Structured products investing: Volta Finance in Hardman Q&A

Volta Finance Ltd (LON:VTA) is the topic of conversation when Hardman and Co’s Analyst Mark Thomas caught up with DirectorsTalk for an exclusive interview.

Q1: Your recent report sits behind a disclaimer. What can you tell us about that?

A1: It is just the standard disclaimer that many investment companies have. In essence, for regulatory reasons, there are some countries (like the US) where the report should not be read. In the UK, because CLOs are not a simple asset class, the report should be looked at only by professional/qualified investors.

Q2: You called your recent piece ‘An easy guide to the benefits of CLOs’, what can you tell us about it?

A2: The industry-specific terminology associated with CLOs can give the impression of a complexity to the product that does not reflect reality, and, in our view, is unhelpful to the Volta Finance investment case.

Accordingly, in this note, we gave investors a simple guide to what CLOs are, the benefits they provide, and how Volta is taking the market opportunities. The core of CLOs is uncomplicated cashflows, just a pooling of loans into a vehicle, which funds itself by issuing debt and equity.

Q3: So, what is a CLO?

A3: We give a very simple chart in our report that shows that CLOs are, at their heart, very simple cashflows. A portfolio of loans is acquired by a special purpose vehicle (SPV), which funds the purchase by issuing a mix of different tranches of bonds (called CLO debt tranches) and “income notes” (the CLO equity tranches). The interest received from the loan portfolio is used to pay, firstly, the coupons on the CLO debt tranches, and then all the excess cashflow is for the profit of the equity tranche. Typically, there will be up to 200 loans in the structure giving good sector, geographical and company-specific diversification. In principle, a CLO structure is very similar to a bank.

Q4: And in plain English, the benefits?

A4: A CLO structure has advantages for all the interested parties:

  • First, loan originators have additional sources of funding.
  • Second, relatively safe instruments can be created that are likely to appeal to conservative investors, such as pension funds. The structure also creates riskier tranches, which appeal to higher-risk-appetite investors by offering higher yields. The overall pool of potential investors is thus increased.
  • Third, CLOs are actively managed by portfolio managers, creating flexibility in the management of the portfolio.
  • Fourth, CLOs pay higher yields to investors. Our note goes into how this is produced, but through-cycle for the AA-AAA tranches, it may be around 70bps, rising to up to 200bps for BBB and 500-700bps for B. In uncertain times, it can be more.
  • Fifth, it is a non-correlated asset class, giving investors diversification, as well as a yield uplift.
  • Finally, the overall cost to borrowers is less because they can access those low-risk-appetite investors at a lower price.

Q5: What about the risk?

A5: CLO structures have multiple risk-enhancement features. Cash is retained in SPV/used to repay investment-grade debt if the level of collateral or interest cover falls below set levels. AXA IM’s skill in picking good managers was shown early in the pandemic, when ca.20% US CLOs saw cash diversion, and Volta had none.

There are multiple income, risk and concentration tests that maintain that an ongoing risk profile of SPV is within known parameters. There is less of a maturity mis-match, with interest and principal repayments from assets matching CLO liabilities. Assets are backed by good-quality security. The end result is shown by the absence of any CLO investment-grade defaults over 2012-21, and losses under the Fed stress-test scenario were just 1/35th the level of corporate loans.

Q6: How does Volta Finance take the opportunity?

A6: The starting point is AXA-IM having the resources, expertise and experience to conduct in-depth due diligence to identify mis-priced opportunities. There is a strong focus on manager selection, and VTA is typically a long-term investor, not a trader. The evidence of superior performance is fewer cash diversion tests than the market, and, to give that some colour, some of the larger underlying exposures are to Virgin Media, Verisure and McAfee. These are major corporates, and, not as some imagine, distressed or non-standard companies.

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