DirectorsTalk caught-up this week with Serge Demay, head of CLO investments at Axa Investment Managers, to discuss Volta Finance Ltd (LON:VTA, LON:VTAS). Serge Demay is in charge of the CLO investment team of Axa IM’s Structured Credit division with team Aum of €21.5bn (30 September 2022).
Q1. Serge, 2022 has been a tough year for NAV performance. How do you think about permanent loss versus ‘mark to market’?
As best as we can judge, at the end of November 2022, the entire YTD decline in NAV is ‘mark to market’. Reassuringly, our positions continue paying their cashflows as expected, risk metrics are stable or even slightly improving through the year. The CLO structure is working well, and whilst loan prepayments are less frequent than in normal market conditions, we are still seeing some prepayments (at par) being reinvested in loans at a discount to par. It is of course reasonable to expect some deterioration in 2023 (more loan downgrades and defaults) but for the moment CLO managers are building a buffer ahead of any such deterioration.
Q2. What is the current expectation of corporate default rates in Europe and the US, and how does this look in a historical perspective?
We consider the US economic situation more stable than the European one, real wages are less impacted and inflation is more generalised (less asymmetrical). Nevertheless we have to recognise that the impact from interest rate hikes on corporates’ finance is more important in the US. As a result default rates might be very similar for both regions. Most rating agencies are expecting default rates in the 4.0 – 4.5% area for 2023. We however consider that 3% is much more realistic as rating agencies’ models do not typically incorporate the debt erosion benefit that comes with inflation. As an example, post Ukrainian invasion, default rates for Europe were forecasted in the 2.5% area for end of 2022. At the time of speaking we are still at 0.4%. With this in mid we have no qualms about expecting 2023 default rates 1.0 to 1.5% below those expected by the rating agencies.
Q3. The revenue of the company has been strong this year, does this give you comfort when thinking about shareholder’s dividend?
Volta’s dividend policy has been very consistent for many years, aiming to pay a dividend in line with 8% of NAV. As noted in the October newsletter, over the last six months cash flows are in excess of 20% on an annualised basis. As such we definitely have a large cushion to pay the dividend, but more than that, we hope Volta will benefit from this current period of volatility, as we can use surplus cash flows to take advantage of some really attractive reinvestment opportunities.
Please also find below the Volta Finance monthly performance commentary and factsheet to 31 October 2022.
October was a mixed month for Structured Debt Markets as European CLO debt tranches experienced a price rebound – especially the ones that were significantly hit in September – while US CLO performances were slightly negative. As a result, Volta’s net asset value (“NAV”) declined by -2.6% in October.
Diving into Volta’s underlying sub asset classes, monthly performances** were as follow: +0.7% for Bank Balance Sheet transactions, -3.9% for CLO Equity tranches; +1.7% for CLO Debt tranches (driven by +6.2% on European CLO debt); and -0.4% for Cash Corporate Credit and ABS (which represent circa 2.3% of the fund’s NAV).
As for every quarter, October was a heavy month in terms of CLO Equity distributions. We were expecting relatively healthy ones across the board and our positions did deliver on that front. Volta received in October the equivalent of €9.1m in terms of interest and coupons. Over the usual 6-month-basis time frame Volta received €23.4m interest and coupons. A 22.3% annualized cash flow to NAV.
Looking at fundamentals, we continued to see slightly more downgrades than upgrades in both the US and the European loan markets, although at a very moderate pace. We have been highlighting for months through this channel of communication the fact that inflation per se can positively impact companies’ balance sheets. The release of Q3 earnings demonstrated once more that when revenues increase (in nominal amount) at a high pace, earnings can be maintained or even increased despite companies suffering from margin pressure. At the time of writing this publication, 90% of the S&P companies have reported their Q3 earnings; revenues are up 12.2% (from the previous quarter) allowing earnings to grow by “only” 3.9%.
In the meantime, this increase in revenues is eroding the real value of debt. We believe that the real value of debt for the average US company was basically eroded by 20% in the last two years when considering that from Q3 2020 to Q4 2022 the US GDP grew by 20% in nominal terms. This relationship between nominal growth and debt and the maintenance of healthy earnings can explain why rating agencies have so far been relatively slow (and they may be correct in doing so) in downgrading debt even though many companies do suffer or will suffer from higher interest rates.
Our view remains that the overall dynamics are still more favourable for the US relative to Europe. At the end of October, 12 months running default rates in Loans were still low at 0.4% in Europe and 0.8% in the US. We expect to see more deterioration in Europe than in the US in the coming quarters and consider it reasonable to see default rates move in the 2% area in the US and in the 3% area in Europe for 2023.
This kind of default pattern will not materially impact the distribution of interests by Volta’s assets in the near term. We believe that we can maintain a high level of coupons in the coming quarters and are actively looking to seize investment opportunities with the extra cash that is being generated.
We recently opened a European CLO Warehouse as part of this strategy. No loans have yet been purchased but we expect to start ramping assets in the near term to take advantage of significant price discounts and patiently build a very profitable CLO Equity position.
As at the end of October2022, Volta’s NAV was €206.8m or €5.65 per share.
*It should be noted that approximately 1.5% of Volta’s GAV comprises investments for which the relevant NAVs as at the month-end date are normally available only after Volta’s NAV has already been published. Volta’s policy is to publish its NAV on as timely a basis as possible to provide shareholders with Volta’s appropriately up-to-date NAV information. Consequently, such investments are valued using the most recently available NAV for each fund or quoted price for such subordinated notes. The most recently available fund NAV or quoted price was 1.1% as at 30 September 2022, 0.4% was at 31 July 2022 and 0.4%.
** “performances” of asset classes are calculated as the Dietz-performance of the assets in each bucket, taking into account the Mark-to-Market of the assets at period ends, payments received from the assets over the period, and ignoring changes in cross-currency rates. Nevertheless, some residual currency effects could impact the aggregate value of the portfolio when aggregating each bucket.
Structured Products fund, Volta Finance Ltd (LON:VTA, LON:VTAS) objective is to seek to preserve capital across the credit cycle and to provide a stable stream of income to its Shareholders through dividends that it expects to distribute on a quarterly basis.