More Asian institutions are committing to US CLOs. For instance, Korea’s Public Officials Benefits Association told Private Debt Investor in December 2017 that it has committed to US CLOs with a dual interest structure. It was not for hedging purposes but for obtaining quarterly coupons from instruments underwritten as investment grade. Do you see stronger demand for US CLOs from Asian institutions?
OW: We continue to see very strong demand for CLO opportunities. We historically have been very strong in Japan – going back to 2011 and 2012, investors became very active. Koreans followed suit, especially during 2013 and 2014. I think the most recent entries into the market are Chinese institutional investors, which obviously have much larger balance sheets than Korean investors. They become active probably in the last 12 or 18 months.
So, we are seeing a sort of shift with the region embracing more opportunities in CLOs largely because there are yields that can be achieved in that market which far exceed the opportunities in investment grade corporates and the yields that can be achieved in US high yield corporates.
Notwithstanding the rally that we have seen in CLO debt securities, they still offer excellent relative value as well as absolute value. So, to your point about the Korean savings fund trying to beat an absolute target rate of return, that can still be achieved through investments in CLOs and mezzanine securities.
What is your thinking on the risk-retention rules that require managers to hold 5 percent of their fund under the Dodd-Frank Act? Do Asian investors ask questions about this during their due diligence process?
OW: Most certainly, yes. Not only are Asian investors I think in tune with risk retention guidelines, I would argue that a number of very sophisticated Asian investors are taking advantage of the changing regulations to partner with CLO managers in order to help them to address the risk retention capital needs.
So, we have seen a number of very large, sophisticated Asian investors investing in CLO equity really for the first time, via a variety of risk retention vehicles. That is not unique to the Asia Pacific region but there are certainly a number of examples. There are very well-known sovereign wealth fund-type allocators which became active in CLO markets subsequent to the introduction of risk retention regulation.
CIFC also raised capital through its own balance sheet, not only from third parties. In broad strategic terms, do you see any more of your new vehicle using this type of platform?
OW: Yes, I think we made the decision that we felt the best partnership was one where our capital sits alongside our clients’ capital. And you are right, we did use our balance sheet and so did our very significant investor in our CLOs alongside our strategic partners. So we will continue that strategy, commingling our capital with that of our clients to create the proper alignment [of interest].
We are unlikely to be looking for vehicles that do not involve CIFC’s co-investment capital. We want to be really aligned with our investors and share the upside as well as the risks associated with these [strategic investments].
Speaking of partnerships, CIFC teamed up with the Toronto-based Healthcare of Ontario Pension Plan in Q3 2017. Was that in line with risk-retention rule compliance?
OW: We were excited to partner with HOOPP. We have successfully set up three different risk retention vehicles. We did a large secondary trade in the beginning of the summer, which effectively allowed us to fund the equity needs of the first four CLOs in 2017.
Our risk retention vehicle with HOOPP first invested in CIFC 2017-V and is now the majority investor in our 2018 transactions.
The third vehicle that we set up was to support our refinancing and reset activities. As you know, to refinance or reset a transaction, it now needs to be made risk-retention compliant. We set up a vehicle with a major US investment bank that allows us to finance the risk retention capital [necessary] to support our refinance and reset activities.
Do you see demand from investors wanting to commit more to floating rate-based products?
OW: Yes, the investor communities have been waiting for years for short-term rates to finally move up. We think it is a definitive path to move short-term rates higher.
The economy is growing and at a very healthy rate. We can argue whether we can analyse it based on 2.5 percent or 3 percent but I think the consensus is that the US economy is healthy and growing at an attractive rate, which allows the Federal Reserve to continue to raise interest rates at a presumably steady rate of, perhaps 25 basis point increments that we have seen in the past.
So, depending on who you ask, the range is anywhere from three to four more hikes expected this year, which would imply 75 to 300 basis points in short-term rates and LIBOR.
We have seen a lot of interest from investors to participate in this expected shift. There is a lot more interest in the asset class today than a year ago. Back then it was not so evident that the Federal Reserve had the all the necessary elements to raise rates.
I think when you look at it from a defensive perspective, [you would ask] what that means for fixed-rate instruments. The 10Y bond has been sold off starting at the beginning of the year. “Where does the long end of the yield end up?” is obviously a key question. Everyone is expecting curve flattening but that doesn’t mean that the 10Y bond stays pegged where it is. And only the front-end moves up? Or finally there will be some movements at the longer end of the curve? So, we see a lot of price risk in traditional fixed income.
Even short-duration mandates are still exposed to rising rates, so even if you do not own conventional five- to six-year duration fixed income instruments, we think that as rates rise, investors will identify the price risk associated with what they are traditionally told are safe instruments and might find themselves reallocating into alternative fixed income out of traditional fixed income. Certainly, CLO, private debt and floating rate strategies should be seen as favorable against the backdrop of rising interest rates.
It seems that some pension funds and insurance companies are not necessarily economic actors when it comes to investing in fixed income. They have constraints when investing. What is your view on this?
OW: You are raising a very good point. They tend to have a very long-life liability and so there is a duration mismatch. The idea for them to go very short is obviously contrary to trying to match their liability, and we recognise that as a challenge for them.
Many of the insurance companies may also be in sort of a ‘hold-to-maturity’ mode where they might not be marking to market their fixed income securities – every insurance company is a little bit different – but they need to be in long durations and they need higher absolute coupons.
So we believe that in the short term, floating rate alternatives will be viewed very favorably. However, we think that there may be an absolute level of interest rates at which point they may be prepared to go and buy traditional fixed rate securities with longer durations.
For instance, if the 10Y bonds go to 3 percent, or 3.5 percent, you may find some types of investors being comfortable and saying “Okay, at this level of absolute interest rates, we would be prepared to go long.”
So that is going to be interesting to watch. What is the level of absolute interest rates at which point insurance companies and pension funds say they recognise that rates may sell-off even further but at this absolute coupon level, they are much more interested in fixed rate investments than floating rate short-term instruments?
Circling back to the original question on your investors, who are backing your products? And why do they invest in them?
OW: It really depends on the country. If you think of Japan, our largest investors are commercial banks. And they will typically invest in [our CLOs] through their treasury function. For them it is really a liquidity management tool and is a principal investment of the highest quality type with triple A grade floating rate CLO tranches.
Korea is a much broader investor base, so we have banks, insurance companies and pension funds. Every form of institutional investor in Korea, we believe that they are involved in the CLO market in some fashion and have been for several years. So, the adoption of investing in CLOs in Korea is much broader based than that it is in Japan.
And when it comes to the latest entrant into the market, the Chinese investors, we have involvement both from insurance companies and banks.
They became active probably in the last 12 or 18 months. It is not so clear to us why they are investing, so that is something that we are still working on. But we have seen broad-based involvement from some of the largest banks and insurance companies in China. So that is something that we are excited about.
The rest of the region, if you look at the ASEAN region for instance, it is predominantly the insurance [companies] from Taiwan, Hong Kong and Singapore.
Again, those investors are running a duration mismatch, and they are generally life insurance companies, so they have long duration liabilities.
CLOs by definition are short-duration instruments, so they are running a mismatch but there is an outspread in CLO opportunities and there is access, spread and benefitting from rising LIBOR, and they are comfortable running this mismatch.
The interview was conducted on January 24, 2018 in Hong Kong.