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

Welcome to the XFLT Third Quarter Update Webinar. Thank you so much for joining us today. We are excited to get to the prepared remarks, but I do have a few brief housekeeping items that we want to cover. So let me start 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. Today, she's going to be covering the leverage loan and CLO market outlook, spreads in the asset class and market fundamentals. And then we are also joined by my colleague, Kim Flynn, who is the President of XA Investments. Kim will be walking us through the performance highlights from the quarter as well as the investment objectives and distributions from the fund. Before we get into the presentation, we do have a few important disclosures that 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 that is quoted. We will also be discussing market outlook and the materials do contain forward-looking statements. Investors should not place undue reliance on forward-looking statements. We encourage you to review all the general disclosures of the presentation. And then -- so 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. Lastly, please check out our website xainvestments.com to find more information on our fund, on our firm and general educational materials about the asset class and some of the things that we're working on in-house at XA. So let's get started. I'll begin with a brief overview of Octagon. Most of you on the call are likely already familiar with Octagon Credit and some of the great work that they do. For those newer to the firm, they're an industry leader in CLO issuance and CLO fund management. The firm has been around since 1994, has nearly $34 billion of AUM as of 9/30 and XFLT, which we'll be discussing today, was launched in September of '17 and was Octagon's first strategy to be publicly available in a registered fund format. So we've got some prepared questions and topics for the speakers that we're going to address today throughout the presentation. And just a quick reminder, if you do have questions for the speakers, please type them into the Q&A box at the bottom of the screen. So with that, let me begin with Kim Flynn. Kim, can you walk us through the financial highlights from the quarter and discuss EXLP's recent performance?

Absolutely. Just to remind everybody, the fund's fiscal year-end is September 30, so we just finished with the fiscal year. And we'd encourage you all to take a look at any of our publications, our annual report, semi-annual report at xainvestments.com. The good news is that we have strong performance earnings to report for the period. For the 9 months ended September 30, net investment income was $.0.97. Throughout this period, the fund has grown common equity significantly through the at-the-market program and an accretive transaction resulting in net proceeds of about $86.9 million, and you've seen that in the growth of the fund and we'll continue to look for opportunities to scale the fund to benefit shareholders. The monthly distributions for the quarter, we're going to talk about distribution. So let me hold off on that topic. We recently made a press release on Monday evening with a change to XFLT's distribution and that was for the December declaration. And we'll talk about the reasons for that in a moment. We did end the September 30 period with total managed assets just under $750 million, a significant increase from the beginning of the year where we started at about $546 million. One thing we like to touch on, just to give you a sense of how the market overall what kind of yields we see in the market today. Today, CLO equity remains very attractive with yields north of 26% CLO debt, $11.39, senior loans at $864 million and then high-yield bonds at $633 million. As you all know, XFLT invests in a mix of senior loans, CLO debt and CLO equity. And in combination, the goal is to deliver strong income for shareholders and do it on a risk-adjusted basis. So we'll talk now a little bit more about performance if we'll go to the next slide. We've had strong performance for both the year-to-date, which is the second column and the 1-year period, which is the third column. Both on a NAV and a price basis relative to the benchmark. Here, our benchmark is the Morningstar LSTA Leveraged Loan 100 Index, which is a common benchmark in the marketplace for senior loans. Just as a reminder, we're not using a CLO equity index because one doesn't actually exist, given the vintage of differences with CLO equity. So -- the fund has always used the same senior loan benchmark reference index. At XA investments, we believe in transparency. It's part of the reason why XFLT does have a daily NAV. And one of the things that we note is that the trust returns do reflect these mark-to-market changes in the portfolio holdings on a daily basis. And the NAV of the fund, we get questions from time to time about the NAV and the NAV does reflect the current marketing prices for CLO equity. And as such, there are some unrealized, I underscore unrealized losses associated with that model-driven valuation change for CLO equity. But bear in mind, CLO equity, this is kind of normal for CLO equity in terms of the pricing of those CLO equity securities to move around. You buy CLO equity because it's a very high-yielding instrument, and it can drive significant cash flow production for the trust and for shareholders. So while the NAV may be lower reflecting the current market pricing for CLO equity and some of the volatility, frankly, that we've had in the market the last few quarters. Just remember that these investments are still producing a high level of cash flow and more reflective of the cost basis of those investments than the actual NAV or the current price of those investments. And this is sort of a normal phenomenon when you're buying CLO equity because the closed-end fund structure is the best structure for volatile securities in terms of the pricing that we see in the CLO equity market and that's why this is the optimal structure for these types of investments. But we like to explain it because we do get questions from time to time on NAV. The excess returns are -- if we look at the 1-year period, there's about a 6.3% excess return above the benchmark on NAV and on price, it's about 4.3%. So we're pleased with the performance. Octagon has done a terrific job managing the fund in the 2024 calendar year.

That's great. So you referenced earlier the press release that we had on Monday. XFLT announced a reduced distribution in that press release. Can you address why that change was made?

Yes. So on Monday, we did declare a distribution of $0.077 per share. That's going to be payable December 30 to common shareholders as of the record date of December '16. This amount is lower, the $0.077 per share is lower than the 8.5% that we had previously been paying. XFLT maintained a steady distribution at that 8.5% level. It was 19% level monthly distribution payments from May 1, '23 to November 1, 2024. So let's talk a little bit about why the distribution change was made. As you know, the fund has an income-based distribution policy, and we want to distribute what we're earning. Now there's going to be variability the fund for the last fiscal year 2023, we did distribute 100% net investment income. Now past performance doesn't guarantee future results, but that's why a change is necessary. You see here in front of you what the Fed has been doing over the last couple of years. XFLT really enjoyed the benefit of the Fed funds base rate that sort of marching stair step higher that you see in orange and the fund benefited from higher earnings. Most recently, the Fed in the past 3 months has cut the base rate twice resulting in an overall total decline in the base rate of 75 basis points. So as a result, we needed to make a change and the anticipated net investment income for the fund, will be lower based on that base rate. We've also noted in the press release that there's a lot of demand in the market for high-yielding assets. And in addition to the base rate decline, we've also seen, because there's so much demand for loans for CLO debt for CLO equity, that means we've also seen spread compression in the market. So these 2 factors together, the decline in the Fed rate and the increased demand resulting in spread compression has resulted in us making a change to the distribution rate, which the most recent declaration is the $0.077 per share. So hopefully, Kevin, this helps explain why we made the decision and the timing as such.

Yes. So let's look at Lauren here to talk through some of that. Lauren, as Kim mentioned, we've all seen very strong demand for high-yielding assets. The loan market, the CLO market, they've experienced the spread compression that Kim referenced. Can you explain how the spread compression is impacting XFLT?

Sure. Happy to. Spread compression has been a major theme in the broadly syndicated leveraged loan market this year. And as you reflect on the question, the market has experienced extremely strong demand for floating rate assets. So it's -- with this demand outpacing the supply of loans, that's leading to lower spreads overall, and this really isn't that surprising given that dynamic. But this impacts the trust in a few ways. One, almost half of the assets owned by the trust today are broadly syndicated leverage loans -- broadly syndicated leverage loans are callable instruments. So that means in a tightening market, these loans can be ratherly refinanced -- and that's what's been happening throughout the balance of 2024. I think on the slide, we highlight 37% of loans have been repriced or that's just another way of saying refinance to lower their interest spread as of 9/30, I think that number as of November is closer to 50% of outstanding loans. The shortage of new issue loan supply has meant that new issue loan spreads are also tighter. So where we do see new supply of loans, they are coming at tighter spreads. On balance, the loan market has experienced in excess of 25 basis points of spread compression this year. So it's been meaningful. The second way in which the trust is impacted by spread compression is through its holding of CLO equity. So CLO equity receives a quarterly distribution, which is simply the difference between the income that the CLO earns on its underlying portfolio of loans, less the interest expense it pays on its borrowed debt. So spread compression in the loan market reduces the value available for distribution. So for our CLO equity holdings, however, in contrast to our loans, there is an offset because CLO debt tranches while subject to a 2-year non-call are also generally callable and after that 2-year non-call period, those securities are eligible for refinancing as well. So what we've seen a lot this year is after the expiration of a non-call period, CLO liability is being refinanced and that's serving as an offset to the compression in loan spreads. So this has benefited some of the equity held by the trust and has served as a very important and meaningful offset to the spread compression on the loans.

Yes. Thank you for that. So let's sort of take a slight step back. And can you please discuss the performance of the leverage loan and CLO markets over the last quarter?

Both the loan and CLO markets have exhibited very strong performance in the third quarter and frankly, year-to-date, the broadly syndicated leveraged loan market continues a strong streak of performance with loans returning just over 2%. And in the third quarter. That's in excess of 6.5% year-to-date through 9/30, and it's even stronger if you fast forward through the end of November, where strong performance has continued and really actually accelerated. CLOs similarly have experienced strong performance. BB CLO tranches have posted almost 2.7% total return in the quarter, also a very strong performance year-to-date. And while there's no real equity index to reference, as Kim mentioned earlier, CLO equity continued to make strong distributions and profiles that were eligible for reset and refinancing generated some very, very strong returns in the quarter and throughout the course of this year.

So let's stick with you, Lauren. And you referenced this earlier, but we've observed an increase in the number of resets throughout the year. Can you explain a CLO reset and the potential benefit it has to the trust?

Sure. Resets have been a very large driver of activity in the CLO market this year. And just to take a step back and describe what a reset is, it's simply the refinancing of the CLO's debt, often to a lower interest rate, not always, but often and the contractual extension of the reinvestment period of that CLO, often to a new 5-year term. And this type of activity can be very, very accretive to holders of CLO equity like the trust. Again, because often you're lowering the interest rate on the liabilities, that leads to more robust distributions it leads to longer interest income distribution streams and more flexibility for the manager. Longer equity is typically less volatile. So that's really good for the trust. It means we should see less price volatility in the equity we own as it is able to reset, but all of these things combined to generate a really positive total return experience for CLO equity holders. Of note, and I think it's worth discussing. About 1/3 of the equity health in the trust has been reset year-to-date, and it's been -- those profiles have had very attractive global return experiences.

So then how do you expect the balance between net new CLO issuance and CLO refinancing and reset activity to evolve in 2025?

Yes. So as we think about 2024, resets and refinancings have occurred at a very, very robust pace. We've seen new CLO issue -- new CLO creation, true new issue CLO creation, but the volume of reset and refinance activity has been much higher. I think reset and refinancing activity is highly likely to continue at pace in 2025. And -- if you think about the theme higher for longer, that means continued strong demand for floating rate assets. Demand for floating rate assets means continued spread tightening and that means continued reset and refinancing activity. As we think about true new issue CLO creation, this is probably the place where I think we might be set up for a change in 2025 versus what we saw in 2024. And I think the potential exists to see more new true issue CLO creation in 2025. And the big driver of this view stems from an expectation of an increase in loan supply. And this is really driven by an expectation of an uptick in M&A. And that would be driven by marginally lower rates the potential for a more accommodative FTC and the general theme of deregulation. I think there's risk to this view, but I think that's our base case today and really what we're hoping for, for the market.

Great. Great. So let's look under the hood quickly and discuss some market fundamentals. How did the financial performance of borrowers trend in the third quarter?

Yes. So borrowers continue to perform in the broadly syndicated leveraged loan market. Similar to previous quarters, and Octagon has exposure to a large portion of the loan market. So when we look at our borrowers and aggregate their performance, we continue to see strong fundamental financial performance, mid-single-digit revenue growth, EBITDA growth, which is in excess of revenue growth, so continued margin expansion. Really strong fundamental performance not across the board, but on average and in most cases. Base rates coming down, it's another fundamental positive driver for levered credit, especially those credits at the bottom end of the credit spectrum. So that's another reason to feel a little bit more constructive about the fundamentals both when you're looking backwards as to what happened in the third quarter, but also as we look forward, and while we still expect some credit issues in the market, I think they are going to continue into 2025. I think this level of credit stress is poised to be lower next year than we saw this year. And certainly, the forward market indicators would point to that being the case.

Thank you. So we've had a few questions come in from the audience today as well as several throughout the quarter. [Operator Instructions] Kim, one that came up, I'll direct this one to you. And this is for a new investor, someone looking at the trust. What is the main investment objective of XFLT -- is the fund focused more on income generation or price appreciation?

Yes. So I think this question stems from the fact that XFLT's price and NAV is basically not moving up. And I think one of the questions was is the fund -- do you expect the funds price and NAV to benefit from capital appreciation over time and I've answered this question with basically pointing to the asset mix, which is this fund and its objective is to generate income or cash flow for shareholders. So the objective is not capital appreciation. So I want to make sure that people have the right expectations for the fund. Our goal is to deliver that cash flow to shareholders. The asset composition, this fund is largely comprised as you see of income-producing assets. And as Lauren was talking about, senior loans make up as of 9/30, 46% of the portfolio. CLO equity is about 35%, CLO debt is about almost 13%. And as you can see, common stock, we don't have any exposure to common stock. So we don't have exposure to instruments that would generate a lot of capital appreciation over time. So you can expect us in terms of we're seeking to deliver on our investment objective and that is driven by our focus on income generation. So I hope that clarifies because I've had a few questions about that and just want to make sure that people understand what XFLT's goal is.

Yes. So I'm going to stick with you, Kim. So we've been asked recently what different types of investors own at XFLT. Can you share with us the investor base breakdown by type of investor?

Sure. We actually -- I thought this was a good question. And on the last webinar, we didn't really have the breakdown. So let me start with -- here you see the breakdown. We don't -- the takeaway is we don't have a big institutional investor base. I hope that's not surprising to you all because this is a product focused on income, and we have a lot of individual investors who are attracted to XFLT. And we do have a very diverse share base as -- in terms of a lot of small investors. As you all may recall, earlier this year in January, we went to shareholders to seek their approval to change the fund from a term fund to a perpetual fund. And the reason I mentioned that is that process you go through and you do outreach to your investor base. So we have a really good sense of who are the buyers and holders of our fund. And because it's -- the fund has grown slowly over time, it's really grown and the demand is coming from income buyers. So you do see our co-founders, our co-CEOs, John Yogi Spence; and Ted Bombach, on this table as owners. You do see Eagle Point Credit as a 5% holder. They also are a well-known manager in the CLO equity fund space. But beyond that, fairly small institutional ownership in the fund. And we also are happy to report that there are no activists in the fund. I think that largely has to do with the strong trading performance in the secondary market. So this is a very healthy, we think, investor base, very diverse and no activists.

So another one that came in is, why is the XFLT expense ratio high relative to loan mutual funds or ETFs?

This is a good one. And I think the reason for some of the confusion about our expense ratio has to do with the fact that this is a listed closed-end fund that uses leverage to enhance income and distributions for shareholders. There's obviously a risk using leverage, but a listed closed-end fund has that tool available, whereas a mutual fund or an ETF is not using the leverage that XFLT or its CLO focused closed-end fund competitors are using to drive performance. And so obviously, in our expense ratio, we're disclosing our management fee, our operating expenses our leverage expense. And so sometimes, especially like I think in Seeking Alpha forum, people will comment about differences between XFLT and some of the ETFs in the marketplace. Those funds aren't using leverage. They don't have that. And leverage, as you know, has averaged about 650 because we've been in a higher rate environment. So the leverage expense is significant and it shows up in our expense ratio. So I think that's why we get that question from time to time. And I hope you all have a good sense of that. I do like to remind shareholders that XFLT does charge a flat management fee, it's 1.7%. We don't charge a performance fee. Our competitors that invest in CLO equity, they are charging performance fees. And so that does result in -- for those funds, typically higher expense ratios then for XFLT. Now there's benefits for those competitor funds in terms of their strategy in terms of their asset mix, I just pointed out as a difference for our fund. But I think, Kevin, that's the source of the question.

Yes. Yes, I agree. So let me shift back over to Lauren. This question has come up a couple of different times. So XFLT primarily invests in floating rate securities. And with will the trust earnings decline along with anticipated future interest rates -- interest rate cuts?

Sure. With the caveat that I am not a rate strategist and can't predict the Fed, I will share that I do think the market expects the Fed to cut in December, probably by another 25 basis points. And the forward curve implies a little more downward movement in 2025. And as I mentioned earlier, loans are floating rate assets. So about half of the trust is comprised of broadly syndicated leverage loans, and they will see their income decline if rates continue to move down further. Now I do think we have the offset on the CLO equity portion of the Trust Holdings. And I do think we need to wait and see what the Fed does to make that determination. As discussed earlier, if rates go down, so will the yields earned by the trust -- but I think there's a lot of outstanding questions about what's going to happen with rates. I think those decisions are going to be very data dependent. So right now, we're really in a wait-and-see mode on that front.

Got it. One last reminder to the audience, if you have additional questions. I don't see any others coming up in the Q&A box.

I think there's -- we didn't quite fully answer. I think they're -- because I mentioned in my comments that there's a question about changes in rates and changes in spreads. And I think Lauren addressed it, like the distribution change was made because the fund is a floating rate fund, and we benefit when rates go up. and we have to adjust when rates go down. That's a natural part of managing a floating rate fund. So I think it's worth repeating just based on some of the questions that we've had. And we've talked about spread compression in terms of being a negative because there's so much demand right now. We've seen spread compression. So I guess just to confirm, maybe, Lauren, could you talk about like if we see widening of spreads to historic norms, do you expect the opposite? I mean is that -- that's a beneficial thing if we were to see widening of spreads right?

Yes, the trust would expect to participate in a wider spread environment, we would be able to increase the yield on the loan book and also see the benefit of that in our CLO equity holdings. And you see even more of a benefit of that in your longer profiles of equity. That's why one of the reasons why we really like resets, we'd like to have long reinvestment period. So when you do hit a period of volatility where spreads move wider, the managers of those CLOs are able to capitalize on that. So yes, if spreads move wider, we would benefit in that case.

Well, thank you for that additional clarification. I don't see any other questions in the chat box, and we'll wrap. But thank you both so much for your input and 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 is a relative of information available on our site in -- under the knowledge bank. Please reach out if you have any additional needs or questions, and we certainly appreciate your time today. Thank you.