Earnings Transcript for XFLT - Q4 Fiscal Year 2023

Operator: Welcome to the XFLT Webinar. Thank you so much for joining us today for our regular quarterly webinar. And we have got lots to report this quarter. I am going to start today’s presentation with just a few disclosures. This presentation is meant to be educational and anything that we discuss today, the investments may or may not be suitable for the audience, we are going to be talking about past performance. And it’s important to understand that performance data that’s quoted is representative of past performance and that does not guarantee future results. Future performance maybe higher or lower than anything quoted in the presentation. We are going to be talking about our outlook for the loan market and for the CLO market. And so just understand that the materials that you are going to see in today’s remarks are forward-looking statements and actual results could differ materially from those referenced in our forward-looking statements. With that, I’d love to take care of just a little bit of the housekeeping. We love questions and you have an opportunity to click the Q&A bar at the bottom of the screen at any point in today’s webinar. And we will weave those into the discussion. We have some planned Q&A, but we love your questions. So keep them coming and we’ll respond either online or we’ll ask Lauren and Steven to address those questions. My name is Kimberly Flynn. I am a Managing Director here at XA Investments. And I’m very pleased to be joined by Lauren Law, who is a Senior Portfolio Manager at Octagon Credit Investors. And she is also the Portfolio Manager for XFLT. Steven Perry is my colleague and he is responsible for product management and spends much of his day – everyday focused on the success of XFLT. So, really happy to have Lauren and Steven with us. I am going to do just a few more firm level introductions. You maybe familiar with Octagon Credit Investors, but if you are not, Octagon is entirely focused on below investment grade credit. The firm has been around since 1994. They managed $34.6 billion in assets under management as of the end of 2023. They use a disciplined process. It’s time tested and the team is a cohesive team. Many of the senior leaders have been with Octagon their entire career, including Lauren and Octagon CEO, Gretchen is the same. So really, really important to Octagon’s approach. They have more than a 25-year track record. They invest in senior loans. They invest in CLO debt and they invest in CLO equity. And that’s the area of focus for XFLT. XFLT was launched in September of 2017. And it really was the first entree for individual investors to have access to what Octagon does so well. I mentioned we had a lot of things to report. It was a really productive 2023 and the first quarter, we’ve had a number of different announcements. So as of the start of the year, January 1, Gretchen Lam was promoted to CEO and Gretchen was the prior Portfolio Manager for XFLT so you may be familiar with her. Gretchen has spent over 25 years at Octagon having started as a summer intern and is now currently the CEO. So, that’s a terrific story. Lauren joined Octagon 20 years ago and has risen to the position of Senior Portfolio Manager. So, really an experienced team at Octagon. We have also made an improvement if you will. We have added Bill Meyers to the XFLT Board of Trustees. As the fund has grown, there was an opportunity to grow the Board. Bill Meyers has over 35 years of experience directly with closed end funds and launched more than 100 closed end fund IPOs. He also was responsible for the launch of Nuveen’s first interval fund. Just with respect to an important proposal that management put to shareholders starting in December of last year, the proposals were to change the fund to a perpetual fund and as such change the name of the fund. We are happy to report that on January 24 that proposal was voted on and passed in terms of shareholder vote. We also were putting in front of shareholders proposal with respect to an Octagon change of control their parent company, Conning was being sold to Generali and so shareholders voted and those proposals passed. In February to kick off the month, XFLT did do a private placement raising $25 million in common assets, which continues to scale the fun and create economies of scale for shareholders. In September of last year, we did celebrate a $500 million milestone. The fund has grown significantly. And now approaching the end of February, the fund is close to about $599 million in total managed assets. We also had Steven will talk a little bit more about leverage. Convertible preferreds are a type of leverage that we use to enhance the income of the fund and we did secure a new tranche of convertible preferreds. One of the questions that we get a lot from investors is about the composition of the funds distributions and we are happy to report for the fiscal year ended 9/30, XFLT’s distribution represented 100% of net investment income and there was no return of capital in those distributions. With that, I’d love to go now to the experts here. My colleague Steven is going to kick us off and then we’ll turn it over to Lauren to talk a little bit more about the loan market and the CLO market. So Steven, could you talk with us just a little bit about the financial highlights for the quarter?

Steven Perry: Absolutely and thanks for having me. Let me know if I am not coming through loud and clear. So I’ll start off with just a few financial highlights that you’ve touched on, but more focused on Q4 2023. So for the 3 months ended December 31, net investment income was $0.27 per share. Now, that’s compared to the distribution amount of $0.255 per share how that was distributed for those 3 months. The ratio of net investment income to average net assets was 16.23%. So, the fund is at this time earnings distribution which I believe investors like to see. For the fourth quarter, XFLT continued to grow and scale. It issued 2.2 million – almost 2.3 million shares for net proceeds of approximately $15.7 million to the fund. Those shares are issued at a price above net asset value, at-the-market market program. As you see going down steady distributions of $0.85 per share and then you touched on the growth of the fund already, but one thing also people want to know about is the weighted average current yields based on market price. And so you see CLO equity almost yielding 25% on market price, CLO debt close to 13%, loans close to 10%, and bonds at 6.5%. So, very good positive numbers for the trust. I’ll hit on a few other topics of the [indiscernible] highlights. So quarter end $545 million in total managed assets, that’s almost up to $600 million as of today. The trust ended the quarter with a net asset value of $6.88 per share that was up from $6.67. The quarter before and market price was $7.14, which was up from $6.95. You will also note the top 10 holdings are primarily they are all CLO equity that’s pretty typical. Those are a little bit chunkier of highs and some of the individual loan positions. I’ll move on talk about some portfolio composition over time. As you will see, senior loans have always been the highest concentration in the portfolio followed by CLO equity. You will also see a significant portion in CLO debt and Octagon will toggle between senior loans, equity and debt as they see opportunities. I’ll move on to talk about some financial returns here. As you will note, the returns are very strong for the quarter, for the 1 year, annualized. And against the benchmark, it looks really, really positive. So we are really pleased with the performance of the trust inception to-date and especially over the last year and last quarter. I think the last thing that I’ll touch on is the secondary market trading dynamics. The fund has historically traded at a premium to net asset value. As of last Friday, the current premium was 2.9% and the inception to-date average premium was 3.42%. So, Kim, that’s I think all I wanted to touch on some of the financial highlights. We can go back to the questions.

A - Kimberly Flynn: Yes. I’d like to talk a little bit about governance and fund board actions. I know the fund board with some of the updates we mentioned has been busy. I know that the board represents shareholders and I think it’s helpful to kind of highlight what the board is doing to serve shareholders. And just talk about – this is they are dedicated to XFLT. So if you could cover kind of what’s changed in the last 12 months that would be terrific?

Steven Perry: Yes, absolutely. So I brought the governance and management slide in the bottom right hand corner, you’ll see Bill Meyers added to the independent trustees or the trustees and Bill brings a depth of experience. He is going to be – it would be great to have in the room, ask questions with. And so you’ll also see the bottom left, the board meetings. There have been 9 board meetings in the last 12 months, some of those routine, some not routine. And so above that you will note the corporate actions and these corporate actions can be kind of broken down into routine, non-routine board reelections, annual proxy meetings, pretty routine. Things that aren’t routine have been touched on and presented the shareholders already. I think it feels like a very long time ago now, but there is a distribution increase due from $0.073 per share to $0.085 cents per share last May. During the summer of 2023, Octagon also started to go through the process of being acquired by Generali Group. And again, that’s the parent companies of Octagon being acquired that was brought to shareholders’ attention via the proxy that was sent out in November and approved by shareholders on January 24. The board was also involved along with shareholders to the name change of the trust and making it perpetual. And so that the board has been very active, very involved with the trust. Last thing I’ll talk about here is the recent transactions. We have touched on the at-the-market that’s constantly dripping shares out into the market and an accretive value to shareholders. It’s a price above net asset value. We have also placed few series of convertible preferred shares, where we feel we get very favorable pricing compared to other avenues of raising preferred shares in the marketplace. You will note the 6.95% series 2029. That’s a new tranche that was not issued. The deal was closed last quarter, but no shares have been issued by quarter end. So you will note those as very favorable leverage in cost when compared to similar funds out in the marketplace. The final thing that you are not going to see on here, but you will see next quarter is that $25 million register direct offering that was also issued at a price above net asset value. So, lots of action, lots of governance, lots of oversight, lots of conversations over the last 12 months and over the last quarter.

Kimberly Flynn: That’s great, Steven. And we’ve been talking about the asset growth of the fund and we did get a question from one of our listeners, which is great. And the question was just about whether or not we had done any dilutive offerings and I am happy to report that XFLT has only done accretive issuance of new shares. And that means that shareholders benefit the pricing of the new shares that were issued was above the fund’s net asset value and that is reflective of the premium trading for the fund in the secondary marketplace. And unlike most listed closed end funds, when a fund is trading at a premium, we think it’s really attractive to do these accretive share issuances. And so, thank you Steven for putting up the growth of the slide showing the growth of the fund, but maybe you could just comment on how shareholders benefit from this activity and this growth.

Steven Perry: Yes, of course. So there are two main ways that I believe shareholders benefit from this. One, it’s an increased volume and increased liquidity in the secondary market allows you to buy into the fund, sell all the fund of very, very easily. And that more volume – to gets more volume and kind of helps liquidity for shareholders. The second is, these the scaling and growth of the assets will spread out all the fixed expenses and costs that the fund has across the broader share base. And so we think over time that those expense levels will become more and more favorable to shareholders, versus a fund that’s maybe smaller in size and doesn’t have the scale and has to bear the burden of certain fixed expenses. So those are the two main ways that I think shareholders benefit. Another way shareholders benefit as we continually grow the trust is Octagon is getting more proceeds to deploy into the assets that they think have the best value and best opportunity for shareholders. So if we’re doing a $25 million registered direct offering and Octagon is feeling like the seal of debt market is, especially if attractive, those proceeds will be put to work at really attractive levels. And so we’re giving Octagon the opportunity to buy more assets for the trust and to make sure we’re managing the trust in the way that’s best for shareholders.

Kimberly Flynn: Yes, that’s a great point, Steven. And I think that in the end, it benefits the performance of the fund. It will benefit hopefully the distributions and the total returns of the fund. Could you talk a little bit about XFLT’s current distribution rate? And I know, I mentioned that there was not a return of capital. We get that question a lot. So if you could just talk about the sort of health and wellness of the funds current distribution?

Steven Perry: Absolutely. So if you see the recent distribution history at the top right of the table. You’ll see that $8.5 cent per share. The fund’s been paying that since last May. And So what you’ll see also is the 14.2% based on market price and the 14.83% based on NAV as of December 31st and so the trust is focused on earning its distribution. It’s focused on trying to the payout net investment income, we won’t know the characteristics of the distribution until fiscal year end. And so it’s hard to say whether or not it’s going to be 100% net investment income or there’s going to be some return of capital. However, the firm does focus on paying out net investment income on a GAAP basis.

Kimberly Flynn: Yes. Yes, it’s an important point you mentioned, Steven, that like any fund that invests in CLO equity, CLO equity in particular can create these differences between tax and GAAP accounting. And we do our best to manage that, we did that last year and we’ll continue to strive to do that in terms of being communicating with shareholders and being very focused on paying net investment income. That’s our goal. Maybe Steven, let’s turn now, I think to Lauren and this question also might, you might comment on leverage, but Lauren, what is the trust outlook on the anticipated path of interest rates in 2024 for much of 2022 and 2023. We experienced rising rates right. The Fed raised rates 11x in the last 1.5 year. So this topic is top of mind and how do you think a higher for longer rate environment might impact the fund?

Lauren Law: Sure. Now, we certainly think that rates are going to be higher for longer. That is our base case. But I think it’s hard to ignore. The downward sloping nature of the forward interest rate curve, a decrease in short-term rates would have some income, some impact, excuse me, on the income generated by the trust underlying portfolio of assets. So we do not expect a meaningful impact from any reduction in rates in 2024. As an example, a decrease in short-term rates would result in lower interest income on the trust loan portfolio, though this would be partially offset by a decrease in the cost of leverage associated with the trust credit facility, as its interest expense is also floating rate. Similarly, when we think about CLO equity. The impact of falling rates is also a manageable issue here. CLOs both borrow and lend at a floating rate and so that largely offsets the impacts of changes in short-term interest rates. So, long story short, we are relatively calm about the prospect for lower rates, particularly in 2024.

Steven Perry: Yes, and I’ll add on to that. I have the slide here about the XFLT leverage sources. XFLT borrows both a floating rate credit facility and the prefers. The retail 650 is the convertible 6% and the other convertible 695. And so there’s some optionality that the trust has to go between fixed and floating rate, interest or leverage sources. Sorry about that. And so we think we have positioned the trust pretty competitively on the cost of leverage and we continue to monitor that maintain it as you do note on the slide, the cost of leverage from Q3 to Q4 did increase. That’s really due to the base rate of SOFR increasing on the bank borrowings and the credit facility, which is the line share of the leverage. And then you see on the bottom left some of the convertible preferreds and retail preferreds outstanding. And then the bottom right, you see some of the interest that institutions have in these retail preferreds. So we continue to monitor that cost of leverage to make sure that arbitrage is attractive enough to shareholders, to still earn what the trust needs to earn.

Kimberly Flynn: Great. Thank you, Steven. I think some recession fears have eased in 2023 as inflation has come down a little bit off its peak and GDP has remained quite resilient. How is the loan market and the CLO debt tranche market reacted? And then maybe Lauren, if you could talk about where loans and CLO debt and equity are trading today, that’d be great.

Lauren Law: Sure, it is safe to say that the loan and CLO tranche markets exhibited very robust performance in 2023. And really so far into 2024. And this was driven by the relatively resilient fundamental performance of loan borrowers. Particularly large expectations as recession fears, receded as you mentioned. The broadly syndicated leveraged loan market returned in excess of 13% last year at CLO tranches also exhibited very strong performance with BB CLO tranches posting at an almost 25% return last year. And by our estimates, equity performing even slightly better than that, though performance certainly varied across different equity profiles. Today, the leveraged loan market continues to trade at attractive levels offering investors of roughly 9% yield and we also think CLO equity is quite attractive in the current environment and have been endeavoring to invest there, in both the primary and secondary market. Primary equity is again attractive to us given the recent tightening of liability costs. And today we see equity trading to a high teen yield and double BB mezzanine CLO tranche, yielding well in excess of 10% to maturity. So All in all, still some very attractive opportunities in both the loan and CLO tranche markets.

Kimberly Flynn: Lauren, how did the financial performance of borrowers trend in the fourth quarter?

Lauren Law: Sure, believe it or not, it is still early in the Q4 loan reporting season, as many loan borrowers have 90 days or even more to deliver year end performance to the market. That being said, the early data that we have seen points to another strong quarter for loan borrower performance with low single digit revenue growth and margin expansion leading to mid-single digit EBITDA growth. Of notes borrower performance continues to surprise to the upside. So we feel good about the performance of the loan market and that should translate into strong CLO performance as well.

Kimberly Flynn: So can we talk a little bit about the different sectors of the loan market? Can you speak to which sectors or industries are outperforming right now and which are underperforming?

Lauren Law: Sure, I would say similar to previous quarters, we still see a high level of dispersion of performance and some idiosyncratic issues facing levered credit. Particularly when you think about the bottom end of the credit spectrum, borrowers that are very fully levered and having trouble generating cash at these base rate. That being said, there are certain sectors which have been under a bit more scrutiny. And I can share an example here today. U.S. cable is a sector that has historically been really thought of as defensive. But over the course of the last 12 months to 18 months, they have really seen a lot of increased competition, which has taken some of their market share. And this has happened at a time, when they have faced very large CapEx budget. And also many of these are levered credits and they borrowed floating. So, they seem very constrained cash flow, increased competition and this has really weighed on structures and valuations in that sector. So, a continuation of that idiosyncratic risk and dispersion that we have mentioned in previous quarters, but I would give you that example is one sector where we have seen some issues that are specific to it.

Kimberly Flynn: And Lauren, this I think this is just underscores why it’s so important to have active management when you are investing in loans, given just the differences between the outperformers and the underperformers and what is Octagon thinking right now with respect to loan defaults? Can we talk about the health of the loan market with respect to defaults?

Lauren Law: Sure, as I mentioned earlier, we expect robust performance on average from loan borrowers in the loan market. But there are there are still stressors out there. And I would say we expect the level of credit losses to remain elevated in 2024 and that’s really similar to 2023. At or about the long-term average in terms of default rates, credit losses are going to take the form of true defaults, and that’s what’s captured in that 1.5% default rate that you have up on the screen. But the market has also been experiencing what’s referred to as liability management transactions. And these are really effectively out of court restructurings that bring the market via default rate to something closer to 3% when you capture that activity. And we expect 2024 to see something similar to 2023. So, certainly a headwind for the market, but something that we do think is manageable at expected levels.

Kimberly Flynn: Okay. Good. Well, we will talk about that next quarter as well and kind of check in on where we are with respect to default. With respect to refinancing and some of the amend and extend activity that we have seen chipping away at the loan wall maturities for 2024 2025, our portfolio managers able to lock in higher rates for longer durations, talk to us a little bit about this refinancing activity.

Lauren Law: Sure. The market has seen a fair amount of refinancing activity. And yes, in many instances as borrowers have extended maturities, they have offered lenders additional spread as compensation for the additional tenure of the loan. That being said, the market has also had a very strong start to 2024. And with new CLO creation increasing and thus increasing demand for loans, we have also experienced a fair bit of loan re-pricing or spread reductions for high quality loans. These two factors I would call it somewhat offsetting.

Kimberly Flynn: That’s good. I think we have got one more question for Lauren. So, I just want to remind the audience if they want to ask a question of Lauren or Steven, please use the Q&A bar at the bottom of the screen. Now, we will move to talking a little bit about the outlook for primary CLO issuance and CLO arbitrage in the first quarter of 2024, after what was a challenging environment for new issuance in March of 2023, Lauren?

Lauren Law: Sure. CLO issuance was somewhat muted in 2023, but activity really picked up as the calendar turned the page. The CLO market is off to a really robust start in 2024 in terms of activity. January 2024 was the most active January on record. And market activity included everything from new issue CLOs, resets and refinancings and even calls of older vintage CLOs. And a lot of this activity tied back to what has occurred in the CLO liability markets and specifically the AAAs. The short story is that AAA, costs have tightened fairly dramatically and tighter liability cost drives a lot of the capital markets activity I just mentioned. Of notes and in contrast to much of 2022 and 2023, the new issue equity arbitrage looks attractive again. And all of this is to say that we have seen robust levels of activity in the CLO market to start 2024 and we would expect that to continue. We expect more new issuance, more resets, more refinancing. And of note, we expect refinancing and reset activity to be very accretive to the trust this year. We see this type of activity is not only a way to offset some of that re-pricing activity or spread compression activity I mentioned earlier, but also an effective mechanism to extend out the weighted average reinvestment period remaining on the underlying equity positions within the trust. So, we are very encouraged by what we are seeing in the market thus far this year and very optimistic for the market going forward.

Kimberly Flynn: Great. We do have one question from the audience. So, I would like to go to that if we could. The first question is for Steven. And the question is about the composition of investors and I know we just went through the proxy process recently. And so the question is, is XFLT’s common shares held largely by institutional investors or largely by retail investors. And maybe also Steven, you could talk about the composition of the retail preferreds in terms of who are the holders of those shares?

Steven Perry: Yes, great question. I don’t have the statistics on the top of my head, but what we have seen over time from IPO to today, is we have seen shares migrate from institutional brokerage houses to more retail. And so one, yes, there are a lot of institutions in the portfolio. They will hold them in income focused accounts in different funds. And so there is a large institution presence in the fund. But what we have seen is we have seen the shares really, really migrate to Charles Schwab to Fidelity to TD Ameritrade, to E-Trade and all those types of accounts. And so when we went through this proxy process, what we did realize is the shares are primarily and mainly held, broadly speaking by retail investors. We also showed a slide earlier and I can go back to it, let’s see here. We showed a slide earlier about the retail preferreds mainly being held by institutions, that’s mainly due to or big in part due to the way that those are sold. They are sold in an underwritten offering to a lot of institutional accounts and some retail investors. But what you do see is, you see about 40% of those in retail hands. And so the fund is popular among retail investors and we saw that in the proxy process.

Kimberly Flynn: Thank you, Steven. And the nice thing, I know I talked with a number of individual investors as we were getting out the vote. So, it was great to talk to people who have been invested with XFLT, many of them for a long time. We do have another question. So, thanks, keep them coming. This question I think is really for me or for Steven to address, but the question says XFLT is popular with several Seeking Alpha income oriented publishers. Do you follow any of these types of postings on Seeking Alpha or other online sources and do they affect XFLT strategies in any way? And are you legally allowed to comment on these postings? And so yes, thank you. Yes, Seeking Alpha is we do follow the postings on Seeking Alpha and we have to follow in a passive way. Meaning, we like to see what research analysts are reporting. We like to see what the Seeking Alpha publishers are reporting on XFLT. A lot of the Seeking Alpha publishers are using information on our website, which is terrific. They are referring to our source materials like this quarterly webinar. I would say that the posts because we are not allowed even if an author says something, we like or says something that we don’t think is true, we don’t comment because then that would become marketing material for the firm. So, we are not allowed to do that. I would say that the Speaking Alpha, the major impact of some of the articles, particularly given some of the authors have very wide followings. You do – you can see an impact in the trading volume. And we have observed that, it does not affect how we run the fund and it does not affect the investment strategy or anything that Octagon is doing. But we do think it’s really important to stay in touch and on top of what people – what questions people are asking, what concerns or what interests them, Steven, anything you would add to that?

Steven Perry: I think you have covered most of it. And the only thing I would add is, as we do try and put as much information as possible on our website, update in a timely manner and run the trust in a very transparent way, inclusive of semi-annual reports with robust market updates and annual reports that, that really detail out Octagon’s viewpoint and how the Trust has performed that year. So, we make sure, we put information into investors hands, so they can make the decisions.

Kimberly Flynn: Yes, that’s a good point. And I think we do have one more question just about whether or not XA would consider a fund with a similar business model or the same business model as XFLT that might focus on tax free, or floating rate loans that are tax free. Good question and not at this time, I like the idea very much. Obviously, there is particularly among wealthy individuals, there is definitely a perennial demand for tax free or tax friendly income oriented products and I would be happy to talk offline about competitor funds that are in the market that I find very compelling. So, please feel free to contact Steven or contact me. But keep the ideas coming. We do really appreciate it. So, thank you, Lauren. Thank you, Steven. Thank you everyone. Reach out if you do have any additional questions and we will definitely get back in touch with you.

Steven Perry: Yes. Thank you very much.

Lauren Law: Thank you.