Active Insights

Leveraged Loans, CLOs and Fixed Income Investing with Scott D’Orsi, CFA

March 25, 2022 Putnam Investments
Active Insights
Leveraged Loans, CLOs and Fixed Income Investing with Scott D’Orsi, CFA
Show Notes Transcript

In this episode, Chris speaks Scott D’Orsi, a portfolio manager in Putnam’s Fixed Income Group.  Scott has been in the investment industry since 1990, and specializes in bank loans, leveraged loans and collateralized loan obligations.

During the conversation, they touch on many topics, including: 

  • Banks loans, and the current Floating Rate landscape
  • Liquidity
  • The importance of fixed income investing in today’s market
  • Historic default rates vs current default rates
  • CLOs
  • The switch from LIBOR to SOFR
  • The sensitivity of bank loans and CLOs to macro events
  • The yield curve

This material is for informational and educational purposes only. It is not a recommendation of any specific investment product, strategy, or decision, and is not intended to suggest taking or refraining from any course of action. It is not intended to address the needs, circumstances, and objectives of any specific investor. This information is not meant as tax or legal advice. Investors should consult a professional advisor before making investment and financial decisions and for more information on tax rules and other laws, which are complex and subject to change.

All investments involve risk, including the loss of principal. You can lose money by investing.

London Interbank Offered Rate [LIBOR] is set by the British Bankers Association (BBA). It is based on offered interbank deposit rates contributed in accordance with the instructions to BBA LIBOR contributor banks.

Investors should carefully consider the investment objectives, risks, charges, and expenses of a fund before investing. For a prospectus, or a summary prospectus if available, containing this and other information for any Putnam fund or product, call your financial representative or call Putnam at 1-800-225-1581. Please read the prospectus carefully before investing.

Putnam Retail ManagementAD20949433/22

You should consider the fund’s investment objectives, risks, charges, and expenses carefully before you invest. This and other important information is contained in the fund’s prospectus available on Putnam.com or by calling 1-833-228-5577. Please read carefully before you invest.

Putnam ETFs are distributed by Foreside Fund Services, LLC. Foreside is not affiliated with Putnam Investments.

Putnam Retail Management AD2557752 11/22

Active Insights

Putnam Investments

Episode 13



Patrick Laffin: Welcome to Putnam Investments Active Insights, a podcast series hosted by Chris Galipeau. Chris is the Senior Market Strategist in the Capital Market Strategies Group at Putnam Investments. Each episode, Chris has an in-depth conversation with a different Putnam portfolio manager to share timely insights on the markets and global economy.


Chris Galipeau: Hi folks, and welcome to the Putnam Active Insights Podcast. This is Chris Galipeau, Senior Market Strategist of Putnam’s Capital Market Strategies group, and this is episode 13. Today, our guest is Scott D'Orsi, Portfolio Manager in Putnam’s Fixed Income Division. Scott’s been in the business for about 30 years and all of that in the High Yield/CLO space and in our time today, we’re going to focus on bank loans and floating rate products in general. So, Scott thanks for sitting down with us today and I certainly look forward to getting a little better educated on your space and welcome to the podcast.


Scott D'Orsi: Thank you very much, Chris. Great to be here.


Chris Galipeau: Yeah. We’re happy to have you. What I want to do is maybe just start it off and talk a little bit about your journey from undergrad, in business school and all of your experience. Maybe the cliff notes version of that, but I’d love to hear about going to Yale and ending up at Putnam.


Scott D'Orsi: Sure, sure. I think I can do 30 years in 30 seconds or less.


Chris Galipeau: Thirty for thirty, like ESPN!


Scott D'Orsi: Yeah. Well, I came out of undergrad with an Econ degree and so was certainly looking into the business community and wound up at Fleet Bank in Providence, Rhode Island, in a one of the more prolific regional banks for underwriting non-investment grade credit risks. So that’s where I sort of cut my teeth in learning about credit, performing due diligence on what are middle market companies with low investment grade balance sheets and performing due diligence, structuring underwriting, that type of credit risks. So really was a great foundation for me to build a career in the leverage-financed markets and from that foundation, I expanded into the leveraged loan syndication market which is distributing the risk primarily to other banks, banks that would essentially piggyback our corporate credit culture and I did that both at Fleet Bank as well as Bank of Austin, and then I moved a little bit more fully into the capital markets when Bank of Austin was launching a high-yield underwriting business. So took those basic credit skill structuring, due diligence, and moved in into a high yield bond capacity, and that’s where really started to get acclimated to what was happening in the broader debt markets. And from that, I was able to leverage that into managing these corporate debt funds that we call CLOs and really that’s what brought me into Putnam and launching that platform here in Putnam.


Chris Galipeau: Right. When you say Fleet Bank and Bank of Austin, that brings me way back. That’s the early ‘90s, right?


Scott D'Orsi: Yes. Exactly. That was a period where a lot of the risk that we now see distributed among hundreds of institutional investors was really captured among some of the more active middle market credit underwriters and Fleet Bank and Bank of Austin were two of the foremost in that type of business.


Chris Galipeau: Two of the foremost in country or just here in New England?


Scott D'Orsi: Well, both. Until they ultimately merged during that period, every banking consolidation there in the late ‘90s and so they were toe-to-toe with the likes of Citi and Bank of America and Wachovia, First Union, et cetera.


Chris Galipeau: I never would have guessed that, actually. Alright. That’s great. So, maybe we should start with just a simple question and maybe define for the audience what a bank loan is.


Scott D'Orsi: Sure, sure. Well, a bank loan unfortunately still carries the term that can be a little bit misleading because these are not loans made to banks. These are loans that historically were made by banks and a bank loan refers to a secured floating rate debt and that debt, unlike a bond, which is considered a security and it can fall under the Securities Exchange Act regulations, it’s a private loan. So it’s a private arrangement between a company as an issuer and the lender as the investor. So these are senior secured floating rate debt instruments.


Chris Galipeau: Okay. So that’s going to be my next question, you beat me to it. How often do the loans reset?


Scott D'Orsi: Sure. So, these loans historically have been priced on what’s called LIBOR which is a floating rate reference pricing index and that is now being transitioned literally as we speak, beginning in 2022 into SOFR (Secured Overnight Financing Rate) and these rates generally will reset between one, three and six months and that is largely left to the issuer, to the borrower to determine those reset periods.


Chris Galipeau: Okay. Alright. I think you already hit on the question about offering protection, but maybe we can hit on that. So, secured senior in the cap structure.


Scott D'Orsi: Yeah. As senior secured loans within the non-investment grade corporate debt world, the bank loans generally offer superior downside protection and in nearly all cases, the lenders will be secured by all or substantially all of the company’s assets.


Chris Galipeau: Okay, got it. Alright. So, is there a max yield the loans can be reset to? How does that work?


Scott D'Orsi: Sure. So, as a floating rate product, these loans are going to be prepayable and generally they’re going to be prepayable after some period of soft call protection and that period can be six or 12 months and it usually cost the borrower maybe 100 basis points to prepay that debt. So, that’s going to put some governor, some cap on the max yield because to the extent, these loans are trading above par, they’re likely going to be refinanced at a lower spread.


Chris Galipeau: Got it. How about the liquidity? And is it easy to transact if we get into it? I guess we’re in a little bit of a risk-off scenario here now and maybe if you could just speak to that because I think that’s a question that we get a lot, right? Do these bonds trade by appointment, are they super liquid? And I don’t know personally, so...


Scott D'Orsi: Sure, sure. I think liquidity is going to be somewhat similar to what you see in the high yield bond market. If not, slightly less. Owing to the private nature of the loans. So, there’s going to be somewhere between 25 and 30 banks that are making active markets in the leveraged loan space, generally skewed towards the names that they brought to the market, and that liquidity can range anywhere from, I would say, 5%, 10%, 20% of a given tranche size for a loan. So if you got a billion-sized loan tranche out there, this generally decent liquidity for, I would say, 5%, 10%, 15% of that tranche on sort of one to three-day basis.


Chris Galipeau: One to three-day. Okay. That’s better that I would have guessed, I think. We’re asked a lot, not just about the liquidity part of it, but I think the safety part of it and we were talking earlier before we hopped on in here about 2008, 2009 GFC (Global Financial Crisis) rough spot, knock on wood, that we’re not anywhere near that here today, I don’t think. But, what about the covenant structure that makes these bonds a little safer?


Scott D'Orsi: Sure, sure. So, one of the key attractive points to the leveraged loan market is the downside protection and one of the ways you get that protection, we mentioned the senior secured nature but also the inclusion of covenants and these covenants, well generally, do not provide assurances that the company will perform to certain standards. It does put restrictions on what management or ownership can do with respect to the assets that they’ve pledged as collateral, thereby capturing the asset value at the time the loan was underwritten in the existing structure for the life of that vehicle and that generally provides significant enough downside protection. Now the way that is typically quantified is through what’s called anticipated default rates and loss in the event of default. So typically, the bank loan market is generally consensus for default rates to hover somewhere between 2% and 3% normal markets. We’ve come from a period in 2021 where we’ve had historically low default rates and that continues to be the outlook for 2022 even with a lot of the volatility that we’ve seen. And generally, as an asset class the recovery rate in the event of default is anywhere between 60% to 70% generally speaking. So when you look at that default rate combined with recovery rate, they’re typically allowing for somewhere between 9, 10 to 12 basis points of loss on a diversified portfolio.


Chris Galipeau: Okay. One of the reasons I asked that is surprisingly or maybe not surprisingly, but in the last three months, I get a lot of questions from our clients about when the next recession’s going to hit and what are our thoughts, and then of course, we don’t think that’s likely at all in near term for a variety of reasons. And so when you talked about, correct me if I’m wrong here, but the percentage default historically seems to me to be little greater than munis but probably less than high yield over time.


Scott D’Orsi: Yes, I would agree with that. I think that’s right and I think we’ve had some great data points in the past, global financial crises being probably the most telling where default rates were somewhere in the high single digits, 8% to 9% in the loan market and we’re up into the teens for the bond market.


Chris Galipeau: Right. Okay and so, knock on wood, we’re not revisiting that. When I think about—and you tell me if this accurate but when I think through my lens, through the equity lens or through credit analysis lens, essentially I think about where we are here now. Economically, we’re very strong GDP through recession, there’s a lot of people talking about mass defaults even at state and local level for munis in different parts of the economy and that never really happened, right? And which is why I don’t like forecasting because if you’re going to forecast, you better forecast often. But it seems like if that were going to happen, knock on wood, that would have happened in 2020 probably, right, and it hasn’t.


Scott D’Orsi: Yeah, yeah. I think that as an asset class, this is a vital source of capital to middle America essentially and middle America or more specifically, the corporate finance teams and the private equity sponsors that are relying on the leveraged loan market have to ensure access to that market and so that in itself imposes some discipline in terms of how they manage that investor base.


Chris Galipeau: Okay.


Scott D’Orsi: And I think that that’s very important because where protections might end in a credit agreement, you certainly want a management team’s willingness and intentions to do right by those senior secure lenders.


Chris Galipeau: Yeah, that makes sense. So, maybe this is a fair question, maybe it isn’t but what we’ve heard from the major banks—let’s just think about their last earnings report in the calls: JPMorgan, Bank of America, Wells Fargo—one of the things that’s been missing here for the last year and a half has been any sort of significant uptick in the loan demand, right, for them to lend. I mean, Jamie Dimon has talked about it probably three or four consecutive quarters where he said, “We have so much excess capital here but the demand from our customer base has been slow or non-existent.” Finally, in the last quarter, almost across the board, the big banks talked about we’re finally seeing a pick up in the loan demand for whatever reason, buying businesses, expanding, hiring, inventory, whatever the case. Does your market—is it sensitive to the same things in terms of the macro backdrop and wanting to go out and expand where they need more money, need more money and can you see that and feel that or is it just not the same? 


Scott D’Orsi: Yeah. Well, there’s been steady demand for the loan product. It really accelerated in the back half of 2021. We’ve seen it come off a little bit. I think that’s more driven by just some spillover volatility that’s come into the loan market just year-to-date in 2022. But the financing in terms of the use of proceeds that we see for companies that come into the leveraged loan market, it will run the gamut from strategic M&A, talking acquisitions, capital expenditures, change in ownership, financing, that sort of thing. So, there’s a pretty steady state of demand for that.


Chris Galipeau: Okay. Maybe we can shift and talk a little bit about CLOs and one of the things I try and do is not use the street acronyms because we could acronym everybody to death. So, maybe I’ll ask you to start by just defining what CLO means and maybe start there.


Scott D’Orsi: Sure. CLO is collateralized loan obligation and I think anytime there’s a discussion around the leveraged loan market, it usually doesn’t take long before you stumble into talking about CLOs and the reason for that is because CLOs in the aggregate account for somewhere between 65% and 70% of the aggregate demand for the leveraged loan product. And I think one of the things that is really telling from that breakdown of investor demand being constituted in one, sort of, profile buyer being the CLO structure itself, really speaks to the performance expectations of the asset class because a CLO is essentially a levered fund. It is about a 10 times levered fund, so it’s going to be capitalized with 90% debt that’s going to be structured into multiple tranches, usually five different tranches from AAA down to BB and then there’s going to be an equity tranche which is going to be 10%, sometimes even less. And so because such a significant amount of the leveraged loan market is held in these highly levered vehicles: number one, I think it speaks to the fair amount of predictability that the asset class is able to generate; and number two, it presents generally a buy-and-hold type of buyer because these are funds whereby once capital is funded and the CLO is priced, that capital is held within the fund for anywhere between six, seven, eight years. So generally, you have a pretty strong buy-and-hold buyer base that really provides a lot of stability to the loan market.


Chris Galipeau: Oh! That’s great. So, thanks for the definition, giving us the backdrop. Why do people invest in this asset class right? What’s the value proposition? Maybe you can talk about the bull case and the backdrop for when they work well and once we’re finished with that, maybe we can go to what investors need to be aware of, maybe not concerned with but aware of.


Scott D’Orsi: Sure. Well, the loan market currently stands in about $1.4 trillion and it has grown at a roughly 10% annual rate for the last eight years or so, so we just had tremendous growth. It is approximately the size of the high yield bond market now.


Chris Galipeau: Yeah, I was going to say, that’s way bigger than I thought.


Scott D’Orsi: It’s pretty significant. So it’s not uncommon for us to get the attention, not always the positive attention from central bankers, congress people, et cetera for what might be taking place in that $1.4 trillion size market. The one difference I would highlight between the high yield bond market and the loan market is the bond market pretty much had a 15-year head start in terms of when its growth really started to take place. But in terms of what’s driving that growth, number one, we’ve obviously been in a period of extended historically low interest rates. So the search for yields certainly extends into this corner of non-investment grade corporate credit where yield is provided. The other attraction for that growth, as I mentioned in the CLO structure, investors can really identify the amount of risk they’re looking to take, whether they’d be the traditional money center banks both domestically and globally, they like to be in the AAA or AA tranches, very, very low risk, negligible if any loss of principal if held to maturity in those tranches all the way down to BB type of risk and the equity risk. So, by way of structuring non-investment grade credit into all of the [status] of risk, which can provide anywhere from 2% yield at the AAA level or thereabouts out to mid to high teens type of return on the equity really presents a nice menu of options for investors to get access to the [asset class].


Chris Galipeau: And so the way I just pictured that in my head is almost the continuum of left to right from two handle on yield out to double-digit handle on yield and of course your risk is up significantly as you move out to the right. Alright, that’s a good way to think about it. So alright, that sets the table. What environment, what backdrop can make these loans underperform, generate negative returns or hurt an investor?


Scott D’Orsi: Sure. Well, these are credit risk instruments for sure. So, credit is paramount in understanding the forward path of these issuers in terms of their ability to service their debt is very, very important and the scenarios whereby we have mass sell-offs tend to be more macro, more global in nature. For example, just in the past couple of weeks, our market has traded down anywhere from 150 to 250 basis points which is considered a fairly significant move for the loan market, which tends to cling very, very close to par. I would say at least 90% to 95% of any given year, the loan market is going to trade between 98.5% and par and so once it pierces through that floor, we generally start to see some opportunistic buyers come in and fill in some recovery there. But there’s certainly going to be downside scenarios where we’re entering into recessionary periods. Generally, these are companies that are not the largest in their given sectors, so they’re likely to be a little bit more at risk in terms of a pricing leverage they have over their customers or the purchasing power they can influence with some of their suppliers. So, understanding management and their business plan and their ability to track to that business plan is very important and to keep part of what we do.


Chris Galipeau: Yeah, right. I mean that’s true in credit, that’s true in equities, true in your space. And so, what I have told our FA clients here for the better part of two years essentially is that we go through the COVID-related pandemic, shutdown/lock down that sort of thing and kind of fast forward to today and now, we have a lot cross currents here, we’ve got this geopolitical situation in Europe, we’ve got the Fed about to move, been pretty risk-off here since you can argue November in equity space, and now we’ve got credit spread starting to move out, that sort of thing. My advice, my assessment, tell me if you agree and if you don’t, fire it back, has been this—that we’re probably going to have some around three and three quarter real GDP this year in the US. That’s the strongest in 18 years. Last year notwithstanding, which was the strongest in 40. When I listened to management teams on calls and we talked from here and listen to our analyst, balance sheets are great, business fundamentals are great and so my take on where we are here is we have got a little risk-off. Yes, we have more vol, but the operating conditions for corporate America for the most part aren’t pretty good—with the balance sheet situation, cash flow generation, that’s probably brushing it but seems very good. Agree, disagree?


Scott D’Orsi: I would largely agree with that. We do not see issues with respect to any maturity walls or significant re-finance risk for the most part. A lot of companies were able to access the debt markets in 2021, extend that maturities, add liquidity to the balance sheet, et cetera. 2021 was also a unique year because you had the impact of COVID or I should say, you had the unwind of the 2020 impact of COVID. So, one of the critical components of our credit work is understanding where demand might have been pulled forward in those 2021 results and what that might imply for comps into 2022. But overall, I would agree with you that we’re in a fairly healthy environment where the other things that you mentioned 3.5% type GDP which is strong, which is very very strong by historical standards. Let’s say one of the hidden cautions to the loan market is generally speaking, we do not need to operate in a 2.5%, 3%, 3.5% GDP environment for loans to hold their value. If we’ve done our credit work adequately, these companies should be able to service their debt even in a more modest GDP environment although that 3.5% type area is important for equity valuations and I think one of the things that we’ve seen just as of late was just how finely the equity markets were priced to that type of growth factor.


Chris Galipeau: Yeah, absolutely. And we came into the year 23 times forward, right, in the S&P, that’s six handles above the 75-year median and so there was no room for error coming into this year at least in my view and so we’ve had some issues here, right, and we’ve had multiple compression. A lot of that is rate, rate and inflation driven, that sort of thing but it happens. Alright, let’s fast forward, talk a little bit about Fed lift off here, Fed policy, how you’re feeling about it and then maybe we can start there and we can talk about how floating rate products generally behave when short end to the curve is starting to move up, of course it already has. 


Scott D’Orsi: Sure, sure. So, it’s a floating rate asset class and in normal times, I would say that tends to provide a nice little hedge for capital allocators that are out there, advising on fixed income, traditional fixed income portfolios but in the market that were now fully immersed in where with no rates are going higher, it’s just a matter of how much and how quickly it becomes a little bit more attractive as an absolute return type of an allocation, and one of the things that we’ve learned from historical rate moves is that when it starts to float, it moves, it moves swiftly and it can ratchet up pretty quickly. So you want to be able to capture some of that float higher and it’s a great product for that. Just this year, we’ve seen record inflows on the retail side and mutual funds, we’ve had approximately $15 billion come in, just in 2022 thus far so that’s just a couple of months and that’s coming off of a strong 2021 where for the entire year we pulled in about $45 billion, again, just for that one segment of the loan market on the retail side.


Chris Galipeau: It’s big number. So, we are on pace here in 2022 if we were to continue obviously for eclipse 2021, it’s interesting. It’s funny, Scott, because we were talking to FAs, I find it’s almost split if I talk to10 FAs in the course of the day and we are trying to position at high level, strategy level of why floating rate products make sense whether it’s, the carry, whether it’s benefiting from resetting, whether it’s de minimis duration, lowering duration risk. I’d say it’s pretty split between FAs who say, “I recognized that, I’ve used that space before, those products before, those mandates. And I liked them and they’ve generally done what we wanted them to do.” And then you have another set of the audience who will say, “I don’t understand those, I don’t want to use those, that they don’t always work,” sort of thing. And it’s very interesting to talk about this just conceptually with FAs and some are bullish on it, some are neutral, some are straight up short, short strategies, don’t want to own them. Right, so we just covered a lot of ground in a short amount of time. If you were a financial advisor and you are listening to you and I talk right now, are there a couple of things that you would want the FA to walk away from this conversation knowing it could be how to effectively use floating rate strategy in the context of portfolio construction, it could be the bull case in the rising short rate environment, it could be anything you think is germane from your 30 years of doing it, 80 hours a week?


Scott D’Orsi: Yeah, sure. Well, I think that it’s an asset class that has always demonstrated, I think remarkable resilience and I’ve noticed that over the 30-year period. We’ve taken this asset class, one that was almost entirely held within banks. We mentioned some of the banks at the front end of the podcast and those banks were essentially underwriting to a zero loss kind of credit standard and they really do that in generating returns by being enormously levered, right, deposit center type banks and over time, we’ve continued to deploy that approach to owning and generating returns with less leverage in the silo structure as well as what’s withheld, unlevered in mutual funds or with insurance company, et cetera. Without really compromising the credit standards by which we monitor that type of risk, so I think that the broader investor base globally continues to discover the benefits of the loan market, of the U.S. dollar-denominated secured loan market in terms of generating those types of returns and that can be on the unlevered basis in today’s credit environment, somewhere between 4% and 6%, all the way up into the low teens when you’re applying some leverage. And when the downside is number one, I think mitigated by proven recovery levels and when I say proven, that’s not necessarily Scott D’Orsi’s model, but these are the rating agency models. And the fairly short-lived nature of those corrective periods not being measured in quarters but being measured in months and even days, I think once people get through the lack of familiarity or the information barrier, it really start to appreciate in value, an asset class that provides fairly good predictability to current income while also affording a lot of capital preservation comfort and that’s something that when you look at the broader demographics and what’s happening in terms of the sheer numbers of people that are moving into retirement age, et cetera that are looking for that type of return in their retirement funds if you will, current income with some confidence around capital preservation, it’s a terrific asset class to generate that kind of performance.


Chris Galipeau: I’m glad I asked you that because that’s the way I tend to think about it too when you said it much more eloquently than I ever could or ever do. So we’re going to wrap it there and Scott thanks for sharing your knowledge with us, with the shareholders. And folks, we’ll be back to you with another podcast here in a couple of weeks. Thanks very much.


Scott D’Orsi: Thanks so much, Chris!



Patrick Laffin: All opinions expressed by the podcast host or podcast guests are solely their own opinions and do not represent the opinions or views and Putnam Investments or any affiliates. This podcast is not investment advice and is not intended as a recommendation to buy or sell any type of securities. This production is for informational purposes only.


Online Title and Description

Leveraged Loans, CLOs and Fixed Income Investing with Scott D’Orsi, CFA

 

In this episode, Chris speaks Scott D’Orsi, a portfolio manager in Putnam’s Fixed Income Group.  Scott has been in the investment industry since 1990, and specializes in bank loans, leveraged loans and collateralized loan obligations.

During the conversation, they touch on many topics, including: 

  • Banks loans, and the current Floating Rate landscape
  • Liquidity
  • The importance of fixed income investing in today’s market
  • Historic default rates vs current default rates
  • CLOs
  • The switch from LIBOR to SOFR
  • The sensitivity of bank loans and CLOs to macro events
  • The yield curve



This material is for informational and educational purposes only. It is not a recommendation of any specific investment product, strategy, or decision, and is not intended to suggest taking or refraining from any course of action. It is not intended to address the needs, circumstances, and objectives of any specific investor. This information is not meant as tax or legal advice. Investors

should consult a professional advisor before making investment and financial decisions and for

more information on tax rules and other laws, which are complex and subject to change.


All investments involve risk, including the loss of principal. You can lose money by investing.


London Interbank Offered Rate [LIBOR] is set by the British Bankers Association (BBA). It is based on offered interbank deposit rates contributed in accordance with the instructions to BBA LIBOR contributor banks.


Investors should carefully consider the investment objectives, risks, charges, and expenses of a fund

before investing. For a prospectus, or a summary prospectus if available, containing this and other

information for any Putnam fund or product, call your financial representative or call Putnam at 1-

800-225-1581. Please read the prospectus carefully before investing.


Putnam Retail Management AD2094943 3/22