← Animal Spirits Podcast
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A
Today's Animal Spirits Talk youk Book is brought to you by Dimensional Fund advisors. Go to dimensional.com to learn more about all of DFA's fund offerings. Today's Talk youk Book is also brought to you by Bondblocks. Go to bondblocksetf.com to learn more about the Bondblocks Private Credit CLO ETF Ticker PCMM. That's bondblocksetf.com welcome to Animal Spirits, a show about markets, life and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain.
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B
Positions in the securities discussed in this podcast.
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A
Welcome to Animal Spirits with Michael and Ben. We have a two for today. We had two talker books in one and it's free, right? Two for the price of nothing. We talked to Wes Krill, who is a senior Client Solutions Director and VP at Dimensional Fund Advisors about everything from small caps to all time highs to what else. They get some really good points on the IPO stuff for small caps, Correct?
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B
Tons of good stuff.
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A
Yeah.
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B
I think, I think today's episode is, it's an interesting pairing. It's kind of like watching Casablanca and then the Matrix. What I mean by that is Dimensional Fund Advisors has been around since I believe the early 1980s is when they got their start. One of the early juggernaut behemoths in the industry have been pioneers of academic investing. And then on the other side of the conversation we have Bon Blocks, a relatively new entrant into the market that is doing all sorts of unique and interesting things. So I think that this one goes together like lamb and tuna fish.
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A
Yeah. So we talked to Tony Kelly who's a co founder of Bomb Blocks. But first we are speaking with Wes Krill from the Ventral Fund Advisor. So here's our chat with Wes. Wes, welcome to the show.
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C
Yeah, thanks for.
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A
All right. I want to talk about a topic that's on a lot of people's minds lately. Stock market has hit a bunch of new all time highs this year. DFA has some really cool research on this. This is something that's near and dear to our heart because I think it's counterintuitive. And so you guys have some research on what happens when the stock market hits an all time high and how Often it happens. What did you find?
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C
Well, I think we can start with the basic premise you mentioned that it's counterintuitive for some people. Most people would probably agree that expected returns for stocks have to be positive. There's not a lot of people that are going to sign up for stocks if they're not getting compens.
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B
That's a very controversial take.
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C
Exactly. I always like to start with a real fire burner. If you start with that basic premise, then you should expect that markets are going to continue to go up, which means it shouldn't be too surprising when you hit new highs. In fact, that's happened about one out of six weeks in the US market historically. That's good news for investors. Then the idea that markets have to go down after one of these new highs. Again, when you think about what investors are doing when they're setting prices, when they're agreeing to transact, markets are forward looking into account what their expectations are for the future and they're agreeing to. People who want to buy stocks today are agreeing to do so at those prices that give them a positive expected return. We shouldn't be too surprised when they go open the following week. And sure enough we find the average return following these new market highs was almost identical to just the unconditional average across all weeks.
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B
Ben and I were talking about this data point that I had never seen before on Animal Spirits about price insensitive buyers and the amount of money that's just on auto drip coming into the indexes. And of course how much money of that is like actually going into the top companies. It's a lot. And I'm not saying that it's a bad thing. It's a, it's a great thing. More money in the stock market, more buyers and sellers. It's a good thing. But how do you think about like price insensitive buyers? Because active management, not what you guys do, but like real traditional active management where there's, it's more of a bottoms up type of approach that is a much, much, much smaller percentage of the market than it used to be. And the price insensitive buyers, I don't mean that pejoratively. Taking a larger share of trading. What's your take on that?
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C
Yeah, I think again the premise here is that you need active investors to a certain extent because these are the ones who are potentially looking for information that's not in prices. That's what makes prices informationally efficient. Right. And to your point, the percent of the managed fund industry that is classified as active. And I'm going to use. When I say active, I mean not tracking an index. That's what I'm defining as active. And that has fallen below 50% last time I looked at these stats. But there's still a good chunk. I'm not sure that number tells you definitively how active the overall market is. We know that trade volumes are still very, very high. Last year was about $800 billion per day on average for daily trade volume and equities alone. Fixed income even more. Another thing that's interesting to look at is even the stuff that some people would consider passive. So index fund ETF. If you look at the top 10 US listed securities by trade volume, three of them are index fund ETFs. So if you look at that level of trade activity in something that is categorized as passive, well, it's likely a lot of people who are trading in and out of these ETFs are not doing so to establish long term buy and hold positions. They actually might be reflecting their views on the market through that trade activity. So we don't know exactly what the minimum threshold is for a percent that's inactive, but we do believe that there's still ample amounts of price discovery happening.
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A
Michael and I were talking about small caps and value stocks recently and one of the surprising stats, we actually used DFA's, US small value and International Small Value to show that they're actually outperforming the NASDAQ 100 and the S&P over the last five years. And that number might have surprised some people. One of the comebacks from people who are saying that the small cap premium doesn't really exist anymore is that while these companies are staying public longer. Right. Amazon came public at like a four or private. Sorry, they're saying private longer. Amazon came public at like a $400 million valuation back in the 90s. And you don't really see that as much these days. What do you think about is, is it really, you know, a much smaller opportunity set for small caps these days or do you not really see that?
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C
Well, one thing we should note is that when people say size and or value hasn't worked recently, it's clear they're only looking at US Data because outside the US the size premium, value premium have been strong over the past 10 years. So then you think, okay, well what has been going on in the US Specific oftentimes I can't put my finger on it. Oftentimes when you think about the size premium, you're talking about Small caps, relative performance versus large caps. Well, if you look over the past number of years, we call it 10 years, small caps have had pretty decent returns in an absolute sense. It's really just they haven't fared as well as large caps. I almost look at this as maybe more of a large cap story. We know that those companies, particularly the Magnificent Seven, the big tech companies in large cap indices, have had fantastic results, probably above what most people would think is their cost of capital. I don't think 72% returns in one year can be a cost of capital. If they've had unexpectedly good developments, which has been a windfall to them in terms of their returns, then what's happened over the past 10 years might be actually less relevant. Looking forward, I wouldn't necessarily expect that trend to continue. Now, specific to some of the characteristics you mentioned for the small cap market, you mentioned IPO age. Some people pointed to IPO characteristics. There's sometimes a misconception that IPOs all of a sudden are much bigger than they used to. There's still, by and large, very, very small companies. The actual activity fluctuates year to year. Some usually have more or less. But I think about all this activity and I'm wondering why it hasn't applied to other countries. Certainly there's been variation in the frequency with which companies go public in other markets as well, and we're still seeing positive size premiums there. If you look historically, this is the last data point I'll throw for this. If you look at the correlation between, if you just plot out the size premium for each year against any of these IPO characteristics, whether it's the age of, whether it's the frequency, whether it's the size of them, you don't see a correlation between the size premium and those characteristics. So it makes me think it's probably a correlation more than a causation in recent periods.
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A
So you think it could just be like some of these really big, well known tech companies that are staying private longer. Those are the ones that you know. And so it's more of a availability thing than anything.
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C
Yeah, I think it's not enough to conclude that the opportunity set for small caps has eroded. Right. And there's fewer small caps now than there were 20 or 30 years ago. Some of that seems to be based on academic evidence, result of M and A activity. But then globally you have more small caps than you did that many years ago. So I think it's an interesting aspect of markets. But I'm not sure that we can really blame the negative size premium in the US on it because in my mind it probably says more about the outperformance of large caps rather than underperformance of small.
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B
Yeah, I agree with you. I think that's something that people say. They just throw it out there and it sounds clever and it sounds like yeah, it makes sense.
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D
But.
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B
But when you think about it, to the extent that there was a size premium, was it coming because new issues were pulling up the index? I kind of doubt it.
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C
That's exactly right. I mean if you look at the performance of IPOs, they tend to do worse than the market on average over the first year, not better. And so it's unlikely that they were being a big positive contributor to the size premium. So if you have fewer of them, it's not clear to me why you would have less of a size premium. Now what about.
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B
I think it's. I don't think it's that complicated. I think a lot of it is. It's mega cap dominance and investor preference. I don't think you need to like it's not rocket science. You don't have to think too hard about what's going on. I was looking at a chart of one year fund flows and the money coming out of small cap stocks. ETFs is a two standard deviation event relative to fund flow history. So investors, they're not even apathetic, they're just throwing up small caps. They want nothing to do with it. Which if you are of any contrarian inclination, should feel good about that.
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C
Yeah, that's one way to look at it. I mean if you go back to. And we know that investors don't always do the best job in terms of predicting when asset classes are going to turn around. I remember a huge amount of outflows in March of 2020 out of equity funds into money market funds. And what happened over the next six months? Well, US stocks and global stocks took off over that stretch. I think it's a real quandary for investors. I think you always want to be careful of what is the opportunity cost going to be if I bail from my investments at the wrong time.
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B
Well, how about this thinking about small caps and their underperformance in the US and yeah, great point that international it's been a different story. Even if the size premium doesn't exist going forward, maybe it never existed, but it's diversification and that's real. If there should be. Right. Like if there's a turn in the AI story, 40% of the index is tech stocks.
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C
It's a good point about, I mean small caps are about 10% of the US market. So they do provide that diversification benefit. In fact, when we launched our first portfolio back in 1988, that was really the way we talked about it was these are companies that you don't have in your large cap allocation. And to your point, once you get to the top 10 holdings of large cap indices accounting for maybe a third of the overall market capitalization, then having an allocation to small caps in addition to value stocks and non US stocks can help mitigate how much exposure you have to what's really a small handful of tech names.
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A
How about the valuation difference there? So a lot of people have been asking us the similarities and differences between now and the dot com bubble. So take the top 10 of the S&P or the Mag 7. They're kind of the same thing, I guess. Are the valuation the relative differences in valuations really that stark between the rest of the market? I guess you could extend it to the s and P 1500 include small and mid.
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C
Yeah. The valuation spreads specifically between large growth and small value are extreme relative to historical levels. In fact, probably the only other time we've seen that they were this high was around that.com era, at least in modern stock market history. So what that means for investors is challenging. Even if you just go to the idea of what these valuation ratios actually mean. You can have a high valuation ratio for one of two reasons. It can be the discount rate applied to the expected future cash flows is low, which would imply lower expected returns for those companies. Or it could mean that the expected growth in future earnings is very high, which would be good for expected returns. In reality, we can never disentangle those two. We've run a number of research experiments to see when you sorted or when you just measured, for example a value premium or the relative returns for small value versus large growth and compare that to the lagged valuation ratio spread between those asset classes. We don't find much predictability. The valuation spreads really have not been strong predictors of what subsequent returns are going to be. There's a little bit of a correlation there, but it doesn't explain much in terms of variation of return. So I think it's interesting, I think there's ample reason why some investors might be sensitive to it, which that might differ dictate asset allocation positioning where you're underweighting those kind of stocks. But I don't think it portends that those stocks are going to crash or small Value is going to greatly outpace them.
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B
Wallace, what are you excited about? What are you talking to clients about? What are they talking to you about?
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C
Probably one of the most exciting areas of our conversations is really been around how we can add value versus indexing. This idea of taking a rules based investment approach and then showing all these different areas of the investment process. I think some of the appeal of indexing for years was the idea that it was cheap, that it had low expense ratios. And so I think the work we've done around broadening the conversation beyond just expense ratios as a type of cost that can be embedded in an investment approach I think been really interesting and very enlightening for many of our clients frankly.
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A
So what are the costs of indexing that we're looking at? Is it just the fact that do you think it's easier for all since they make these names and lists public when they're going to do a change over that it's easier for people to front run them. And I know there's been plenty of studies done that shows a lot of these. When these companies are added to the Dow or the S and P, they tend to go on to underperform. Actually the companies that get booted out outperform. What are those costs of indexing that you're seeing?
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C
Yeah, that's something we've done extensive research on and we can use the simplest example which is Russell. So traditionally Russell has done a reconstitution event once a year where they will add and delete things from the indices. And then the managers who are running funds that are tracking those indices then have to follow suit and buy the stuff that's added and sell the stuff that's deleted. So they make their announcement, they communicating this really weeks in advance. And then the actual reconstitution event happens at the end of June, which is when you're going to have these managers who are going to do their buying and selling there. So there's two forces potentially at work. You mentioned one of them which is if you're telling everyone what you're going to do and when you're going to do it, probably not going to get very good execution costs. But the other element is just the sheer amount of transactions that take place really on one day and at the end of one day it causes a lot of price pressure. We see that the trade volume in these names that are being added or deleted can spike 20 or 30 times what their normal level of trade volume is. And that can impact their prices pretty substantially. 4% or 5% on average in the study that we looked at. These are costs that don't show up in the expense ratio. They're actually in the indices themselves. If the index fund is tracking those, then that's going to be something that comes out of an investor's pocket at the end of the day.
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B
Wes, one of the themes in the market recent years, and I don't see this changing anytime soon, is the gambler's mentality. People see the market as a casino and certainly over short periods of time, resembles very much a casino. How do you think about investing as it relates to the casino?
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C
I think it's an interesting description for it. I probably look at it differently than some people when they're using that terminology, which is I actually think that casinos or specifically sports betting can be a pretty good framework to understand equilibrium markets. What I mean by that is, let's say I have two football team squaring off. One of them is 10 and 0, the other one is 0 and 10. You're not going to find many people who will bet on the win list team to actually win the game. And if I'm a sports bet, if I'm a casino, what I'm ideally after is I get half the bettors, half the money on one side of the bet, and half of the money on the other side of the bet. So that's not going to work in that scenario. So what I have to do to induce people to bet on the winless team is I have to offer a point spread and say, okay, they might not win, but as long as they lose by, say 10 points or fewer, then technically that counts as a win. And so that will induce some people to bet on it. But that also means that the spread of that, the number of points that that team can lose by, is going to be a function of what the overall market's perception is on the quality difference between those two. And it's also dynamic. We just saw this recently with Micah Parsons getting traded. Dallas Cowboys point spread for the first game went up by a whole point. They were even more of an underdog than they were before. Where this is relevant is when you think about investing, where a lot of people are accustomed to the idea of trying to identify what's a good company. Well, a good company is going to be priced based on success in the future, which means it might have a high price, which means it might not be a high expected return company. That's why it's so challenging to just pick a company and try and do better than the market. And that's probably why we see so little evidence of active managers trying to pick stocks who have outperformed benchmarks historically.
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A
See, my favorite casino analogy is the fact that the people who say the stock market is a casino are wrong. Because if it was, it's the best casino in the world. Because the longer you stay in the regular casino in Vegas, the higher your odds of losing. But the longer stocks are high. Yeah, your probability is much higher if you stay invested in the stock market of seeing a gain that is besides me. As Michael knows, I have a very high win rate when it comes to blackjack. So I'm the outlier here. All right, Wes, if investors and advisors want to learn more about dfa, where do we send them?
- [17:56]
C
They can come straight to Dimensional's website. Also, look for us on social media. We have a sort of a podcast, a video show we do that is on YouTube as well, so you can find us there as well.
- [18:06]
D
Perfect.
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A
Thanks a lot, Wes.
- [18:07]
C
Thank you, guys.
- [18:10]
A
Okay, thank you to Wes. Remember, check out dimensional.com for more. And now, here is our talk with Tony Kelly from Bond Blocks. Tony, welcome to the show.
- [18:23]
D
Thanks for having me.
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A
So every week we get questions into our inbox from listeners. And I got a good one yesterday I thought would be apt for this show since I was gonna answer it myself. I fear you can actually answer it as the expert. So this comes from Mark. He says since I live on my pension alone, I can afford more risk than most. I researched clos and decided that while complicated, they're worthwhile investment, offering higher yields compared to bonds, floating rates, and some diversification into private companies. CLO returns appear less volatile compared to bonds in rising rate environments. So I've added CLO ETFs the past two years. I'm curious what you think about CLOs as investments compared to regular bond funds in terms of their illiquidity, risk, and anything else I may be missing. So I'm curious your thoughts. This is kind of a softball, but anything Mark missed here, what should he be considering? Because clos for, I think for a lot of individual investors are still a very new asset class.
- [19:17]
D
I think that's right. They're not a new asset class. They've been around 25 plus years. But you're right, they may not be as widely known as other asset classes. It sounds like he's got a pretty good understanding on some of the characteristics. They're floating rate, so that's one of the advantages. So they won't be impacted by Changes in interest rates. They do generally offer higher yields than similarly rated bonds. So that's kind of the one of the big appeals for investors is to be able to with the same amount of risk and get that enhanced or higher in yields.
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B
All right, so what exactly is a collateralized loan obligation?
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D
You know, at one level, you can think about it clos a lot like a bond, but instead of the bond being issued by a corporation, the underlying assets are these loans and investors own the loan. They own the tranche is what it's called, receive a coupon, it has a maturity date, an issue date. What makes it a little different than a traditional bond issued by a corporation is that these are managed by companies that are managers in this space, like a Blackstone or a KKR or Blue Owl or some of the bigger managers in the private credit CLO space. So CLO is an asset backed security. And maybe an asset backed security that investors might be more familiar with would be like mortgage securities. Mortgage backed securities. Right. The mortgage backed securities are the collection of our home mortgages put into a bond and then through a securitization process get sold to investors, various investors, institutional investors. And the CLO is a very similar structure that it owns loans. The majority of the CLO market is what we call BSL or broadly syndicated loans. So those are generally public companies, large borrowers that are in those loans. In pcmm, which is our private credit fund, the underlying loans are of private companies, which is what makes it a little bit different than some other CLO products.
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A
So there obviously is no free lunch when it comes to this stuff. And you mentioned similar duration or maturity. These bonds tend to have higher yields. So what is it that investors are being compensated for? Is it the fact that these bonds are more liquid? Like, why are the yields higher?
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D
Yeah, it's a good question. So you're right. There are no free lunches. And this part of the market because it's fragmented and frankly illiquid at the loan level, it pays investors a higher coupon. Sometimes you can think about it as maybe even a complexity premium. Right. The simpler it is to invest in it, to access it, the less investors will be paid within the private credit space. You know, there is a complexity to ultimately navigate the market, access the market, and investors are benefiting from that as they're investing in this because they're picking up that illiquidity premium, that complexity premium, and that's what they're getting paid for.
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A
So today we're talking about the bond blocks, private credit CLO etf it's ticker pcmm. So how does that work where you have an ETF that is liquid on a daily basis when the markets are open and these underlying bonds are more illiquid, how does that liquidity mismatch work? What are the challenges there? So I'm just curious. I was just questioning the liquidity mismatch between a daily liquid ETF and more illiquid loans. So just kind of how does that work?
- [23:29]
D
Yeah, so the CLOS is the sort of key to bridging that liquidity gap. The underlying is less liquidity, quite fragmented, and the clos, through the security securitization process, ultimately takes this illiquid portfolio of loans, turns it into, call it a bond, and with that Q sip, and with that process, now it's a tradable basket of securities. And that ultimately is what, what creates the liquidity. And, you know, market makers that make markets in the ETFs to provide the liquidity in the ETFs. ETF are able to trade those CLOs, they're able to trade the ETF, and that's ultimately how investors are able to access it.
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A
Oh, sorry. So you're saying the underlying loans themselves are liquid, but when you pull them together, that makes them more liquid?
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D
Correct. The securitization, putting them in that wrapper creates a lot of liquidity.
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A
So you mentioned that. And our guy Mark said one of the things that draws that drew him into clos is the fact that, that they're floating rate, meaning when rates go up, these bonds tend to do well or better than other bonds because they don't get hammered. What about the alternative where rates are going down? If we see a situation like that, is that potentially a downside of these bonds where you don't get like, the more bang for your buck when yields fall?
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D
Yeah, I don't know if it's a downside, but yeah, that is true. You're describing the impact of your portfolio due to duration. Right. So if you've got more duration in a portfolio and interest rates are going down, you benefit from that and vice versa. If interest rates go up, your bond portfolio becomes worth less. These are floating rate, so they're not impacted by the change in interest rates. What you're earning is basically the credit spread is what we refer to it as.
- [25:21]
B
So I'm looking at the top 10 holdings, and the top one as of April 30th at least, is Golub Capital Partners. So money is going to Golub Capital Partners. They're the ones that are taking out the loan and then they're doing what with it? They are then providing loans to private companies.
- [25:43]
D
Yeah, in a nutshell, that's a good way of putting it. I mean, basically what Gallup is expert at is underwriting the loans. So going out to the middle market companies, doing the credit analysis of what companies are credit worthy to lend money to, they've probably raised some money somewhere else to be able to lend to the companies that need the companies. Then when they've amassed a large enough portfolio, call it, you know, $50 million, $100 million, then that's the portfolio that they're going to use to put into the clo. And then it'll go through that securitization process where they will cut up the various tranches into slices, different ratings, aaa, single A, work with a rating agency to make sure that everything looks good and then they'll sell those, those tranches to investors. And oftentimes those investors are not individual investors like you and me, they're institutions. So different institutions like to participate at different parts of the cap stack. So certain institutions will only want the AAA tranches, which is the tranches that get paid first out of the monies that come into the structure. And they're the least likely to be impacted by defaults. And then there's other institutions or other investors that will participate in the double A, the single a, the triple Bs, because they make a little bit more yield by being lower in the, the cap stack. And that's in a nutshell. Basically we had Gollum operates.
- [27:29]
B
I'm looking at the top 10 holdings and they're all different managers, none of them are the same. So there's diversification there. But inside of each of these top 10 holdings and there's 56 total holdings, there's got to be thousands of loans. Like how diversified is this, is this instrument?
- [27:46]
D
Yeah, that's a good question. So each CLO, each private credit CLO on average has about 100 different loans. And our portfolio right now has about 60 plus CLOs in the portfolio. So you can just do the math. The 60 CLOs, 100 different loans, that's 6,000 different companies that are represented in PCMM.
- [28:11]
A
What is the typical spread an investor could see in CLOS over say the 10 year? Is it pretty strong relationship or does that spread narrow and widen over time quite a bit.
- [28:21]
D
Usually the comparison that investors that we're talking to are sort of thinking about is, is how does this compare to investment grade or high yields portfolios. And you know, right now the coupon yield on PCMM is about 8%. If you looked at the portfolio for that portfolio, we've got an average rating of A. So we invest from the AAA tranche down to the double B. But the average rating is an A portfolio. That comparison with would probably be an investment grade corporate bond portfolio that right now is yielding less than 5%. The ice B of A index I think as of today is yielding about 4.8%. So the yield pickup is about 300 basis points on investment grid even at 8%. When you compare that even to high yield corporate bonds, it's out yielding high yield corporate bonds and it's significantly higher rated than the high yield bond index.
- [29:26]
B
So I'm looking at the website, at your website, I should say, and when you look through to the portfolio and you scroll down to like the industry group because all right, I understand these loans are being made to the big players in the private credit market and then they're making loans to private companies.
- [29:45]
D
Companies.
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B
And one of the big themes that investors have been talking about in recent years is the rise of the private markets. 83% of all companies in the United States with $100 million in revenue are privately held. So there's obviously a huge amount of demand for this market to exist. All right, software, 10.6%. Healthcare providers and services 8% give or take professional services, 6%. Insurance, five and a half commercial services and supplies, diversify consumer services. And on and on and on. My point is you're not just diversified across lenders. It looks like you're pretty well diversified across industry groups as well.
- [30:25]
D
That is right, correct. You know, you're kind of touching on kind of one of the key points of PCMM. It's diversified across companies as we mentioned. Right. There's 6,000 companies. Those companies are across many different industry groups. So there's diversification that way. There's also diversification across the managers. Right. So you mentioned Golub, but there's also Aries, Blackstone, blackrock, kkr. And that's important because each one of these companies have access to a different part of the private credit market. Right. And PCMM is, gives investors access to all these different managers as opposed to just investing in an Aries fund or a Blue Owl fund is just somewhat limiting in terms of the amount of access you have to the deals that they have access to.
- [31:19]
A
You mentioned the fact that these CLOs have been around for a long time. But I looked did a quick search yesterday for the different funds and there's not a lot of CLO funds that have been around for very long. So this is still a relatively new investable asset class where people. So if we took this back to. Because in 2022, this asset class handled itself really well, as we said, in a rising rate environment, but in sort of a credit event. So in 2008 and then again in 2020, these were pretty quick. But say the corporate bond ETFs, they fell 15 to 20%. High yield was more in 2008, obviously, and maybe about the same in 2020. And those are more kind of, you know, you get the flight to safety in Treasuries. And then if there's a credit event, people kind of really get scared out of these. And those tend to be very quick V shapes, but you get a drawdown. Would this be a similar profile, do you think, in terms of risk for people, since these underlying loans are more liquid?
- [32:12]
D
Yeah, I think if we had a 2008 event, I would expect, as they did in 2008, that they went down in value. Right. Yields went up. Up. Investors required more compensation for making loans as the risk profile changes in the market. And that results in prices. Prices going down. Clos, you touched on it. We do have a bit of track record of how CLOs have performed. And you're right. In 2022, CLOs performed well. And the way we think about the performance of the CLO is we compare it to its underlying. Like, how are the CLO default rates rates relative to the underlying default rates? And in 2022, they were significantly lower than the default rates that we saw in the underlying loan market. And also in 2008, it was one of those parts of the market that worked, quite frankly, that the CLO structure showed that the default rate was lower, about half as much as the underlying loan market at the time. And I think that's a testament to the managers that are managing these portfolios or these baskets of bonds that their underwriting process is robust enough to do better than the average underlying loan market.
- [33:34]
B
The price of the ETF doesn't move in a very wide range, which I guess makes sense considering that. Why should they, really? Especially if rates are relatively steady, Although I guess rates are. These are less sensitive to interest rates. But if the economy is relatively steady, if interest rates, credit spreads are calm as they are right now? These are loans. So you make a loan, the company pays you back, and there's thousands of them. And so why should the price be volatile? Would you expect this to go sort of sideways absent some sort of credit event?
- [34:12]
D
No I mean, certainly since we've launched it, there's been no credit event. So, you know, that is recent history. But yeah, you're right that when you think about a fixed income instrument, there's two things that drive the change in price. The biggest source of volatility most of the time is actually the change in interest rates. And this, since it's floating rate, doesn't have that. So what's going to change it is investors expectation for compensation for taking on risk, which is basically credit spreads. Right. So when spreads widen or tighten, that's what's going to drive the change in price because investors are demanding a different yield for the same amount of risk. So if there was a credit crisis, like all credit securities, the price, you would expect the price to go down as yield yields go up as credit spreads go up. But you know, in a normal market like we've had in the last nine months, you're right. Like it's kind of a sleepy product. Right. It's sort of a sexy private credit asset class and that's really sort of interesting. But when you start to peel it back, it's just a somewhat boring, you know, simple asset class that's just paying out its coupon on a monthly basis and you know, there's low volatility.
- [35:37]
A
I'm curious about the investment process. You talked about the diversification of it. Is this something that you can use a quantitative method for to look for certain characteristics of bonds or is this more fundamental bottoms up research? How do you pick the underlying investments to put your money into?
- [35:53]
D
Yeah, I think it's a bit of both. It's definitely fundamental, but there is a quantitative component. The quantitative component is that we're targeting an aportfolio know we're looking to build a portfolio by investing from the AAA tranches down to the double B tranches. What maybe is, you know, I don't know if this is fundamental or quantitative, but the portfolio managers are, when there's an inflow, are looking for the relative value. So they're, you know, looking to put the money to work based on these parameters of diversification, of keeping it at a, an A rating and then looking for the best values in the marketplace. What, what can they get that basically is a good value at that point in time?
- [36:39]
B
So Clos have been around for a while, as you mentioned, mostly being bought by institutional investors. How are they bought? Was this like you call up Goldman and they give you a quote type of thing?
- [36:51]
D
Yeah, I mean, it's not again, something that I can buy on my online account or have access to. But institutional managers can and, and do. And you know, as you mentioned, CLO ETFs are relatively new, but CLOs in ACT and things like mutual funds is not. You know, CLOs have been in mutual funds for 20 plus years. So those managers probably buy them one of two ways. The first would be again, like a lot of fixed income securities in the primary market. So they will tell Gollum or tell Blackstone that they're a buyer whenever Blackstone has a CLO that fits their criteria. So as they're issuing new CLOs, they know to call Pimco and they'll call BlackRock and sort of go through that, that process. Or just like you mentioned, they'll call Goldman, they'll call bank of America because they're sitting on or they're inventorying the CLOs because the PIMCO might have bought a CLO in the primary market, held onto it for two years, but had a redemption in their fund, needed to sell some bonds. This is part of the portfolio that they sold. Goldman now has it on their, their inventory. And now when BlackRock wants to buy it, they sort of call and maybe ask, what kind of inventory do you have in clos? They show it to them, Yep, that looks good. We'll buy it. And it's very similar to the way bonds trade.
- [38:25]
A
Do you have a lot of turnover in the portfolio or is it because these are such short duration assets that you kind of buy and hold them and when something comes due, you roll that into a new loan. How does that work?
- [38:36]
D
Yeah, good question. So we do not have a lot of turnover in the portfolio. So it is actively managed, but it is not churned for lack of a better term. So as flows come in, the portfolio managers put the cash flow to work buying the clos. And it's likely that we won't sell that unless there's a redemption in the fund. Even though they're short duration, the maturity of these securities is between 5 and 10 years. So the duration is short, which is the sensitivity to the changes in interest rate. But the actual maturities are much longer than that.
- [39:16]
B
So you launched this product not even a year ago and it's already got $150 million for a niche asset class is not nothing. Clearly there's investor demand. Do you have any sense of where it's coming from? Like, are you talking to the investors? I know it's hard to parse with an etf, but.
- [39:30]
D
Yeah, no, no, we're having, we're definitely talking to the investors. I'm spending a lot of time with advisors. That's who is the majority in the fund right now. So it's advisors that are managing money for other high net worth individuals. Also having a lot of conversations with institutions because they're interested in the product. Institutions are interested in it because of the liquidity, that this might be a, the liquidity sleeve within their private credit allocation. So that's why they're interested in it. Financial advisors are interested in it because not all their clients can access private credit through private funds or interval funds for various reasons. You know, private funds, there are asset level thresholds. So for some of their smaller accounts, this might be interesting. This also is appealing. As I mentioned, it offers manager diversification, which is something that advisors appreciate and that's part of the interest.
- [40:40]
A
So what do you think about all this money that's flowing into the private credit space? Does any of it worry you at all or do you think that. Well, no, this is just the way that things are now and this is the way that it's going to operate because of the regulatory changes and the fact that these are the way these loans are made now.
- [40:54]
D
No, I think it's, it's, I think it's that I think it surprises people when we talk about private credit. It's a $30 trillion asset class which makes it actually bigger than the corporate bond market here in the US and you know, as you mentioned, what's driving that is regulatory changes. Right. The sort of, the companies are staying private longer. So that's one of the drivers. The other things that they have access. But regulation like the JOBS act has made it easier for these companies to raise capital and easier for the managers in this private credit space like the KKRs and the Blackrocks to pool assets and invest in this way, which doesn't necessitate going to the public markets anymore. So the markets are just, you know, they're always changing.
- [41:49]
A
Right.
- [41:50]
D
And I think that this is, this is one of those shifts that's been playing out for 20 plus years. So it's, it's, you know, here to stop.
- [42:00]
B
Last question for me. Any, any worry about some of the Covenant Light stuff that is popping up out there. There's so much like there's so much money coming in that there's, there's almost more supply of dollars than there are loans. And so it's like a buyer's market on the loan side or borrower's market.
- [42:23]
D
Yeah, that makes sense. I mean we're always as credit managers we're always worried.
- [42:29]
C
Right.
- [42:29]
D
Like I think it's just the nature of the, of the beast as bond managers, you know, as it relates to pcmm. But the managers of the underlying closing, they all have a good track record and historically have proven to be able to navigate through volatile times like a 2022 and 2008. And the other thing to point out about, about these CLOs is they're senior secured loans. So they're the loans at the highest part of the cap table. So they're the first to get paid. So these are the safest loans in, in the cap table. So they're the last to be defaulted.
- [43:12]
A
So obviously the one thing people have been worrying about forever that hasn't happened in seemingly forever is a recession. And let's assume it's a run of the mill recession as opposed to some sort of big credit, even financial crisis. How do you see these kind of bonds handling? Just a consumer slowdown or something where the economy contracts?
- [43:31]
D
Yeah, it's a good question. And again, it's something we think about a lot of. Right. You know, because as a bond investor it's, it's asymmetric risk. Right. Like the best you're going to do is get your coupon back and you hope to get your money back at the end of the day. So you're more concerned about the downside than the upside. And in terms of PCMM and the structure, that's why we're so hyper focused on diversification, because we think that that's going to be the best way to sort of weather the storm, if you will. So diversification across the underlying loans, diversification across managers, and that is sort of the best approach to manage the, I don't want to say, but the inevitable downturn that we'll see at some point in time, that's the approach from a credit perspective that we're taking.
- [44:24]
A
For people who want to learn more, where do we send them? Bonblocksetf.com okay, thanks very much, Tony. Appreciate it.
- [44:31]
D
Cool. Thank you.
- [44:34]
A
Okay, thank you, Tony. Remember, check out bonblocksetf.com to learn more. Email us animalspiritsompoundnews.com.