XAI Floating Rate & Alternative Income Trust (XFLT) Earnings Call Transcript & Summary

Good morning. Welcome to the XFLT second quarter update webinar. Thank you so much for joining us today. We're excited to get to the meat of the presentation, but I do have several brief housekeeping items that we need to cover. I'll begin first with some brief introductions. I'm Kevin Davis, with XA Investments. I head up sales and distribution for the firm. I'm happy to be joined today by Lauren Law from Octagon, who is a Senior Portfolio Manager. She joined the firm in 2004 and overseas Octagon's structured credit investment strategies. She'll be covering the performance highlights from the quarter as well as the outlook for the fund and the asset class going forward. And we're also joined today by my colleague, Kim Flynn, who's the President of XA Investments. Kim's going to be walking us through fund management matters as well as updates on governance or actions, et cetera. So before we get into the presentation, we do have a few important disclosures we want to address. We will be talking about performance throughout the presentation. Certainly, past performance does not guarantee future results. And current performance may be higher or lower than the performance data quoted. We'll also be discussing market outlook and the materials do contain forward-looking statements. Investors should not place undue reliance on forward-looking statements. We do encourage you to review all the general disclosures of the presentation. One last housekeeping item. Please note the Q&A box at the bottom of the screen. If you have any questions, please type them into the box, and we will do our best to answer them in real time. We'll also open up for questions at the end of the prepared remarks. And if you don't get your question answered, please feel free to contact me directly and we will get those answers for you. And lastly, please check out our website, xainvestments.com to find information on our fund, our firm, general educational materials about the asset class and some of the other things that we're working on in-house. So let's get started here. I'll do -- most of you on the call are likely familiar with Octagon Credit and the great work that they do. For those newer to the firm, they are an industry leader in CLO issuance and CLO fund management. The firms has been around since 1994 and has nearly $34 billion of AUM as of 6/30. And XFLT was launched in 2017 and was Octagon's first strategy to be publicly available in a registered fund. Okay. So we have some prepared questions and topics for the speakers, which we'll address throughout the presentation. Just a quick reminder. If you have questions for the speakers, please type them into the Q&A box at the bottom of the screen. And with that, let me turn the call over to Kim Flynn to begin with the financial highlights. Kim?

Thank you, Kevin. Really appreciate it. So we're about to celebrate 7th anniversary of the launch of XFLT. And we're going to talk about performance for the most recent period and for the last 12 months, which has been very strong for XFLT. The 6 months ended period June 30, net investment income was just shy of $0.50. As you recall, XFLT does have a income-based distribution policy. This is an income-oriented fund that has floating rate assets. And so obviously, for income investors, this is a key sort of important point to be tracking. The fund has grown significantly. I think the fund has increased total managed assets by about $200 million in the last 12 months. And we're going to talk about the benefits for shareholders, but these are all accretive and that means that shareholders are benefiting from these transactions because they are done at prices above NAV. The fund does have an at-the-market program, which is really an effective cost-effective way to grow the fund and create some scale benefits as the fund gets larger. We have maintained steady monthly distributions. Distributions remain unchanged for the most recent period, the most recent declaration. And one thing that we do get asked a lot, we included here the weighted average current yield as of the end of July for the different components of XFLT. As you know, XFLT invests in both senior loans as well as CLO investments, including CLO equity and CLO debt. The CLO investments are quite high yielding. Average current yields in the market: CLO equity, north of 20%; CLO debt at 12.25%. Senior loans right now at 9.4%. And then every now and then, you'll see like a small usually less than 5% allocation to bonds in the portfolio and bonds right now on average. These are index averages, are yielding about 6.45%. So let's get into the overview of the fund. Total managed assets as of the end of June were just shy of $700 million. As of last night, the fund was about $726 million. And really important we talk about this later, but the secondary market trading, average daily trade volumes have gone up significantly over the last year creating a healthy secondary market trading for investors who want to get in or out of the fund. And that's really, for us, a sign of sort of wellness that we monitor in terms of average daily trading volume. So happy to see it. As you know, leverage for the fund is in a range which usually between about 37% and 39% and the fund has a mix of fixed and floating rate leverage which we like in combination in terms of leverage benefits this fund in a couple of ways in terms of income production. So we'll talk more about leverage and the different types of leverage that the fund has on the books. As you might expect, CLO equity comprises about 10% of the portfolio -- excuse me, top 10 presents about 10% of the portfolio. CLO equity in total allocation for fund is about 36% and CLO debt there is about 13.5%. So as we talked about the strategic mix of having loans at about 50% and CLO investments at about 50% is where the fund has typically been over time. And we think the combination of these assets is optimal together, and it gives Octagon a lot of flexibility to move between the different parts of the credit market. So we'll talk more about that with Lauren. Lauren is going to speak to portfolio composition in a moment. Net returns for the 1-year period: NAV return at 24.02%, price return at 22.44%. The benchmark the Morningstar LSTA leveraged loan index is at 10.78%. Happy to report that for all of the performance periods shown here, the 1 year -- excuse me, the year-to-date, the 1-year, the 3-year, the 5-year and the inception to date, the fund is beating the benchmark on both NAV and price. Moving now to look at just premium discount history. Quickly, the fund is continuing to trade at a premium as it has on average since the fund's inception. Right now, the current premium 3.37% is on top of the average premium over time, which is 3.38%. I will note that this fund has traded in the past at discounts. It does trade sometimes at larger premiums, as you see in the slide. And obviously, there's strong demand in the marketplace for income-oriented products and we're benefiting from that in today's market and today's trading. If you look at the price and NAV history, we have -- unfortunately, in the last 12 months, you'll see in the middle of the slide, we highlight the last 12 months. Right now, the current price of XFLT is 6.90% and the current NAV is 6.73%. So we're off the 12-month highs for price to NAV. And I think this reflects some of the concerns in the macro market. It also reflects concerns about the interest rate environment that we're in. So the fund has already experienced these price and NAV declines and we just wanted to address it here with you today. And so while we can't predict the future, it's helpful to kind of share where we've been the last 12 months and we'll see. We'll report back next quarter where we stand in terms of a price of NAV. In terms of trading volume, this is what I mentioned is that it's really healthy to have an expansion of the buyer base for this fund, and we've seen increased daily trading volume. And the box on the right shows the trend which we will only see higher levels of trading. And this is interesting because the last 90 days, as we all know, has been the summertime and that tends to be sometimes periods for slower trading. But nonetheless, XFLT continues doing well in the secondary market. Lastly, and I'll, I think turn it over to the headliner, which is Lauren, who's going to speak with you directly about the CLO marketplace. I just want to highlight the good work of our Fund Board. They've been very active this last year. They've met 9 times and part of the reason for this, a typical Board might meet 4 or 5 times, but with the transactions that XFLT has done, and you'll see in the upper right, just a review of the share issuance that the fund has done to continue scaling and increasing scale economies. That requires the Board to actively consider and to approve these transactions. So Nonetheless, the board is very, very thoughtful about doing the best for shareholders and looking out for being thoughtful about what shareholders are thinking about and that's what we discussed at our Board meetings. We just met recently on August 13. So Kevin, let me turn it back over to you to do our Q&A.

Yes. That's great. Thank you so much, Kim. So the first question that we've got here, really, I'll address it to Lauren. And Lauren, do you mind to review sort of the strategic mix of loans and CLO debt and equity in the portfolio? And maybe shed some light on why Octagon likes this mix?

Sure. Good morning, everyone. XFLT's ability to invest across loans and CLO tranches as well as high-yield corporate bonds allows us to take advantage of the relative strength or weakness in the different markets and really maximize income for the fund at a lower level of volatility. The Trust's 50% exposure to broadly syndicated leveraged loans does provide a little bit of stability for the fund, particularly relative to other just CLO equity-focused strategies. A couple of things worth noting as to how we've transitioned these allocations over time. If you remember, we increased our allocation to CLO BBs in 2023 as those were trading at significant discounts and very high yields. That trade has performed really well over the course of the last 12 months. That portion of the market has remained attractive. But we've begun to bring that allocation down somewhat in 2024 in favor of higher yielding CLO equity opportunities. We have maintained a relatively high allocation to BBs, but we are moving that in favor of equity. And while we're thinking about our equity allocation and how attractive the yields are there, we have always been and will continue to be very selective in the assets that we source. This year, we have been focused on clean new issue primary equity opportunities as well as secondary opportunities, where we believe a reset or the contractual extension of that equity position is likely. We like longer, clean profiles of equity that are well positioned to take advantage of moves in the loan market over time.

Great. Thank you, Lauren. So we do have a couple of questions regarding fund management. I want to get to those quickly before we move on to Lauren's prepared comments regarding sort of the broader CLO market. So Kim, for you, you mentioned the at-the-market program. Let's turn to the growth of the fund. How does XFLT grow its common share base? And then how did the shareholders benefit from that growth?

Sure. So XFLT is a bit different than most traditional listed closed-end funds. And so it's worth noting the way that we've grown the funds successfully, partly because XFLT trades at a premium and the fund is in demand. We've been able to do accretive share issuance and the aftermarket program is a really terrific way. That's how the fund has largely been growing recently. We have done some registered direct offerings. There is demand for the fund shares by small institutions, just had a really interesting call a couple of days ago with an institution that likes the income generation ability of the fund, and so we've been able to be thoughtful with some of the capital markets activity. And because the fund has grown on the common equity side, we've been able also to diversify on the leverage side with preferred securities issuances. We also have convertible preferreds, which start out as a form of leverage and then convert into equity, which is also fairly novel, but is another accretive way that we can grow the fund. The benefits, really, I think, Kevin, are twofold. One is that these are accretive transactions. So they're not dilutive and shareholders benefit -- existing shareholders will benefit with these accretive share issuances. The second thing is that it does create potential scale efficiency so as the fund gets larger. The fund has a mix of fixed and floating expenses. And so to the extent that the expenses are floating, the scale efficiencies will help reduce expenses that shareholders pay over time. So that's really the benefit of asset growth. And we just wanted to mention it here today on the webinar because we get a lot of questions, confused. People wondering how a closed-end fund can grow because most of them stay about the same size, but I think this helps explain that.

Great. So you mentioned leverage in the fund. What types of leverage does XFLT employ? And then a follow-up to that is how would potential rate cuts impact the cost of that leverage?

Yes. So -- we always talk -- when we're talking about the fund has assets and the fund has liabilities in the form of leverage. So we're going to spend a moment talking about the liability side, which is the leverage side. We use leverage in XFLT because it's an income-focused fund. Leverage is designed to enhance the income that we can pay out to shareholders, and the fund has benefited from historically benefited from leverage. And there's always risks associated with using leverage. We like leverage with this asset class. Because as you know, senior loans are floating rate assets; CLO debt and equity also have a floating rate characteristic to them. And so when assets are floating, you want your liabilities also to float so that there's a pairing of the assets and the liabilities. And so that's what we say with this asset class that it does lend itself to the use of leverage because the assets float and the leverage will float, which means -- floating just means when it, when rates go up, things go up and when rates go down, things go down and then there's parity. And so you're always able to add some -- let me rephrase that, which is that leverage can benefit you depending on different market environments, and that's why we want that parity with the assets and the liabilities. We've taken a thoughtful approach to the different types of leverage that we use. So we have bank borrowings, which are the bulk of the leverage at about 28%. That is all floating rate tied to SOFR. And then we also have some fixed rate retail preferreds at about 5.73% of the leverage, and you can see the cost to leverage in the last 2 quarters on the right-hand side of the slide. We also have a small amount of convertible preferreds. Those were the convertible preferreds that I mentioned that at some point will convert to common equity. So they give us a benefit for a period of time, serving as leverage, and then they also will benefit shareholders once they convert to equity and continue helping us scale the size of the fund. And so we're always thinking about being proactive with leverage renewals because we want to be thoughtful about how we are maintaining our leverage over time.

Great. And so we have -- one last question for you regarding sort of the management of the fund. This is a question that comes up a lot. Does XFLT charge performance fees? And how do those fees compare to other competitive funds?

Yes. It's a good question. But no, XFLT does not charge performance fees. It is common among some of the CLO focused competitor funds out there. XFLT, I'll just speak to what we do, which is that the management fee is 1.7%. It's a flat fee, and we're not charging an income incentive fee. We're not charging a total return-based performance fee. Those are becoming more common within the private credit space. There are a handful of listed closed-end funds that focus on the CLO investment market that do charge income incentive fees. And then we also see it in the interval fund market, where private credit is a large part of that marketplace. And so we're hopeful -- I think given the asset mix, I think Lauren spoke to the benefit. Our fund gets compared a lot to CLO equity-focused funds. We also get compared a lot to straight senior loan funds. And we're definitely a hybrid with this 50-50 asset mix. And so that's part of the reason why, obviously, we don't -- we're charging performance fees. And we still think we can develop attractive distributions over time for shareholders as compared to our competitor funds. And we are -- the nice thing is we are uniquely positioned in the marketplace. There's not a direct competitor that does what Octagon does with respect to their asset allocation.

Great, great. A unique offering for sure. Okay. So let's change gears here. I'd like to turn the call back over to Lauren Law. Lauren, can you kick us off with some recent performance of both the leverage loan and CLO markets over the last 6 months or so?

Sure. Both the loan and CLO markets have exhibited strong performance year-to-date. The broadly syndicated leveraged loan market has returned in excess of 5% year-to-date, and CLO BBs are up almost 12.5%. CLO equity has exhibited similar or strong performance, benefiting from the improvement in loan prices as well as a tightening of the yield that buyers have commanded to purchase equity. This has been offset, at least in part, by some spread compression on the underlying loans owned by CLO collateral pull. Strong loan market performance has allowed many borrowers to effectively refinance their debt to a lower cost of funds. This has created a little bit of a headwind to the interest income earned by CLO equity positions though it is offset by the CLO's ability to take advantage of spread compression by refinancing or resetting their own liabilities. So all in, it has been a very strong year for both the leveraged loan and CLO markets in 2024.

Great. So I will let you take it from here if you want to go through sort of the broadly syndicated loan market, outlook of the asset class.

Sure. So I had prepared some comments about the potential for credit stress. Going forward, I think that's a big question that we're getting about the loan market. And I think in reality, we don't anticipate that credit stress is going to increase in the loan market over the next quarter. We certainly saw some volatility in trading prices and spreads with broader risk markets in the beginning of August, and we can certainly see a scenario where we may see some additional trading volatility this fall as the Fed potentially starts to cut rates. We would view this technically driven trading volatility as an opportunity to buy good credits at better prices. Credit stress in the loan market has been coming down. The forward indicators of default are pointing to stable to lower levels of distress and the fundamental performance of borrowers actually continues to be healthy. In the second quarter, we're seeing continued revenue and EBITDA growth across loan borrowers and continued margin expansion. The rate of margin expansion, I think we've been talking about this trend for a few quarters now, the rate of margin expansion has come down a little bit, but it still exists. And on the whole, we are seeing very healthy performance -- fundamental performance from levered borrowers. And lastly, as the Fed begins to pivot towards easing, a decrease in interest expense for levered borrowers improves free cash flow profile, improves the health of the borrowers in our market. So on the whole, we envision the market experiencing stable to potentially lower levels of credit stress going forward than we have seen in the past 12 months.

Great. So let's turn to technical dynamics. And Lauren, if you could address what's the Trust's outlook for primary CLO issuance and CLO arbitrage in the second half of the year? And then along with that, where in the CLO capital structure is Octagon seeing the most opportunity?

Certainly, sure. It is our expectation that primary CLO issuance will remain fairly robust in the second half of 2024. We've certainly seen that through August, and this is owing to a lot of demand for CLO product and relatively tight spreads, making issuance attractive. Issuance has been dominated by resets and refinancings, owing to the attractiveness of this type of activity for existing CLO vehicles as well as relatively limited new loan supply. Limited new loan supply makes it harder for a CLO to ramp sufficient amounts of loan collateral to securitize into a new CLO. So that's led for a little bit of a slowdown in true primary new CLO issuance, which we're hopeful can pick up a little bit in the fall. We do see the potential for an uptick in loan issuance this fall, which should allow for more primary CLO issuance. And we think given where CLO liability spreads are, that it's a good time to participate in long, clean new issue equity transactions as well as secondary opportunities, where we see a strong path to a reset or refinancing of existing liabilities.

Great. And then so speaking of sort of broader market commentary, do you want to address some of the market themes that you're seeing right now?

Sure. Given the decline in -- excuse me, the relatively muted levels of true new issue loan supply, maybe it makes sense to take a step back and talk about why that's happening. One, the loan market has been seeing competition for financing opportunities from private credit. This was really a headwind in 2023 to new issue loan supply, but something that is still out there a little bit in 2024. But the bigger issue is just a general decline in M&A volumes. The decline in M&A is at least in part due to a valuation disconnect between buyers and sellers as well as the rate environment. And with valuation multiples remaining relatively high and the cost of financing being high as well, it's really been hard for PE buyers to hit their return thresholds. Said differently, the debt capacity of borrowers in this rate environment is simply lower. So where a PE sponsor may have been able to finance with 10x enterprise value LBO with 6 turns of debt in 2021. Today, that same borrower may only be able to afford 4 to 5 turns of leverage with the enterprise value unchanged or barely changed. And it's hard for PE sponsors to meet the return hurdles in this type of environment. And the financing environment does appear like it will be more active this fall. We are seeing some transactions get announced. We are being previewed some opportunities that we expect to be in September. So it is hopeful -- it is our hope that there will be more loan supply for the market this fall. But the other interesting dynamic is with the Fed shifting towards easing and rates coming down a little bit, it may make it a little bit easier for borrowers, both from a fundamental basis, as we mentioned earlier, but also for some M&A to take place as it's cheaper to finance some of these transactions. So we're pretty constructive on what we see for both the broadly indicated loan market, what we see for loan activity in the fall and what that means for CLOs and CLO creation.

So we did have several questions that came in prior to the webinar, which we've covered many of them. [Operator Instructions] I do have one other prepared question here, and this is really probably for both Lauren and Kim. Given the decline in leverage loan origination and its effect on non-reset refinance CLO issuance, what is the outlook for the return of robust leveraged loan activity? Also, are there any key factors that might influence this such as federal reserve policies or the upcoming election? So Lauren, I'll begin with you.

Yes. I think I just -- I touched on a lot of that, that I think rates coming down may actually: a, help the fundamental performance of borrowers; but, b, also help lead to some M&A activity, make it cheaper to finance M&A activity. So I think Federal Reserve policy easing, rates coming down, not because we expect the economy to go into a recession, but just as we get to a more stable economic environment. I think that can be really constructive for the M&A environment for the broadly syndicated leveraged loan market and for CLOs and CLO creation.

Great. Kim, anything to add there?

Sure. So I think one question that we did have in the Q&A that was just -- one of our listeners just noted that, Lauren, obviously, you lived through it, but 2022 was an interesting environment for this marketplace and we did see in XFLT significant price and NAV declines, which is in the materials that we've shared with you. And the I think there's sort of -- the question stems from, you've already addressed kind of where the fundamental credit if -- what pricing has done to CLO debt, CLO equity in the secondary market based on concerns about fundamental credit declines. And so maybe if you could just speak to the experience of 2022 from a borrower's perspective relative to where borrowers stand today in 2024. I think you've already said that with rate cuts coming, potentially that might make things easier for borrowers. But maybe contrasting '22 to '24, if you would.

Yes. I mean in 2022, what we saw was borrowers contending, but not only some business headwinds, right? There was much more ramp in inflation and some sectors experiencing challenges with labor, lots of holdover issues from the pandemic. But in 2022, we were dealing with a market that had levered itself in a very, very low rate environment, and then we were contending with a rapid increase in rates. And so in 2022, we saw some borrowers hedged. Their interest rate exposure, floating rate interest rate exposures, but others had not and we saw a dramatic increase in the interest burden and corresponding decrease in the free cash flow of a lot of borrowers in the market. Where we stand today, and that led to some of the credit stress that we saw really. It occurred on a lag throughout 2023 and are still experiencing in 2024 year-to-date. So if I were to contrast 2024 to 2022, I would say, where we are today with rates coming down, with borrowers getting a little bit of relief on that front, we think it's very healthy and constructive for levered borrowers today, the opposite of the headwind that we were facing in 2022.

Good. I think that helps. There's another question from one of our listeners that I want to address because this one is more of a technical broker-dealer issuer question. But it comes up so often. I'm going to take it, which is, the person is saying that they hold their accounts at Schwab and they're asking about the DRIP program, the Dividend Reinvestment Program, and is that available for XFLT? And yes, the answer is. I know some of my colleagues have their savings at Schwab. And so we know that there's a DRIP program. One of the issues that comes up with a lot of broker-dealer firms, including Schwab, is that XFLT has its own Dividend Reinvestment Program, and you can ask your representative or you can call up your contact at your firm like Schwab and ask them to participate, have you participated in the XFLT Fund-specific Dividend Reinvestment Program because that's going to be more beneficial. As we noted, the fund has traded at a premium in the past and the Dividend Reinvestment Program that the fund runs. The reason I am mentioning that is that a lot of broker-dealer funds run their own Dividend Reinvestment Programs, but they're done at different prices. They're just done in the open secondary market. And so that may not be as advantageous as the fund-specific DRIP. And so I think it's a good question worth asking to make sure that you're not just in any DRIP program because when we trade at a premium, the way we have been, the fund shares are issued at NAV, not at the secondary market price. And so that's why you want to make sure you're in the XFLT Fund DRIP. It is somewhat of an automated opt out. A lot of broker-dealer firms will opt out of the fund Dividend Reinvestment Program, but you just need to direct that you're in the appropriate DRIP program. So please do and if you have any questions on that -- sometimes we get questions also related to distribution payments and timing of those payments. And so if you ever have a question -- usually, it's an issue with the specific broker-dealer firm, please give us a call. We can help you track down any questions you have about that, about the Dividend Reinvestment or about the timing of your distribution. As you know, we do pay monthly. But sometimes, the broker-dealers take a couple of extra days to make those payments, and we wouldn't want to have you worry. Kevin, I'll turn it back to you to the extent that there was any other questions. I think we've addressed the questions that we're able to do from the Q&A bar.

Yes. Thank you, Kim. So one last reminder. If you do have any additional questions, type them in the Q&A box at the end. I don't see any others popping up here. So we'll wrap the call. But thank you, Kim; thank you, Lauren, so much for your time, your input, your commentary today. I will remind everyone that the webinar will be available via replay on our website. And as I mentioned at the outset, there's a wealth of information available on the site as well in the knowledge bank. So please reach out if you have any additional needs or questions, and we appreciate your time today. Thank you.