leverage was 6.34%. The CLO focused closed-end funds are mainly leveraged by preferred shares. And those preferred shares run between 5% and 7.75%. A benefit of the credit facility is that it's easy to toggle and maintain leverage ratios that the fund and portfolio management team would like to see pulling down incremental leverage and maintaining that steady leverage level. Some of the CLO competitors have a little bit chunkier of leverage issuance as they use mainly preferreds.:

Another thing we'd like to highlight is the net asset value is daily marked on XFLT versus monthly or quarterly estimates from some competitors and the valuation for XFLT is done by a third party. Additionally, moving down to fees, XFLT does not have any income incentive fees or performance fees associated with it, just a flat management fee.:

Lastly, the distribution rates on market price are -- it's competitive, it's slightly lower than some of the CLO equity-focused funds as expected, but also going to be slightly higher than some of the loan-focused funds. Lastly, this asset class in this group oftentimes trades at a premium to net asset value. As of 6/30, the last 12-month premium for XFLT was [ 2.21% ] and then for the four other focused CLO funds, it was -- they had an average premium to net asset value of 7.67%. So those are some of the main differences, and that is -- those are the main differences with the CLO-focused group. :

Kimberly Flynn: Thanks, Steven. Just a quick reminder for the audience. We've got one more prepared question for Gretchen. If you have a question, please go to the Q&A tool at the bottom of your screen and submit your question there, and we'll ask the audience. Okay. For -- we do have one question coming in, terrific. I would love to see a couple more.

Gretchen, what is your outlook for the loan and CLO markets going forward? :

Gretchen Mae Lam: No doubt, macro challenges persist, most notably in the form of still high inflation and still high interest rates. At this point, we sit in the higher-for-longer rate camp. And so that is our expectation as we look forward. And these challenges will certainly test many of the companies that have borrowed in the broadly syndicated loan market. At the same time, loans and CLOs have seen these environments before and they've exhibited resiliency through them. Over collateralization cushions for CLO equity are still well positioned to withstand credit losses and increased CCC loan downgrades. And this supports continued robust CLO equity distributions.

On the debt front, current yields on loans sit at 10-plus percent, current yields CLO BB tranches sit at 12% to 13%. These are very high levels historically. Technicals in both the loan and CLO markets are supportive, we have modest CLO issuance which is supporting what is historically low net loan issuance. Prepayments of loans are steady and as we look forward into the back half of 2023 and 2024, we are most focused on both, avoiding credit losses while at the same time really positioning the fund to take disciplined risk over time. :

Kimberly Flynn: Great. Thank you, Gretchen. We do have one question from the audience. And I think Steven this one is best directed to you. Gretchen, feel free to comment.

But the question is, is the gross investment income of the fund rising in proportion to the rising leverage costs? :

Steven Perry: Yes, that's a good question. I'll give a couple of comments on it and if Gretchen wants to add anything, please feel free. And the general answer is, it's twofold. On the loan side, you have the base rate plus spread. And as leverage and interest rates have gone -- or leverage costs and interest rates have gone up, we've also seen the base rates plus the spread -- the base rates on the loans go up. And so from that perspective, it seems to be in lockstep with the increasing rates.

On the CLO equity side, there was a little bit of a lag to the earnings of CLO equity as there was a headwind of the difference in 1-month and 3-month LIBOR, and so that spread between those two, initially caused a little bit of a lag of earnings of CLO equity. And so as that spread between them has compressed and come down. We've seen CLO equity start to earn a little bit more incremental income. And so overall, the arbitrage opportunity using leverage and the increasing rates has been seen, and we saw that with the increase in distribution with the May declaration and so overall, the increase in rates has corresponded to an increase in investment income for the fund. :

Gretchen Mae Lam: Yes. I would just underscore that many of the headwinds that we saw in the back half of 2022 and 2023 in terms of the CLO equity distributions, that was really a temporary phenomenon. That was a function of timing of the shape of the SOFR and LIBOR curves. That has, for the most part, kind of run its course. But there are sort of persistent differences on the margin of the various base rates within CLO structures, the assets may be referencing a 1-month or 3-months, the CLO liabilities always referenced 3-months.

That is a persistent difference, right? So that basis is -- I would call permanent. Now the amount of the basis will shift, but that sort of -- the difference is a permanent difference. And in the case of the leverage to the fund, the credit facility references but, SOFR, which is daily SOFR as opposed to the assets, which earn 1 in 3 months. So a little bit different there, but I think the punch line is that the benefit of the leverage in the fund is very much sound and in play and really as base rates have moved up across all of the points on the curve, the fund has benefited as a result of the slug of fixed preferred debt, which, of course, hasn't moved in its cost. And so there is a net benefit to the fund and the distribution stream that the fund generates. :

Kimberly Flynn: Thank you, Gretchen. Thank you, Steven. I appreciate the thoughts today, another great quarterly webinar. If anybody has additional questions, feel free to contact me or contact my colleague, Steven, at any point, there will be additional information and the replay available on our website. So please check back, thanks to everyone today for joining us and hope you have a happy Labor Day weekend and final weeks of the summer. Thank you. Bye-bye.

Steven Perry: Thank you.

Gretchen Mae Lam: Thank you.