Asset classes for the masses: CLO ETFs

Morley Conn: Good morning, everyone and welcome to the first session in our new webinar series, Asset Classes for the Masses. I am Morley Conn, Director of ETF Services at Scotiabank Global Banking and Markets and I’ll be your moderator today. Today we are focusing on a development that is bringing a long-standing institutional asset class to a broader investor base. Collateralized loan obligations (CLOs) now available through the ETF structure in the Canadian equity market.

Our agenda is going to be as follows. We will begin with a 20-minute discussion with representatives of two of Canada's leading ETF issuers who have been instrumental in bringing the first CLO ETFs to the Canadian market. Next, we'll take a 20-minute mini deep dive into the mechanics of the CLO market with Scotiabank’s structured credit team. We'll wrap up with about 15 minutes for audience Q&A, so please feel free to submit your questions to the window down below.

At this time, we're joined by Prerna Mathews, Vice President, ETF Product Strategy, Mackenzie Investments, and Mark Jarosz, Managing Director and Portfolio Manager, Credit Alternatives, BMO Global Asset Management. Welcome to you both. Let's get started with the basics. Prerna, can you walk us through exactly what is a CLO and what the benefits of this product are for investors?

Prerna Mathews: Thanks, Morley and good morning, everyone. Collateralized loan obligations, while quite familiar to many institutional clients over the years, has become a term that many investors are now facing and perhaps are less familiar with. So collateralized loan obligations or CLOs are essentially structured financial products. They are comprised of a pool of loans, they are typically senior secured loans that are made to businesses and these loans are collected and packaged by a CLO manager. So, let's unpack that a little bit.

The pooled loans, how are they put together? How are they trenched out? So, every one of these CLOs has multiple tranches. So, let's start with the equity tranche, which is the lowest tranche within the CLOs. It is the lowest tier. It tends to take the first losses if any loans default and it offers typically the highest potential return, but also the highest risk.

Then you have a number of mezzanine tranches that are often found. These are the middle tiers. They do absorb losses after that equity tranche. They do offer moderate returns, but of course also do come with moderate risk.

And finally, at the top of the structure, you find AAA tranches. This is the highest tier. It's typically the safest. It's the last to absorb losses, the first to receive payments, and of course, in all of these tranches typically the lowest return compared to other tranches, but with minimal risk. Now these AAA tranches have seen 0 default risk, essentially default rates since well over the past 20 years. And so, a lot of investors have found themselves, including institutional investors, really gravitating to AAA as well as further down the structure. So, the CLO manager essentially collects payments from these borrowers and distributes them out to investors across these different tranches and again that AAA tranche is the first to receive that payment.

So, this type of structure that CLOs are found in, they offer a lot of layers of protection as you can see because the lower tranches are often taking the hit first, you get far more protection at the top of the tranche. These types of products have been very helpful in diversifying fixed income portfolios for institutional investors beyond your traditional corporate bonds. They are less sensitive to interest rate risks due to their floating rate nature, so they have been quite appealing and now more so for a very large set of investors. It's hard to talk about CLOs though, without talking about what they're not.

MC: And so exactly, Prerna, I just wanted to get on that is that we need to talk a little bit about what CLOs aren't because at the same time, you know, there's a lot of confusion around CLOs versus collateralized debt obligations which are very famous for having been a driver during the great financial crisis in 2008 and 2009. Can you outline some of the key differences for us?

PM: Yeah, absolutely. We still hear this confusion from the nascent investor into the CLO space who often connects it right back to the global financial crisis and CDO. So, I am going to focus my comments on three key differences. Underlying assets #1. Risk and return profiles is number #2 and #3 would be transparency.

Going back to underlying assets, CDOs typically include a variety of debt instruments such as bonds, mortgages, including subprime mortgages or even other CDOs packaged into CDOs, right. And as I mentioned, CLOs are exclusively focused on leverage loans. These are senior secured loans made to businesses. The focus for CLOs is on corporate credit results, right, and higher recovery rates and lower loss rates.

MC: Is that bank debt effectively?

PM:  Effectively, yes. And so very different to the subprime mortgage crises, essentially that found its way through CDOs in 2008.

#2 risk return profile. So, CDOs have a higher risk due to the inclusion of subprime mortgages and other lower quality assets. And these did contribute to their poor performance during the GFC. Of course, CLOs have, as I've just mentioned, built in protections. They invest in higher quality assets are very different outcome from a performance standpoint. And we saw that through periods of stress, including the global financial crisis. And #3 like I said, transparency. CDOs are often very opaque. It's very difficult to understand the assets that are comprised within that CDO, whereas CLOs are generally very transparent. So as a manager of a CLO product, we understand not just the CLOs issuers, but of course what they invest in. We see the portfolios and you're able to perform your own underlying loan and credit analysis if you so choose. So, I just wanted to highlight those three key differences. CLOs are not the same as CDOs and important for us to remember.

MC: Gotcha. Thanks, Prerna.  Mark, why are CLO ETFS entering the Canadian market at this time?

Mark Jarosz: Yeah, great question. And again, Morley and Scotia team, thank you so much for inviting me to be a participant in this morning's conversation. So, first of all, CLOs do have a 30-year history. I don't think most of us on the retail side have heard of these products until recently. But really, it has been in the marketplace for well over 30 years available only to qualified institutional buyers. So that means if you've got 100 million in the bank, then you're qualified to purchase these tranches.

Otherwise, it was really for sophisticated investors, predominantly banks, hedge funds, pension plans, etcetera would be buyers of this paper. And so really it wasn't until late 2020 that we witnessed the first ETF that was investing solely in AAA tranches. And so, when we start to dig into this asset class with the ETF wrapper, we had the meeting with one of the biggest ETF managers in the U.S. and start to dig a little bit further as to the why.

And so, it was during COVID where there was quite a bit of volatility in the market and managers were in a position where they did have to create cash. And so many managers would primarily liquidate treasuries or other HQLA, highly qualified liquid assets. And so, what this manager discovered was during this volatile period, AAA tranches actually behaved quite steady and in that bid spreads remain tight, and that the market actually remained resilient.

It gave them the kind of idea to take this to market and see if this works in an ETF wrapper. This also couples with the time frame where floating rates did increase, and so it made this product extremely attractive, providing daily liquidity and yield pickup.

And so, up here in Canada, I think most asset managers have been watching this space quite carefully. And so, us doing our due diligence and wanting to ensure that there was indeed a kind of viable product here, we had to go through our proof of concept and ensure that there was indeed kind of breadth and depth to this market. And so, we had worked closely with our regulators to ensure that they're comfortable around this product as well. And so here we are several years later with our first CLO AAA ETF.

MC: Well, here we are. Yeah, indeed. What fixed income alternatives will this compete with, Mark? You know, are we talking cash money market proxy?

MJ:  It definitely is a very unique asset class and speaking with some of our investor base, I will hear use cases of it being a substitute to treasury or money market equivalents in that it's safe but higher yielding.

Many hedge funds and asset managers I speak with will use this as a component of their HQLA. And one of the things that we did look at as well is know how this has performed during periods of high volatility like what was there a market indeed, should investors want to sell out of their positions?

And Liberation Day was a prime example of that. We saw volume was being driven, particularly by unwinding of positions, as managers were seeking liquidity, and the market was there to absorb the flows. On the IG corporate side, we see that this does offer comparable risk. Again, we are we are focusing today's call on the AAA tranche primarily, but CLOs has lower duration in that these are floating rate products.

And then lastly, you've got high yield or loan funds. So, CLOs will offer lower credit risk just given the cushioning, but with the attractive yield profile.

And I think lastly alternative credit will provide investors an access point to alternative credit that perhaps may not have otherwise been able to access.

MC: For sure, all part of the extending out of institutional mandates to retail investors. Prerna, where do you see these assets place in a little bit more on fixed income portfolios and investment portfolios in general?

PM:  Yeah, as we've had these conversations across the country with advisors, everything from the multi-billion-dollar advisor book down to the 200, 300, $100 million advisor book. We’re really talking about CLOs in the context of drawdown management, cash management. It is a solution. It is definitely not the only solution, and it fits within a spectrum of tools that advisors and institutional investors are using today.

So just adding to Mark's comments, you've still got persistent GIC usage happening here in the Canadian market, but there are more alternatives. There are more alternatives to managing that drawdown across a multi month, multi-year period. And it does not all just have to be though a GIC or a HSA, right. And so, this is really the discussion around how do you think about using these different tools, products, structures across a period of let's say two years in managing that drawdown for your clients as you're raising cash. A lot of times for older clients who are in draw down mode or with targets to need cash within a certain period of time. So, it is sitting alongside the he says ETF, the ultra-short bond ETFs the low to no duration is incredibly attractive for that reason. But this does present more volatility for example than you would find in adhesive product whose NAV is going to be typically pretty close with an abandoned reset within a month, right. You should expect that this will look a little bit different in terms of how it trades over time in the market. So, we really are talking about it in the suite of solutions that solve these problems for clients.

MC: Gotcha. For sure, Mark, so we know it has been made clear CLOs are actively managed. Does that mean that there are two sets of eyes that are looking at the portfolios, the credits all the time, the CLO manager as well as yourself, the ETF manager?

MJ: Absolutely. And so, Prerna had touched upon the differences between a CLO and a CDO. We cannot stress enough that these products are very, very different in that a CLO is actively managed. So, you have a manager that is out there and ideally has a long track record and a history of selecting credits. They they'll have a large credit team that are doing their due diligence and sourcing and underwriting loans for inclusion into the portfolio. And so, the CLO manager will have the ability to trade in and out of positions based on their underlying thesis. And then you overlay on top of that CLO ETFS such as myself and Mackenzie where the fund manager is effectively choosing managers based on their track record and based on their ability to underwrite these loans. So, we often use the term a dual lens of credit adjudication going into these products.

MC: I see. You are recognizing that your firm is both are classifying the product as either low or medium rated risk. Do we run the risk, Prerna that investors reach for yield here without fully understanding what they're buying and how do we avoid that?

PM:  Yeah, I think there's always a risk when it comes to new products available, and those products not being used effectively. I mean, we saw this even with floating rate loans a few years ago when at Mackenzie, we launched a floating rate loan ETF here in Canada, it was the same thing and you had the informed investors in there certainly, but you had what we called tourist investors who found the product because of its high yield and weren't quite familiar with what kind of exposure they were really buying into.

So, education is key here. And the great thing about having lots of ETF providers now offering these types of solutions in the Canadian market is that we're all playing that part, including Scotia, of course, and helping educate investors and what CLOs are, how do you use them, how do you put them in a portfolio, and ensuring that you know there is ample awareness of the potential risk you're taking on certainly, versus cash in a portfolio and with the outcome could be as a result of that.

So, I think just like anything new that is introduced in an available for the masses structure, you're going to have some time for education. That being said, the conversations we've been having over the last month across the country clearly show that advisors are A) hearing this from lots of different providers like I said and B) seeing and reading a lot about CLOs just generally speaking in market commentary and headlines, so that education level is going up pretty quickly I'm finding amongst the advice channels at least.

MC: Thank you. And Mark, when corporate bond ETFs first launched, there was certainly a lot of doubt as to how they'd handle liquidity and tough market conditions. But they've proven themselves, gaining adherence along the way through every market crisis or dust up. Could CLO ETFS follow a similar sort of trajectory?

MJ: Great question. And in preparing for this product in packaging the materials also for the regulators here, we spent several quarters digging deep into the full history of CLOs AAA tranches and looking at the behavior through cycles and looking at how they performed during highly volatile times.

And what we can say is that we found that it has performed phenomenally well and that it has been a resilient asset class.

And it is worth pointing out that the global market for AAA tranches alone is well over $650 billion. And my numbers might be a little bit off and perhaps your team that is speaking next can provide accurate numbers, but the ETF market is only 4% to 5% of the global market. So, you've got banks, pension plans, you've got life goals that have been buying this paper for several decades now.

And just I guess an additional point, we looked at the bid ask spreads as well during different cycles and again what we have found they they've been stable and that there have been buyers indeed when needed.

MC: Thank you. Prerna, for investors looking at multiple CLO ETF offerings, how should they be evaluating this? You know, it's all AAA to me. So how do they differentiate?

PM:  Yeah, so Mark mentioned this, you know, assessing manager experience and credit research capabilities is an important one here, right. As Mark mentioned, there is this additional layer of active management and oversight. So, you should get to know the capabilities of that CLO manager and how they can manage through ensuring you're getting the best exposure in the triple CLO space. So that would be #1.

#2 would be to evaluate fees with 5-6 tickers now available here in Canada. Fees are an important factor when you're looking at certainly cash, cash like high yielding solutions, you want to ensure that you're being mindful of the fees. So that would be another factor I would certainly highlight.

And then of course, look at your bid as spreads. These are the typical ETF measures as you would for trading anything. Ensure that you are comfortable with the bid ask to spread that you're seeing or engage with an ETF provider to better understand the size that you may be trading at and what that spread could look like.

And of course, yield, coupon, all these important factors that you're going to now start to see published after that sort of one month mark across all of the ETF providers. Make sure you're doing your checks and balances across what is yielding. Not everything is pure AAA in the Canadian ETF space. So, some of the CLO products have the ability to go further down into the AA single A. So, you could see some yield differences as a result of that and of course potential risk differences as a result of that. So just make sure you're understanding the composition of the products as you look across the providers.

MC: I see. And Prerna, where can we direct people to go for additional information on Mackenzie CLO ETFs and AAA?

PM:  Yeah, so mackenzieinvestments.com, just in the search box at the top. Through our AAA ticker in there or through our ETF drop down there, can give you lots of information on our ETFs.

MC: Fantastic. And Mark, where can people go for BMO's CLO ETF and AAA?

MJ: Absolutely. Our bmoetfs.com website under Z AAA is the ticker.

MC:  Fantastic. Thanks, Prerna. Thanks, Mark for a great conversation.

PM: Thank you.

MC:  Let's turn to our U.S. Structured credit team for a mini deep dive into the CLO market itself. We're joined by Sheri Koval, Managing Director and Head of Structured Credit Sales at Scotiabank GBM, who will facilitate this portion of the call. Sheri, take it away.

Sheri Koval: Hi, good morning. I am Sheri Koval and I'm Managing Director and Head of Structured Credit Products here at Scotiabank and I'm joined by my trading specialist, Joe Guzzi, who heads up the structure credit trading effort here as well. We're going to elaborate a little bit on what Mark and Prerna highlighted. What are CLOs, who uses them, their main benefits? We'll use an illustrative structure, the main risk as we briefly highlighted on before and really their liquidity profile. Joe does trade our secondary book. And so, we find that to be very important and it's also very important part of Scotiabank.

So, what is a CLO? We've talked about it a little bit. We could put up Slide 1 so we can look at it and Joe will chime in kind of throughout the discussion. CLOs are securitized, actively managed and diversified portfolio of corporate bank loans. They typically hold anywhere from 200 to 300 loans from corporate issuers spread across various sectors and industries. The underlying collateral of CLOs are senior and secured leveraged loans, meaning they have the most senior claim on all the issuers assets in the event of a bankruptcy and they're really responsible for roughly 60% of the underlying loan market, someone can fact check me on that, but it's roughly accurate. One of the main benefits, again, we'll have Joe kind of really elaborate as he goes through the illustrative structure. We'll talk about the attractive yields, attractive carry, the low volatility, the low default rates and really the low correlation to traditional fixed income. And Joe, if you don't mind, can you start going through the different tranches how the underlying pool of loan really works? The credit enhancement and feel free to add in.

Joe Guzzi: Sure. Thanks everybody and thanks Sheri, and thanks everybody that went before, that was fantastic. The first thing I'd like to say and you know when I'm talking about CLOs to folks, especially folks who are new in the space and it was mentioned a couple of times here is CLOs and CDOs are very different animals. What sort of hurt folks in the financial crisis is not what CLOs are made of. So as everybody has said, firstly senior secured loans. Very basic stuff. I hate to use the word safe because that's a relative term, but safe things.

So firstly, in senior secured as Sheri mentioned, other folks mentioned first in line and you know the event of a default and the underlying collateral, the deals are essentially sliced up into different tranches from AAA all the way down through equity. As was mentioned before, the losses are taken from the bottom of the structure, the income comes and flows through the top. There are actually structural features that we won't really dig into as much here, but there are structural features.

Triggers and tests that need to be put in, they need to stay in compliance in order for the equity to get cash flows. All of these structures and triggers benefit the senior most note holders. So, when you start looking at the Class A notes and down, we have AAA obviously the highest rating and those typically have 30 to 32 to 40% par subordination are attached. Essentially what those numbers mean is you need to lose 40% of the stuff below you in order to get impaired. That's not including benefit of any triggers. So that's an almost impossible thing to happen. In fact, it's never happened. There's never been a AAA CLO that's taken a principal impairment throughout the history of the CLO market. In fact, there hasn't been a single A that's taken a principal impairment in the history of the CLO market. There have been some lower MEZ tranches that have, but those were CLOs that don't really exist anymore. Stuff with really, high bond buckets. Stuff and things that as a CLO market is currently constructed you no longer exist.

So, moving down the stack double as you know 22 to 26 ish percent subordination single as 16 to 20, triple BS 10 to 14. Double BS 6 to 9 and then equity which is not rated. Obviously, these are fantastic investments. Obviously not necessarily what we're talking about on this call, but we trade a lot of it here. But equity gets the excess interest that flows through the waterfall. So essentially the funding is between where the assets yield with leverage applied to them minus the weighted average cost of all the financing. Totally interesting product. Really neat, but a different kind of animal. AAA CLOs right now are trading in the sort of 100 to 125 over sofa range. So, you're talking anywhere from, you know, 6/6.5/ 7% yield sometimes depending on the duration. I would challenge anyone to find another AAA rated security that trades anywhere near that. That's an interesting, really interesting trade. For folks to look at and then again mentioned here shorter duration. Also, primarily floating rate products. There are fixed rate CLOs, but the CLO world is about 98% floating rate. There is some fixed rate tranches created, but that's usually upon specific demand and kind of rare.

In terms of the investor base and what we're seeing and who buys what, banks, money managers and insurance companies are typically the biggest investor bases at the top of the stack.

SK: I would add pension funds and ETFs, pension funds and ETFs as well.

JG: I was going to hammer that at the end, but yes, absolutely. Those are folks that are getting more and more involved. And in fact, I was always mentioned the pension and specifically the ETF part of the world that is a very small part of the buyer base right now. But growing you know, single digits percent that could you know, be made a much larger portion of the buyer base. One of the reasons why we don't see as many - we trade AAA, CLOs all the time, they trade - but one of the reasons why they don't trade as much as one would think is because banks typically own them, and they love them so much that you have to pry them out of their hands, or they put them in a whole maturity book and never think about it again because they are fantastic investments from an asset liability management standpoint. They almost work so well that they become harder to trade because they're harder to pull out as you go down the stack into the sort of what we call the belly of the stack, the signal, the AA through the Triple B. That's mostly money managers and insurance companies and some hedge funds as well.

Sometimes with leverage, sometimes with not, and then the double B and equity tranches are the large, largest buyers of those are hedge funds, but also some family offices, some CLO managers themselves. By debt and equity obviously in their own deals, business development companies, BDCs and some money managers and actually even some insurance companies have been active and consistent buyers of CLO equity in the past. So, a wide range of investors within the stack up and down all the different kinds of ratings.

SK: Let's talk a little bit about the size the global CLO market reached over 1 trillion benchmark in size in 2021 and has just continued to grow. I think we're well into 1.2 plus now and it's roughly equal in size to the U.S. high yield bond market to date. The global CLO market size is you know, not just within the U.S., not just within Toronto, it's growing in Toronto. We span across. Europe, APAC, South America, North America. And that's across all tranches, not just in AAA but down through equity.

Joe, I think it might be a good idea Now. We talked a little bit about the different crisis fees. Can you talk about the most recent market hiccup? I wouldn't call it a crisis. It was a very brief moment of dislocation and how AAA CLOs were impacted.

GJ: Absolutely, it was an interesting time. The in shorts AAA CL OS performed exceptionally well. They widened out a bit, but the effect was super muted and for a couple of different reasons. Number one is there's a large and ready and willing and able pool of investors looking to put cash to work. As soon as anything sort of shakes out a little bit #2 these are floaters. So, you're almost completely insulated from the interest rate of all that these pay three months so for plus coupons. So, the rate duration you're taking is super short and there's not a lot of interest rate risk. That's a big thing. And #2 is there's overall short duration. The average AAA CLO is somewhere between 4 and 6 year duration. So, what we found, and we traded a lot of it is stuff one from, you know, 100 to 125 ish over sulphur out to maybe 150 or so, which was about a point in dollar price. So, listen, no one likes to buy something in par and have it trade down to 99. But when you look at what other asset classes and what generic macro did at that time, which was obviously a pretty significant draw down in risk. CLO, especially CLO AAA's outperformed massively again where they were down 1% something like that. It wasn't a big wasn't a big deal and that lasted for a very short period of time before it snapped back. There was a well as I mentioned, a large amount of folks waiting on the sidelines.

Up the bombs when you're in the middle of all that kind of all, it feels super crappy essentially. But you know, we're all lamenting not putting more of that stuff on as stuff's come in, you know, almost to where it was pre tariff. It's a so again, that it was another example of CLOs outperforming in a crisis. We saw that in COVID. Obviously, there was a larger shock in COVID, and it lasted for a little bit longer. COVID was hopefully a once in a lifetime event.

In the financial crisis, CLOs traded wider, but again there weren't principal impairments and stuff came back. And I would argue that the vast majority of the price pricing that in the price path that we saw post great financial crisis was due to leverage getting kind of extinguished from the system and just massive amounts of supply coming. Deals were totally different back then. Now much less levered obviously is not as much leverage in the system. So again, we saw a very muted impact in terms of AAA CLOs now it stinks if you own billions of it be down a point. There's a mark to market amount there. But when you look at we had a lot of conversations with guys who were like, wow, I wish I owned more CLOs because it barely moved and this was an interesting, a really nice product to have that was already cheap and didn't cheapen up that much. We were able to buy more, and you know, Gee, I wish we could buy more than that.

SK: I'll put you on the spot now. Speaking of cheap right now, AAA BFLPO are right around 130 with a few very Tier 1 managers able to achieve inside of that. What's your projection on where spreads are going? Do you think we're going to tighten up into the one 10s that we hit this year, or do you think it's going to widen?

JG: Yeah, thank you for putting me on the spot. Which Sheri does every day. And I love it, and that's why she's great. I do think we're going to tighten up. It's not a massive stretch to think that you know. Again, with the continued growth in the investor base, here's the thing. There's a lot of investors looking at it, but bottom line is the structures work. The they've proven again and again that they work with reasonably muted mark to market volatility, obviously with no risk of principal loss. I hate saying things like no risk of principal loss, but I am happy to say that unless there's really no risk of principal loss, there's, you know, trading movement that things can go wider and tighter, but again, that's muted. I do strongly believe that we go back to the tights and potentially even inside of that in the next, you know, by a call at the end of 2025. So, the six months or so, again, the growth of the new investor base is the fact that they're floaters. All of the good stuff about these is just we're, we're continuing and folks like our colleagues on the call here and our customers, we're continually telling this story and it's because it works. It's not like an once people really sit down and listen to the story; they work. There's no magic here. It's just something that people haven't quite paid attention to as much as maybe they should have and now, they're starting to. So, I think there's going to be from a supply demand standpoint, a lot of what still a limited amount of supply and a lot of demand. So, we're going to see that stuff tighten. But there's enough product to associate all of that and still maintain the ARB for the CLO equity investor and also to feed all of the mouths that I think want to look at this stuff.

SK: So, there's a lot of talk about manager tiering. Can you know discuss a little bit about what goes into what someone would call a Tier 1 issuing manager versus a Tier 2 Versus a Tier 3 and what that liquidity profile looked like as well.

JG: Sure. Just to take a quick step back and I think folks know this, but it was mentioned the manager, and the CLO is the firm that's engaged in choosing not within the ETF, but with the underlying CLO, what goes in and out of it. Subject to a legal document called an indenture, this manager can buy and sell certain not security, certain loans in the pool in into the CLO pool. So, in there, it's a very limited amount of things that they can do.

In terms of tiering, people talk about manager tiers, better quote UN quote manager and a worse quote UN quote manager. What does that mean? That means a manager, that a tier one manager is a better manager. That's somebody that is considered by the market to be a more institutionally significant player in the market. They have larger resources, broader resources. Sometimes those managers don't even have the performance that dictates a better manager tier. They just are considered a better manager by the market. There's actually a lot of work that we've done on. that there are certain managers that are the market loves that are fine, they're not bad, but they're not great either. And then there's some managers that are considered Tier 2 or tier 3 lower tier managers, managers that should trade wider because they're not considered as institutionally significant and as quote UN quote good. Some of those, when you look at the underlying rules and the way the structures are actually quote UN quote better or at least the numbers say there's, you know a lot all the quantitative factors we talk about. And on the trading desk all the time and the market value over collateralization we get in all this stuff weighted average spread of the portfolio Wharf, all of this kind of CLO nerdy stuff is better for some of these that trade wider.

So, there's a lot of relative value stuff to be mined within the CLO market. But when folks talk about the Tier 1 managers are talking about the guys, the large managers who are off and on the approval list for the large Japanese banks, which are a big buyer in our space who by the way, rarely if ever sell. And that's one of the reasons why I mentioned some of the AAA's, you know, would be a lot more fun sometimes if there was more trading involved. But a lot of that stuff just gets put away and never comes out.

Manager Turing's a real thing. It's a real thing in the AAA part of the stack where on the same day a quote UN quote tier one manager in a quote UN quote Tier 2 manager can price a bomb that look exactly the same almost 5 to 10 basis points apart, so. Do you want the most liquid person liquid manager? You're going to buy the tighter 1, the tier 1. If you want the rel Val and maybe aren't going to trade as actively, you want the wider one. I recommend to investors all the time a sort of sprinkling of both. Maybe you buy a bunch of the Tier 1 stuff and then you have, you know, a little, I don't know, whatever percentage you're comfortable with of the lighter stuff to sort of get a little juice, extra juice in the portfolio, But it's manager tearing's a real thing. It's also a real thing when you go down the stack if it gets very significant when you get to the equity. And that's obviously a different conversation, but if you can get a massive difference in spreads and yields in the multiple percentage points sometimes.

SK: And I think we're coming up on time, Joe, but very quickly. We here at Scotiabank trade a lot in the secondary market. We're well over 10 billion, probably nearing 11 billion at this point. What how actively traded are these? We talked about it a little bit, but how actively traded are them, how liquid are they?

JG:  AAAs are actively traded. I wish they were traded more like I mentioned, but they're very actively traded CLO AAA's. It's not uncommon for a couple of billion of them to change hands in a given week.

We've traded AAA CLOs with over 100 different investors here. So that's you and we're, you know, we're a big part of the market, but there's other guys that trade more. There's obviously hopefully more that trade less than us, but you know, we trade a lot of it. The bid ask in AAA CLOs, listen, every, every dealer is going to want to have the bid ask be super wide and that's great. You're the only one trading it. The fact is the bid offer on AAA CLOs are, you know, in the single digit sense.

May on a running basis point kind of basis in the one to two basis point range it's you know one to three cents bid offer something like that, maybe 5. It's liquid and it should be because it's a product that frankly has demanded and now earned this kind of liquidity and this type that offers. So, it trades a lot and again 10 billion and billions a week on an average week and here hundreds of millions for sure. And you know again lots of investors, it's a liquid product.

SK: I think we're getting close to time, but I do want to impress upon the folks out there watching that we are here and available to really elaborate on any of this at any time and we love to talk about it, especially Joe so. Just reach out. We're here. And I will turn it to Marley.

MC: Thanks, Sheri. Thanks, Joe. That was a great conversation. We've covered a lot of ground here today and now we'd love to hear from you, our audience. If you haven't already submitted a question, please do at the bottom of the page here. And now I will go through some of the questions we've already gotten in. We've gotten some great questions here. First one. Could you explain the fee structure inside the CLO for the CLO manager and just attach to that? I assume the management expense ratio we see on the ETFs does not include additional fees for the CLO manager. So, could you please explain or extrapolate on that?

JG: I'm happy with that. I'm happy to talk about the CLO manager fees. The ETF fees on top of that are not my expertise, but CLOs are managed by a manager. Like I said, it's the firm that's tasked with trading in and out of the out of the collateral subject to the indenture, which is the governing legal doc. There is an equity investor as well. Sometimes that equity investor is related to or is exactly the manager, usually not. It's half the time they are, half the time they're not. There's a fee structure there's a couple different fees. If you think about ACO, it's like a little mini hedge fund, but 2 and 20 model, which I know it doesn't exist anymore, But whatever it is, the there's a management fee, which is essentially the two where the CLO manager gets a certain percentage in its bits of the total assets within the CLO with the total par value of the assets within the CLO. And it's, you know, in the depths, like I said, it's not huge. And then they have two different levels of fees based on the performance. Actually three, but the two main ones are. A senior and sub management fee which is based on the performance of the equity in the kind of short and medium term of the deal. And then there's actually on top of that and that's again in the BIPS 15 bits, something like that. It's not huge. And then there's A and that's to align the manager with the incentives of, you know, generating returns for both the equity and you know, obviously in preserving capital in principle for the note holders.

That's also actually another level of fee which is called the incentive management fee, which is after the CLO manager is able to earn a certain percentage or IRR. Look looking back over through the life of the deal, they are they're have the right to an additional fee on top of that. But all of these fees are basically borne, the vast majority of these fees are borne by this equity, not the triple as triple as the first. The AAA principal and interest comes out. Before any of these fees. And then for the ETF stuff, that's not my thing, but I'm assuming they're not doing it for free.

MJ: Yeah. So, what I was just going to add on top of Joe's comment is those fees don't enter the ETF. So, ETFs will have their own management fees as a part of operating the fund. And then the I guess the second leg to that is investors would look at obviously the bid ask to spread of the underlying ETF that they're looking to acquire.

MC: OK. Will CLO ETFs generally be buying primary or secondary CLO position?

PM: I'll just provide some comments from a Mackenzie standpoint. It could be both and we will be trading in both primary and secondary. We have managed well before the launch actually of our ETF, have been investing in CLOs within sleeves that find its way into a number of our funds today and have been participating both in the primary as well as in purchasing secondary. So, it's a great question to ask. And to understand what different products are doing in the marketplace, but Mark, perhaps I can turn it over to you.

MJ: I would call out the difference really comes down to the settlement period. So, in the secondary market, we're able to trade CLO tranches with AT plus one settlement, which obviously works for a fund that is an ETF wrapper. The primary market does have a longer settlement. So, depending on the fund structure or the asset managers view or cash management. It could prove to be a little bit trickier, so a cash management is absolutely key when thinking about primary market purchases.

MK: Thank you. OK. You mentioned the bid ask to spread of the underlying ETF, what is driving size of that spread? Is it liquidity of AAA CLO market or liquidity of underlying ETF market?

PM: OK. I can start off and then I'll turn it over to Mark. So, there's a few different elements to it. This is like for any ETF, right? You've got the liquidity of the underlying bonds or stocks that you invest in. So certainly, the liquidity of the CLO market is going to find its way into the spread. You can also have secondary market activity, of course, in the ETF that tightens that spread over time. And often times you'll find ETFs trading inside their indicative NAV when you've got enough secondary market happening. Now this depends on ETF to ETF in the Canadian market. Some ETF providers are charging what is called a creation redemption fee. Some do not and those fees can vary depending on the provider. Now those fees are not explicitly stated. It's not stated in a prospective document or stated on a website. These are fees that are communicated between the asset manager, the ETF provider and the market maker. So, in this case, Scotia's ETF trading desk and so the ETF desk will know to create or redeem APNU prescribed number of units of M triple the cost is X. And so that basis point fee often finds its way into the spread as well. And that's basically like I said the cost of the underlying to trade into the underlying CLO market, right. So, it's just us passing that cost along to say we don't want to impact existing unit holders in the product and so we're going to externalize that cost into the spread of investors trading in and out of the ETF. So that can vary provider to provider.

MC: Mark anything to other? Nope, that sounds about fair. How have the rating agencies looked at these structures? Has their rating methodologies evolved over time or remained stable?

JG: Good question. I can jump in real quick for that. The rating agencies methodologies have evolved over time to be much more restrictive. Pre crisis the deals had significantly more leverage in them. Remember I talked about those attaches, They're much lower, much more leverage within the system, much more equity friendly. Over time, that's evolved, and it's continued to evolve. Post COVID, it's even changed a little bit. The rating agencies are more restrictive, which I think benefits. Obviously, it benefits the note holders and to me it benefits the AAA investors the most. But they know there's a lot of. When we were underwriting ACO, when we when ACO is created and I'm a secondary trader, not the new issue folks, but I can sort of fake it for a little bit with these guys. But the when the, when the deals are created, there's a ton of work that goes into analyzing all the collateral. There's a bunch of different metrics that need to be managed to. There's obviously the underlying ratings of the loans themselves. There's the diversity within the portfolio. So you can't have -there's a quantitative metric run by the rating agencies called Diversity Score. You can't have too many related industries. You have a certain diversity score to get a certain rating. There's a quantitative rating methodology called a Wharf rated average rating factor where they, you know, the underlying loans can't be of a certain below a certain rating threshold on average. There's a lot of different metrics that go into it, but I think the questions really getting at is how those have changed over time because they've always been rated. How they've changed over time is what I said in the beginning. They've gotten more restrictive and conservative as they should have because frankly. Pre-crisis, there was a lot of Hocus pocus going on in the rating agencies in my view. More unrelated, more or less related to CLOs and other stuff, but CLOs certainly got tightened up in addition to everything else.

MC: Thanks. Do you expect ETFCLO activity to pick up in European CLOs as well? And within what timeline? Sheri, any are you guys seeing any interest from Europe on the standpoint?

SK: I'm not currently. The newest that I'm seeing are in Toronto. Obviously, there's a lot of ETFs in the US, but we'll certainly keep an eye out for it. Seems like the next natural.

JG: Yeah, I don't see why there wouldn't be. It's yeah, similar product.

MJ: And I would just add to this, particularly with all things Trump related, there is definitely a kind of shift or tilt towards European markets. So, I think it's only a matter of time that we do see increased flows and movement towards euro tranches.

MC: Fair. OK, next realize every CLO is different. But for a AAA CLO, what level of defaults could lead to ACLO impairment? How extreme I guess is the question. How extreme would it have to be?

JG: I could jump in. We've done this analysis. It's pretty, it's crazy, it's pretty draconian. So given that there are first of all take that, take the actual number of just the amount of parse subordination and attach on an average BSLCLO, which is called 35 if you run. Just so just that number of that amount of assets needs to default essentially, or not even default. You have to have that amount of losses. To impair the tranche, just taking a quick super not sophisticated look at it, but really when you look at how the things work, there are like I mentioned those triggers. There are triggers that need to be maintained and coverage tests that need to be maintained in order for the cash flows to leak down below the AAA's. There's an over collateralization test, there's an interest coverage test. There's a bunch of other tests as well, portfolio quality tests, but we've done the numbers and by the way, the average senior secured loans have the market standard for running recoveries upon default of a senior secured loan is 70.

Actual realized recoveries of senior secure loans in the US over the last 10 years is on average about 80. It's moved around given the time, but it's about 80. But if you run 70% default, excuse me if you run a 2% default rate, or excuse me, a 70% recovery rate, solving for defaults where principal losses are taken by the 888, it's something like 60% Oklahoma. It's such a high number that we didn't even bother finishing the analysis, but it's something like 60% defaults every single year. For you to take a principal on some massive amount of defaults.

MC: Wow. That must be multiples of the GFC default corporate defaults?

JG: Yes, it's a, I mean, it's not a funny thing to say, but it's something we talk about on the desk. The scenario in which AAA CLO starts taking defaults is such a bad scenario for the world that I don't know. For all in our seats in the 1st place, it's who know it's just a, it's a, it's anything can happen. We've all seen that in the last five years especially. But again, the default rate that needs to happen every single year because of the triggers and the dynamic function and the dynamic way CLOs are put together and behave. It's something that it's, I can't imagine.

MC: Thanks, Joe. The loans and CLOs are referred to as bank debt. Are the loans structured and papered in the same way as syndicated credit facilities? Anyone want to handle that one? I guess what they're what they're getting at is it, are you acting like the bank when you're when you're when you're buying CLO ETFS and when you are investing in CLOs as well, are you effectively acting as the bank?

JG: Yeah, so. CLOs themselves, I can't answer the ETF part, but CLOs themselves buy loans. So yeah, they buy, they buy first lien senior secured loans, term loans. Or I don't know if they're asking about credit facilities like revolvers. You can have revolvers in CLOs, but they're not as common because of the funding drag, but they can be there. But you're effectively a bank. Yeah. But you're, you know, you're part of a syndicate that's lending money to a, to a company, to a credit. In that respect, you are. I'm not sure if that's the question, but sure.

MC: Well, no, that's just, that's just fine. Great. Thank you very much for the Q&A.

And in closing, thank you to all our panelists for the insights and clarity you've brought to this new Canadian ETF asset class today. And thank you to our audience for joining us today. I think we're ending 5 minutes early here, but I just want to impart that this is just the beginning of our Asset Classes for the Masses series. And so, stay tuned for future sessions as we continue exploring the evolving ETF landscape. Have a great rest of your day. Thanks for tuning in.