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

Good morning, and good afternoon for those of you on the East Coast. Welcome to the XFLT First 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 we need to cover. I'll begin first with some 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 Credit who is a Senior Portfolio Manager. She joined the firm in 2004 and oversees Octagon's structured credit investment strategies. Today, she'll be addressing the spread compression that we've seen in the loan and CLO markets, credit fundamentals and stress indicators as well as the outlook for the fund and the asset class going forward. We're also joined today by my colleague, Kim Flynn, who is the President of XA Investments. Kim will be walking us through recent news on the fund's distributions, financial highlights and portfolio composition. Before we get to the prepared remarks, 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 data 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. One last housekeeping item we've got. [Operator Instructions] We'll also open up for questions at the end of the presentation. 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 information on the fund, on our firm and some general education materials about the asset class and some of the things that we're working on in-house. So let's get started. Most of you are likely already familiar with Octagon Credit. If so, you know their rich history, their expertise and successful long-term track record in the space. For those newer to the firm, they are an industry leader in both CLO issuance and CLO fund management. The firm has been around since 1994 and has over $33 billion in assets under management as of the end of the first quarter. XFLT was launched in 2017, and it was Octagon's first strategy to be publicly available in a registered fund format. I'll also provide a bit of brief background on XA Investments. I know there's a lot on this slide, but I'll just point to a few highlights. We are a Chicago-based boutique alternative asset manager with $915 million in AUM as of 3/31. We were founded by an investment bank in 2016. We have a suite of proprietary registered funds focused on alternative income. For each of these funds, XA acts as the adviser, and we work with best-in-class sub-advisers such as Octagon Credit. We have two listed closed-end funds as well as an interval fund, which is also sub-advised by Octagon that's focused primarily on BB CLO debt. Lastly, in addition to our proprietary suite of funds, we have a robust consulting and research practice focused on the closed-end fund, interval and tender offer fund markets. We help outside firms build products, bring them to market and publish research to support their efforts. We also make our research available on a subscription basis for those interested in learning more about the space. Okay. So let's get to it. We have some prepared questions and topics for the speakers, which we will address throughout the presentation. And just a quick reminder [Operator Instructions]

So Kim, let me begin with you. XFLT recently announced a distribution decrease earlier this week. Can you please walk us through that?

Sure. Thanks, Kevin. Yes, we just wanted to be upfront in terms of the news of the week with our shareholders and folks, thanks for joining us on the webinar today. So at the close of business on Monday, June 2, XFLT did declare its regular monthly distribution. As you know, we consistently pay monthly distributions for XFLT. So the most recent distribution declaration represented a decrease. The new level of distribution is $0.07 per share, which was down from $0.077 per share, representing a 9.09% decrease. As you have heard from us on prior webinars, we're focused on tracking the earnings of the fund and the net investment income for XFLT declined in the quarter. You're going to hear more about that as we talk about performance. So XFLT and other CLO focused funds, other loan funds have been impacted by spread compression. And we've seen competitor funds also realign their distribution rates with earnings. And so I think we're going to talk today on the webinar about the recent market volatility that the fund has experienced since the beginning of the year, there has been drastic spread compression starting in 2024 and continuing into 2025. So in the most recent quarter, market conditions were marked by heightened volatility from the developments on tariffs and ongoing trade tensions. So that's what is latest -- the latest information, we did just publish our semi-annual shareholder report. There's additional color in there in terms of the management discussion and Q&A to the extent you're interested in reading a little bit more about the period that we're talking about today. So take a look at the semi-annual report. Kevin, I'll turn it back to you.

Great. Thank you, Kim. So I'd like to bring in Lauren Law with Octagon to talk about the spread compression that you mentioned, Kim. And Lauren, can you address the spreads in the loan and CLO markets and how spread compression impacts portfolio earnings potential?

Sure. I'm happy to. Spread compression has been a notable headwind to portfolio years -- yields, excuse me, really over the course of the last 1.5 years. So first on what's been happening, loan spreads tightened almost 30 basis points over the course of 2024 and then an additional 10 basis points in the early part of 2025. So of note, broadly syndicated loan spreads are now at post-crisis tights. This spread compression was driven mainly by robust demand for floating rate product. Loan demand was driven by investor desires to own floating rate instruments in the face of interest rate volatility as well as just the robust yields for loan product given high base rates. And CLOs are really experiencing the same trends. Strong loan demand was not met with strong loan supply, and this technical imbalance allowed the rapid refinancing to lower spreads of broadly syndicated leveraged loans. The trust was obviously impacted by this dynamic through its holdings of broadly syndicated leveraged loans outright as well as through its holdings of CLO equity. For our CLO equity positions, when loan spreads compressed, but liabilities remain static, the excess spread that constitute the equity distribution shrinks. So in short, loan spread compression has been a large headwind to the earnings ability of the trust's assets.

Thank you for that, Lauren. So let's go back to Kim and pivot to the financial highlights of the quarter. Kim, can you expand on that for us?

Yes, absolutely. I just want to orient the group to this quarterly presentation while it's coming on June 4, the materials, much of the information you're going to see is for the period ended March 31. So I'm going to hit a few of those financial highlights. I don't think that changes anything, but I do want to make sure you understand when we're doing our quarterly webinars, we like to report on the prior quarter. We're going to get to some of the questions that you have. So type them in the Q&A bar. I see one question now about market volatility, and we'll have Lauren speak to that in a moment. Just for this period ended, for the quarter ended March 31, net investment income was basically [ $1.776 ]. This is under -- below our estimates for net investment income as modeled. It is what has prompted us to look at the distributions and is part of the rationale for the change in the recent distribution rate. For the period, we did declare distributions on January 2, the third and -- February and the 3rd of March at $0.077 per share, respectively. The most recent declaration that was done on June 2 represents the change going forward. That prior distribution was held for a period of about 6 months. We're very thoughtful about changes to distributions, and we're not in the practice of changing distributions from month to month. So I think for investors that have been investing in XFLT, they can appreciate that there's some consistency in terms of our distribution payments and our distribution modeling. Now with that said, there's only so much forward visibility that we have on earnings. And so that's why this 6-month period is sort of consistent with the view that we have and the information that we have on the loan and the CLO marketplace. We ended the period at $758 million in total managed assets. Part of that represents leverage proceeds. The fund is about 37% levered, so a little bit below its target leverage, which is in the range of 38% to 40%, where we typically see leverage for the fund. We did close last night on price at $5.74. Yesterday was the first day post distribution announcement. The NAV was at $6.05, so we closed at a discount to NAV of about 5.12%. And the distribution rate on price is 14.63% annualized. So again, 14.63% is the current distribution rate on price. I want to end on a positive note, just talking about the attractive current yields in the CLO equity, CLO debt and the loan marketplace. I think that given some of the volatility you might be saying, "Well, are these compelling investments going forward?" These yields are still very attractive, especially if you compare it to other private credit in your portfolio if you look at direct lending or if you look at asset-backed lending. CLO equity, current yields north of 22%, CLO debt at 10.69%, senior loans yielding just north of 8%.

Great. Great points, Kim. Thank you. So let's widen out a bit and talk at a more macro level. Lauren, as Kim mentioned, we've seen a great deal of volatility so far this year. How have CLO spreads been responding across tranches? And keeping volatility in mind, how has it impacted the supply and demand dynamics in the CLO market?

Yes, sure. It's a great question. 2025 has certainly been an interesting year, I think, for all risk assets. And obviously, the CLO tranche market followed broader risk markets this year. So at the beginning of the first quarter, CLO issuance was supported by dramatic spread tightening across the CLO capital stock. With spreads actually hitting the types of the post-great financial crisis era during mid-February, we saw BB's pricing in the mid-400s. I think previous types were much closer to 500. So that's really meaningful. With the escalation of trade tensions in March and even more so in April, and the global sell-off of risk assets, we saw AAA CLO tranches, spreads widened roughly 30 basis points. And we saw BB tranches move out anywhere from 100 to 200 basis points or more depending on the profile. This volatility in spreads really slowed new issue CLO creation. There was not a lot of supply of new CLOs in March and April, reset and refinancing activity slowed considerably during these months, though we did find some attractive opportunities to participate in this much diminished new issue calendar. Now fast forward, so far in May and into June, spreads have tightened considerably again, though we are not yet back to the tights of earlier this year, though we'll see if we get there at this current pace. And CLO issuance has accordingly rebounded from very low levels. And reset and refinancing activity is again part of the discussion. And as a reminder, this type of activity can be really attractive for our CLO equity position. So we find this to be a really healthy development for the market. So a fair bit of volatility through the end of the first quarter and the beginning of the second quarter, but where we sit in June where things look a lot better.

Great. So let's look at some fundamentals. And Lauren, this is for you. How have loans been performing in the secondary market? And has there been a significant increase in rating changes due to all this recent volatility?

Sure. Loans, similar to CLOs, and similar to that commentary, started out the year really strongly, posting firmly positive total returns across both January and February. And at times during this period as much as 70% of the loan market was trading above par. As I mentioned earlier, we saw a significant amount of spread compression early in Q1 on the back of this market strength. And then after a few weak economic data points at the end of February, an increasing tariff rhetoric, loans also began to trade off in March before declining more meaningfully during the month of April. The loan index actually fell about 3.5 points peak in February to trough in mid-April before recouping much, though not all of that value, in May. Loan price volatility does create volatility in the trust NAV as the value of both the loans we own and the equity we own are impacted. But the good news is that this loan price volatility arrested that long wave of loan spread compression, allowed active managers to trade their portfolios based on views of risk-adjusted return. We think this will be ultimately be healthy for our CLO equity positions despite that mark-to-market volatility we experienced in April. In addition, given the volatility in the secondary market, primary loan spreads have been much more attractive in the second quarter than they were in both the first and fourth quarters. So also good for the trust loan and CLO equity positions. On the flip side, you did mention ratings. And I would say we have seen a continuation of the downgrade trend from the rating agencies, particularly downgrades to CCC. And I would say during March and April at the height of the volatility that, that activity accelerated from what we had seen earlier. It's something we're mindful of. It's something we're watching and something we certainly managed around, but it is a headwind for both the CLOs we own as well as the loans we own outright.

Yes. So following that and specifically talking -- speaking to loans, we've seen the leverage ratios for public and private loans issuers steadily decline since Q1 of '21, as you mentioned. How should investors think about this decrease? And what implications does it have for the loan performance moving forward?

Sure. No, that's a great question. Leverage coming down in the market across broadly syndicated borrowers is an obvious positive. We can all agree on that. I think this leverage reduction is in large part likely a result of borrowers reacting to higher grades. The most meaningful reductions in leverage occurred early in the cycle in '22 and '23 as rates were increasing, and leverage has been, I would call, stable to declining more recently. I think borrowers have been reticent add additional debt to their capital structures even as they've experienced EBITDA growth. So we've seen some organic deleveraging activity. In addition, capital markets activity has been somewhat muted in this environment. We haven't seen a lot of M&A, a lot of leveraging transactions. So that has also kept leverage levels moving in the right direction. The one caveat I would say is -- and really the bigger question to me is interest coverage. I think that's actually more meaningful of a question than leverage. How has interest coverage trended given the dramatic increase in base rates, and therefore, the cost for floating rate borrowers really in 2023 and 2022. I think that's a more important metric than leverage. Interest coverage bottomed in Q4 of 2023 and has improved since then as base rates come down, as spreads have tightened and as EBITDA growth, whilst slowing, has continued at relatively healthy rates. So I think interest coverage bottomed Q4 2023 in a fairly constructive place and has improved since then. And I think all in, we think the broadly syndicated leveraged loan market, while there are certainly pockets of stress or weakness, overall is in relatively healthy shape. Leverage has come down. Interest coverage is healthy and trending in the right direction. And it also bears noting there's no real maturity wall of note for borrowers to contend with, and maturity wall just refers to a large amount of loan maturities that the market needs to refinance. Given how supportive credit markets have been over '23 -- end of '23, '24, most of '25 absent that period of March and April, many near-term maturities, almost all near-term maturities have been dealt with. So I think all of these things point to a relatively healthy position for levered borrowers overall.

That's good. So let's stick on some of the stresses that you mentioned, Lauren. If we look at the next slide, looking at the loan market from a pricing perspective, could you discuss which sectors are experiencing stress and the potential impacts of the -- on the overall loan market?

Yes. All sectors have not performed in the same way during this period of volatility. There was a fair bit of dispersion across sectors during March and April. Sectors viewed by the market as overly exposed to tariffs, or a slowing consumer or a slowing economy certainly underperformed during this period of volatility and risk. As an example, the building product sector is one that really suffered and still hasn't rebounded nearly to the same degree as maybe some other places. I think the market is taking a more measured approach as it relates to risk here. I think the sector is plagued by a number of issues, including waning residential housing demand driven by rates, tariff headwinds and an air pocket in nonresidential construction. I think longer term, there is a thesis for this sector to rebound given housing dynamics in the U.S. But until rates come down, it's hard to see a significant catalyst for improvement and valuations in the sector are really reflecting that dynamic. Other sectors that experienced outside pressure during March and April, specialty retail, consumer products companies, specifically those with supply chains heavily invested in China, really saw a lot of volatility in their trading levels. And lastly, I'd say we saw a lot of weakness across the chemicals sectors as investors positioned ahead of a potentially slowing global growth at the same time as there is an elevated supply in some chemical products in light of significant capacity additions in China. So we're trying to pick our spots. We're trying to be mindful that not all sectors are created equal, and there are some headwinds out there.

Got it. Okay. So let's transition to rates. Lauren, as we know, the Fed has maintained rates so far in 2025. With the Fed's next meeting coming up on June 18, what rate expectations are being priced into the credit markets currently?

Sure. I think the credit markets are looking at the futures market, which is pricing in 2 rates for 2025. And those cuts are not expected to occur really until later in the year if the futures markets are to be believed. I think the Fed will be patient. They will evaluate the data before moving rates and the market has really coalesced around the higher-for-longer narrative. Again, I think the market has moved in and out of that thesis. And I think the higher-for-longer narrative right now is again driving demand floating rate assets. If you just look at the flows for floating rate loan funds, for the CLO ETFs, those have again reverted to pretty significant inflows recently, and I think that is just indicative of a view that floating rate is going to remain attractive as base rates remain elevated.

So you bring up ETFs. So I want to bring Kim back into the conversation and discuss some of the specifics of the fund. So Kim, can you talk us through why XFLT is structured as a listed closed-end fund? And then to add to that, can mutual funds or ETFs invest in a similar way in CLO equity as XFLT does?

Yes. So the answer to the second question is actually no, which is that this is why XFLT and other CLO-focused listed closed-end funds are unique and worth, I think, shareholder consideration in contrast to CLO ETFs. But because of the episodically illiquid nature of CLO equity in particular -- now you might argue that CLO debt may also become episodically illiquid. But you don't see ETFs or mutual funds for that matter, having significant allocations to CLO equity. And now if you're familiar with XFLT, we've maintained a pretty consistent portfolio composition over time, and that even goes back further than June of '24, back to the inception of the fund. XFLT, when it was launched in September of 2017, was unique. None of the CLO debt ETFs existed at that point. And we think that this asset mix is really compelling from a risk-adjusted return basis, having about half the fund in senior loans, the other half in CLO debt and CLO equity. And you see in XFLT as of the end of March 31, CLO equity represented almost 40% of the fund's holdings. And while I think that there's a lot of really interesting attractive benefits of the CLO debt ETFs, we like the composition, the diversified mix of loans, CLO debt and CLO equity. And as Lauren was talking about opportunities in the market, it allows Octagon to pivot if they need to and move between some of these opportunity sets. And CLO debt itself is attractive. XFLT has a 10.62% allocation in the fund, and it's always been anywhere from about 10% to 15% of XFLT. So we would argue that XFLT is still unique. There are listed closed-end funds that are largely CLO equity, they tend to have higher yields. They tend to be a bit more volatile. We like the fact that XFLT has a transparent daily NAV that we report to shareholders. And part of that is driven by our asset mix because half the fund is sitting in loans. And you can't find this asset mix in a mutual fund or an ETF wrapper. And so that's why I think it's still a very compelling value proposition. And the nice thing is, is that with a lot of the shareholder and education awareness that the CLO ETFs have brought to the marketplace, I would argue that there's been a broadening in the buyer base, there's more awareness for this asset class than there was when we launched the fund in September of 2017. So that's a good thing for XFLT shareholders, and we just wanted to contrast the unique asset mix that XFLT has and the benefit of that for the fund.

Yes. That's good. So let's maybe dig a little bit deeper on a comparison of CLO with -- I'm sorry, of XFLT with other CLO-focused funds. So Kim, you've talked about the fund's unique positioning in the market, we've seen, as you mentioned, an increase in popularity of CLO ETFs. So can you describe some of the structural advantages XFLT has as a closed-end fund compared to other CLO ETFs?

Yes. We -- in the past, we've had questions about how XFLT is different than funds that are mostly CLO equity. And so we've talked with you in the past about those set of funds, which includes ECC, EIC, OXLC, OCCI, the newer Carlyle fund, CCIF. And many of our shareholders also own shares in those CLO equity-focused closed-end funds. So I won't spend quite as much time talking about that. We modified this slide to include the CLO debt ETFs because with the growth in some of those CLO debt ETFs, they've gotten quite large and are attracting more headlines. We wanted to include the comparison. But listed closed-end funds do have the benefit and the risk of leverage, both XFLT and the other listed closed-end funds are using various types of leverage because XFLT has senior loans, we're also able to have a floating rate credit facility in addition to preferred securities. Most of the CLO equity-focused closed-end funds rely upon preferred leverage and are not able to get a credit facility because it is hard to lend against CLO debt and CLO equity. It's also not common for ETFs, I know that there are leveraged ETFs, but most of the CLO debt ETFs in the marketplace are not using leverage for strategic purposes. I think the big difference because the CLO debt ETFs are debt focus, their yields are going to be a bit lower than anything like XFLT or the CLO-focused closed-end funds because of the CLO equity being such a higher yield at 22%, as I presented on a prior slide. So you're going to pick up incremental yield with the listed closed-end funds because of the use of leverage, because of the inclusion of CLO equity. And now CLO debt, we included that the CLO debt, they don't trade at a premium typically. Over the last 12 months, XFLT has traded at a 1.76% premium. The CLO equity-focused closed-end funds tend to get to larger premiums, partly because they're not doing daily NAVs. Now the CLO debt ETFs, there can be wide bid-ask spreads. Lauren referred to that period where there was some dislocation, some selling out of the largest CLO debt ETFs. And so we did see small discounts develop. But typically, the debt ETF is not going to trade at a large premium or a large discount.

Great. So -- thank you, Kim. I've got another question for Lauren in regards to portfolio holdings. So Lauren, looking at XFLT's portfolio, I know you touched on this briefly earlier, but can you explain the potential opportunity that CLO refinances and resets represent for the fund?

Yes, sure. As a reminder, reset and refinancing activity is very accretive for the trust's CLO equity positions and really for a number of reasons. Number one, if you consider the comments I made earlier about spread compression in the loan market, resets and refinancings allow a CLO to lower its cost of debt, thus mitigating the impact of loan spread compression on the equity distribution. So in the case of a reset, this refinancing occurs concurrently with the contractual extension of the CLO's reinvestment period. And that just means that the equity the trust owns receives a larger stream of cash flows from refinancing its debt to a cheaper rate and a longer stream of cash flows from this extension. And both of those things increase the value of the equity we own today. This type of activity benefited the trust throughout the course of 2024 and early 2025 before being halted during the spring volatility. As volatility has waned and as spreads have begun to compress again, we would expect this activity to resume and again, benefit our CLO equity positions. A lot of the positions we own today benefited, as I mentioned, in '24 and '25, but we still think there is a significant portion of the trust that can benefit from this in 2025 -- the rest of 2025 as well. So very exciting opportunity for XFLT's portfolio.

Fantastic. Thank you for that. Looks like we have one question here from the audience. Lauren, I will direct this one to you. And some of this, again, you've touched on briefly, but what is your view on whether the loan market is an equilibrium and whether spreads will stabilize?

It's a very good question. I'd probably refer to it as the million-dollar question. I think the loan market is in a place of equilibrium today. We are seeing CLO creation, though not at incredibly robust levels. We are seeing inflows to floating rate funds, so there is demand for loans. We are seeing some supply. That supply is coming from small add-ons to fund M&A, in some cases, fund dividends, term out second liens as well as refinancings of loans that went to the private credit channel and are now moving to the BSL channel. Today, that supply and demand feels fairly well balanced. If one of those factors was to move strongly in the other direction, we may see that equilibrium get out of whack. But today, I think spread tightening has really been halted. But not to say things can't change in the next 3 to 6 months.

Yes. That's great. Well, thank you for that, Lauren. It looks like we don't have any further questions, so we'll wrap. Thank you both so much for your input and your commentary today. I will remind everyone that this webinar will be available via replay on our website. And as I mentioned at the outset, there is a wealth of information available on our site as well in the Knowledge Bank on our website. So please reach out if you have any additional needs or questions, and we certainly appreciate your time today. Thank you.