I’m pleased to introduce our speakers today. Joining us, we have Tim Leary, head of U.S. High Yield senior portfolio manager, and Anne Greenwood, CFA, institutional portfolio manager from RBC Global Asset Management. So with that, I’d like to go ahead and turn it over to today’s first speaker. Welcome, Anne, the floor is yours.

Thank you very much. I am very pleased to be here today with Tim Leary, head of U.S. High yield and senior portfolio manager on the global leverage finance team here at Blue\Bay Fixed Income. For those of you who don’t know, Tim has been in the leverage finance industry for over 20 years, starting as a trader on the sell side back in the day when he had hair and then moving to the buy side, joining Blue Bay, initially as the head of trading and then moving to the portfolio management side. Needless to say, he brings a wealth of knowledge on sub investment grade, sometimes referred to as leverage finance or simply high yield credit markets. And we hope you enjoy today’s discussion. So, Tim, there’s not really a whole lot going on in your space today, is there? Before we get to some of the themes and risks and opportunities, it seems important to understand how do we get to where we are today? Can you spend some time on the evolution of the leverage finance market over the last, say, ten years? It seems like what was once a relatively straightforward 2 to 3 pronged marketplace is starting to feel like a much larger ecosystem of lending. What’s driven this, and what are some of the consequences or outcomes of it?

Sure. Thanks. So you’re right. The leverage finance market has grown for a number of different reasons. I tend to frame the discussion around the size and scope of the leverage finance market by thinking of it as two sides of the same coin. You have fixed rate debt on one side and floating rate debt on the other side. You’ve got high yield bonds and high quality Triple B’s, obviously investment grade rated on one side. You’ve got leveraged loans and private debt on the other. Over the last ten years in particular, you’ve seen the private debt market grow really exponentially. The leveraged loan market has grown, but not to the same degree. High yield has also grown in size, but at a much smaller pace.

The use of proceeds—the types of deals and financing that the private debt market has done—have largely been sponsor-related LBO activity. A lot of capital has been driven towards the software space, in particular lending to companies based on recurring revenue as opposed to LTM EBITDA. The nice part about that development is that those vehicles are largely locked up capital. Granted, some of them have quarterly redemptions and some have had to put up gates recently, but it’s much different and much more appropriate to have that type of risk in those vehicles than, say, daily liquidity mutual funds.

Over the last ten years, you’ve certainly seen the market grow and pick up space. High yield is more liquid today than it’s ever been. It’s better rated than it’s ever been. It’s more transparent today than it’s ever been. The benefit of that is that more and more individuals and institutions are looking at high yield as an asset class with a fresh set of eyes.

So maybe just looking at the numbers here, I mean, obviously private credit really stands out. I think another interesting aspect is the evolution of the CLO market. That obviously creates pretty different dynamics in terms of how loans trade or perform given more of a structural buyer, which is something I think you talk about a lot. There’s also been recent discussion around private CLOs and where that sits and how that might evolve relative to the public space. But what have been some of the key metrics or dynamics of what that private market exposure is? What’s really driven it? Obviously, you’ve seen a lot of investment in it and some of that’s come from more democratization and having it be more in retail hands. And then on the flip side, you have issuers. What types of issuers would move away from the traditional high yield market into private debt? And then maybe talk a bit more about how that has changed the dynamics within the high yield market that might make it more compelling today.

Sure. Let’s define what private means. There are multiple different layers to it. You can have a private company, which is a family owned business that’s not public equity. Those companies can still issue bonds that public investors can trade and invest in. Maybe they’re 144A for life. Maybe you need to be a qualified institutional buyer to buy them. Maybe you can have larger minimum sizes like 100K or 200K lots, which make it challenging for retail to buy, but you can still own it and not be restricted from trading the bonds.

Conversely, you also have private companies with leveraged loans or private debt institutions where it’s more clubby and there’s a smaller subset of investors in it. Those investors benefit from seeing the projections and budgets that the individual company has submitted to that cohort, because it’s a club group. In leverage loan land, broadly, you have syndicated loan land where 70% of the market are CLO vehicles owning that market. It’s a mix of the two. Some loan investors are private and have seen those budgets, and some are still public, which means that if the company came to print a bond, they could participate in a bond deal.

And so, while it may feel like a bit of a gray area, there isn’t really a gray area. It’s just a function of how you define your level of private. Effectively, they’re all behind a non-disclosure agreement in terms of being able to share this information. All that said, that’s a small cohort of the high yield market. There’s still a great deal of companies, more today than ever before, where you can actually get access to information, usually because they’re public companies and public filers on as high yield issuers. Which makes developing a buyer in the secondary easy, right?

Think of it this way if you are a large sell side bank, there's probably 500 different accounts you can call to syndicate a deal, right? Whether it's a data center deal, a global telecom company, software company, whatever the case, whatever type of company that is, you could there's probably today 500 different accounts you can call in the loan market. There's probably half that, maybe a little more.

When you think about the universe of people that will participate in a high yield bond deal, there are funds that are regular mutual funds, insurance companies, hedge funds, segregated accounts, the portion of high yield funds that are attached to core plus type vehicles, and investment grade. But there’s also today more what we call pods or pod shops associated with private capital that is designed to trade like a small hedge fund. There are different ARB strategies, long short equity versus debt. There’s a multitude of different investors in a high yield bond.

Potentially many of those types of investors won’t be able to participate in a bond that’s private or 144A because there’s no equity on the other side or they can’t get access to information. That lack of information is a design feature, not a flaw, because the companies and the ownership do not want that information out there.

It’s really a spectrum of what private is. On one end is private debt, where developing a buyer when you have redemptions or the investment goes south and you need to exit—or you want to develop a buyer so that you can create some liquidity and sell—becomes more challenging because there are restrictions on who can actually access that data.

And then when we think about focusing a bit more on that high yield market and how that has maybe strengthened that market, and what you’ve seen in terms of valuations across the different segments. We’ll certainly get into software next. Obviously AI is more and more becoming a leveraged finance story, which is what we certainly want to focus on.

There’s kind of two sides to that coin. We’ve seen the investment grade build out with the hyperscalers. Now we’re starting to see that trickle into the high yield market. But let’s look at how much that quality has improved and what are the components of that—whether it’s LBOS or other types of activity that might have been in a junk bond market and is now filtered out.

Great question. So effectively what you’re asking is how has the market evolved over the last really year or so. As AI has grown and the demand for compute power has increased, there’s more project-related finance designed to build out data centers and compute. Some of that is centered around the actual shells. Some of that is centered around getting power to the data center off grid. There’s a variety of different uses there.

The difference is that the newest entry to the high yield market, the US high yield corporate bond market, is often a function of that project finance for data centers or for software companies that are used within data centers where that end data center is actually contracted, where the lease payments are actually guaranteed by an investment grade company, usually a Mag Seven type of household tech name.

You know, where that differs relative to software in the loan space—and you always have to start with how big is it in the benchmark and how much paper, who owns what, and what’s the technical. About 16% of the US loan market is in tech, about 14% is in software within tech. So a decent slug of it.

In the US high yield market, it’s probably 3 or 4%. Believe it or not, some of the data center is included under telecommunications because they’re really hardware, not software. There’s a difference there. On one hand, one’s a big, large double B-rated senior secured real estate play with an A-rated tenant. The other is a six, seven, eight, or low teens times leverage software company where it’s really, really hard to get information because they’re private. And by the way, maybe like a third of that market may just go away when companies realize that their customers can actually, through AI, do in-house what they’re currently paying some of these software companies to provide.

So it’s going to get very choppy. It’s not going to happen tomorrow, but it’ll happen in the next year or so as the market adjusts to what services they really need a software company to provide, what services can they take in-house, how do they use AI, what’s the cost of a token. All of that is really unknown.

The direction of travel is certainly towards greater usage, and we know that there’s going to be capital demand and that companies are spending probably $1 trillion worth of CapEx over the course of the next few years on these things. So they’re going to expect to get paid a return on that investment. The question is going to be who the winners and losers are.

I think it’s going to be hard to believe that some of these really small companies that are niche software providers all survive. So in a lot of ways, I would liken it to what the early energy crisis was when we had oversupply and the price of shale gas fell through the floor. We could see that kind of reckoning in software, but it’s certainly not going to be all software. There are going to be a lot of winners and a lot of losers. As the market has grown, there’s going to be a great opportunity for active managers, whether you’re a loan fund or a bond manager, whatever the case may be. So it’s going to be interesting.

I think what it got me thinking about is, you sort of talk about some of these smaller companies, maybe more levered, obviously also floating rate. So as we think about what’s been going on in the world and Iran with payroll on Friday, it feels like higher for longer is here to stay. Do we have a risk of a hike? And how could that filter through as we see some of these companies start to refinance going into 2028-2029? What are your thoughts on that impact?

There’s no such thing as a free lunch, right? If you are a floating rate owner of assets and you’re benefiting from higher rates and they’re being elevated for an extended period of time because of conflict, the macro, and inflation running rampant, you’re going to benefit in terms of your duration benefit and your current income going up. But the net payer of that is the company, and their free cash flow profile is going to decline as a result. Their net interest coverage margins are going to look far worse if that extends for an extended period of time.

There are really only three reasons why companies go bankrupt: when they can’t pay their debt when it comes due, they can’t afford the debt cost (either interest expense), or there’s some sort of exogenous shock.

Let’s do the math here. They’ve got a big maturity wall in 2028 in leverage loans. There’s a big maturity wall that is coming to—B3 rated or lower quality, as the lowest quality cohort before triple C in loans. Interest expense, while some of it is swapped out, as those roll off will go up.

If we see this elevated rate environment because it’s floating, you now have exogenous shocks where some of these business models are going to be materially disrupted between now and 2028-2029. These are going to mature within the next year and a half to two years. So again, it’s going to get pretty choppy.

What we’re looking for is the ones that are going to survive are going to try to tap markets in other related cohorts. Maybe a loan issuer will come with a bond to refinance a portion of its term debt out in bond form. Maybe they go to the private debt market. Maybe they go to other sources of funding or do amend and extend operations within the existing lender group.

All of these things are going to play out as we think about the winners and losers from the macro. The floating rate will look good for a while until it doesn’t. On the flip side, it’s actually an interesting time for investors to deploy capital into fixed rate assets because as rates go up, bond prices go down.

If you are currently looking at the asset class and interest rates, as we sit here today on the ten year at around 4.55%, you’re getting something like 300 over a ten year. That’s like mid-sevens yield. If you are of the view that rates will come down at some point, you’re going to get a tailwind.

Bond price performance should be a nice insulation should insulate you from some of the impact if the economy slows. If you see job losses pick up, like it should do what fixed income is supposed to do and provide a bit of a ballast to your equity component of your portfolio.

Again, high yield can behave that way now because, yeah, sure, it’s shorter duration than some investment grade. And it’s a little bit lower quality than investment grade. But 50% of the triple B—50% of the investment grade market is triple B-rated—and 55 to 60% of the high yield market is double B-rated. I mean, it’s a very small difference between the two when you consider the whole entirety of the risk profile.

So again, the macro—we’re not. I’m not a macro investor. A very small component of our product design is managing interest rate risk. We don’t take any currency risk. That is for someone far smarter than I to opine on. But if you think you know what’s going to happen in Iran, you are mistaken because nobody has any idea how it’s going to play out.

But at some point it’ll probably end. And so at some point things will normalize and we’ll see where the world is when that happens.

So I know that in the US strategies, obviously interest rates aren’t being a major component for the high yield piece, and non-U.S. isn’t being a large component, but you certainly have experience and manage global portfolios as well. Are you seeing any divergences regionally relative to the high yield market, the AI build out and the financing of that, or just broader economy? I have probably 4 or 5 questions that popped into my head when you were just speaking. So I’ll try to fire away.

Sure. The data center buildout has certainly been more focused in the US. It is starting—you’re starting to hear more and more about deals coming down the pipe in Europe for data center buildout. But that’s been primarily, and honestly the CapEx spend has been largely US. It’s leading to GDP, the economy in the US. It is having a positive impact. So that is thus far mostly a US phenomenon from a flow perspective.

Post the conflict in Iran which is now 100 days in, you’ve seen outflows and folks moving away from dollar-denominated assets. Part of that has to do with the likelihood of recession because of spending and all the fears that go along with it. But the reality is that companies and sectors that can pass pricing through to their clients are going to benefit because they’re growing their revenue, they’re growing their EBITDA, and their debt levels aren’t increasing. So there’s the credit stats actually look better.

We’re seeing and we’re focusing on sectors where they can actually pass costs through. And the consumer in the US in particular is very strong. They’re employed. They have the ability to service their debt. The bad debt expense and the debt limits—the data we get from credit card data is broadly supportive in terms of unpaid debts and unpaid accounts and so on. It’s all very constructive.

So I think on balance, there’s been outflows that we’ve seen from the global high yield asset class, not our strategies, but the asset class as a whole, have really been dwarfed by inflows into the asset class out of the states or within the states. Makes a lot of sense.

And actually, before I kind of take us on a zig zag, this is a good point to maybe touch on supply and specifically how that might be being reshaped. As you know, we’ve seen massive supply come from the hyperscalers. Of course, we recently just saw Alphabet with their equity financing of $85 billion. But we are also starting to see some of those high yield companies become relatively major players in the AI build out, whether it’s the likes of Neo Cloud or some of those larger, more AI-related entities becoming bigger players. How are you seeing that unfold and what do you expect from there? And do you think that could impact valuations?

Sure. But we’re a ways away from that. I think you’re seeing more supply coming to the market, and what’s interesting about it is you’re seeing supply come to a variety of markets. You’re seeing it come to the private debt space. You’re seeing it come to the delayed institutional bank space. You are seeing it come to the convert space. You’re seeing equity raises. You’re seeing high yield debt and IG debt deals.

We’re cognizant of the supply, the use of proceeds, and the success rate. We’re not overly concerned that there’s going to be a deluge of paper that needs to come to the market and reprice the whole cohort of issuers. It is something we have one eye on. Supply concerns are generally short lived. That’s a technical that works itself out. Oftentimes it provides an entry point where you can put real trades on at good size. When you get through the fog of supply indigestion, they end up being great positions.

If you underwrite correctly and underwrite well, you shouldn’t need to worry about that short-term technical because the benefit of credit markets is that you’ve got this monthly coupon payment that just keeps accruing, and it makes up for a fair amount of supply in and of itself. You’re getting cash in the door every month.

So not too concerned about it. That said, there is some velocity with which some of these longer-dated bonds can trade, and they’ve added some really interesting entry points as a result.

Very interesting. So what do you think could potentially break the market or force spreads wider when you think about historically? Is it the technical on the other side? Where do you think there’s—given all the potential IPOs that we might be seeing at such massive scale and where valuations are today within high yield—do you see any risk of a shorter-term pull out of high yield to fund some of that equity issuance? And do you think that is meaningful enough that it could matter?

I don’t think so. I think folks very rarely treat high yield as an under-allocated asset class to begin with. I don’t think folks are looking at their high yield allocation saying, "I’ll go sell this 6% double B bond that matures in three years and roll into a space IPO or whatever IPO they’re thinking about."

That said, I do think the idea of what could break the market is certainly correlation. If you start to see the Nasdaq sell off because you have evidence that the CapEx spend that has been earmarked—where the power of compute is not doing what it says it’s supposed to do with regard to creating efficiencies and productivity, improving productivity for end users, or the use cases do not come as fast as they would expect, or that there’s supply bottleneck issues, whether it’s from chips, storage, or power—any of those aspects could be problematic.

If you start to see snags—and we’re going to see some of that—this is not going to be smooth sailing the whole way. So look, I think if the technology continues to work, and that’s your base case, then it will be implemented over time at various paces. There’s going to be winners and losers because of that. Certain aspects of leveraged loan software, the smaller cohort, and private debt software are going to go out of business, for lack of a better term, because of the AI trade, but not all of them.

That’s where it gets really interesting, because there was a period of time about a month and a half ago where there was a baby out with the bathwater in loan software, and they’ve rallied back. Some of them have rallied back, others have stayed and lagged behind. High yield has been insulated because there isn’t a lot of software in it.

In a year from now, some of those deals that were in loan land may get refinanced in bond form, maybe. Something we’re keeping an eye on. It gets your question earlier about supply. But what’s interesting is there are aspects of the market that are related to AI that are not directly software.

That could be a really interesting thing. The market is not pricing in the efficiency and the margin improvement in these business models that are actually benefiting from AI because they can get to market faster, they can service clients faster, they can do it with fewer humans potentially, and they can take costs out of their own business model as a result.

And that’ll work until the cost of a token goes up. So again, we’re very early innings here, which is why we want to make sure we don’t get out over our skis in terms of the market length in this trade or the debt.

Yeah, it’s going to be fun to watch.

Awesome. Thank you. So maybe we just take a few minutes to talk on a few things that I’ve heard you say—like if you’re underwriting effectively and talking about amending and extending, and if we think about some of the software companies, of course there’s going to be winners and losers. How do you see that impacting the outlook for default rates and recovery rates? Do you see any potential changes happening there? And then it sounds to me like the high yield market could be relatively well insulated if we do start to see that tick up. But we did see default rates in loans kind of pick up last year and they’ve come back down a bit. Where do you see that going from here?

High yield default rates really can’t go down because they’re so low already. They’re less than 2%. So yes, I would feel very confident that at some point in the next year, the high yield default rate is going to go up. It will go up by a lesser degree than the leverage loan space.

What’s really interesting about defaults is that private debt is already witnessing them and seeing them, and they’re just calling them something different. They’re picking bonds or payment in kind, where instead of an actual cash payment default, they’re just saying, "Oh, on second thought, we’ll just take payment in more debt and we’ll figure it out in the back end," or we’re going to equity some portion and avoid a default.

Everybody that knows what the non-accrual rate is knows what the real default rate is for some of these strategies. And again, it’s not all of them. Some of the managers are doing fantastically well. That’s why as an asset class I’m not overly concerned that it’s going to be systemically problematic. Far from it. I think it has proven its worth. I think it is going to be here for the duration.

 And in a lot of ways, it reminds me of what the leveraged loan market used to be like in 2005 and 2006, and even before then when I started in the business, because there was a lot of price discovery. I think you asked this question earlier and I forgot to answer it and my rambling, but what are the dynamics actually happening in pricing?

You saw a period of time where private debt prices were coming down—the coupons. The amount of premium that could charge over public markets was actually coming down and compressing. And then you saw some indigestion and that widened out again.

High yield spreads have been fairly insulated because the faults have been loans. It’s a really well-rated asset. You’re just not going to get paid so much more to take risk in it because it’s not going to default. There’s no such thing as a free lunch. The volatility is largely been rate-driven, or in software in private debt and loans.

So when you hear that, you kind of think, "So how do I—if I’m an investor, whether it’s private credit or even potentially less liquid loans—look at how yield works? What are the benefits or even what are potential disadvantages of the greater liquidity in the high yield market?"

You certainly have opportunities to capture value and dislocations. On the flip side, you have sort of some maybe masked lower volatility within less repricing of private credit.

Does that change when the likes of Apollo start actually pricing that on a monthly basis? Does that change the dynamic at all? But for now, how do you think about being liquid versus being not liquid in today’s environment?

Depends on if you need the money. Like, it’s really that simple. If you are a retail investor or institution that needs their capital back at some point—either because they want to reallocate to a different dislocated space or they would like to stick it under their mattress because they’re worried the sky is falling—if you want your money back, high yield can actually allow you to take your money out to create an opportunity for somebody else that wants to allocate in at a better level. Depending on the level you take it off, like the entry point matters.

What people misunderstand about high yield right now is that while spreads are a little bit snug, the entry point because rates have risen is not too bad. You have a low-sevens yield for something that’s not going to default. That’s a three-year, three and a half-year duration product, but that’s going to look pretty good over the next three years.

To that point, as I think about the private side of things, if you allocated it with the view that you’re going to be in it for the duration, and you’re happy to realize that that money is not something you’re going to touch, you do not want to take it out. It will do the trick. You’re going to pay your advisor a lot of fees, but it’s going to do what it says it does on the pin if you pick the right manager.

But what about from a returns perspective? If you’re in a sort of less liquid fund and you have this dislocation going on, how does that change the expected return for some versus going through this in a more liquid asset class versus one where you can’t adjust your risk?

It’s a good question. Look, I think the biggest difference between the two is the fees that they charge. The regular on-the-run US fund is a fraction of the fees that private debt charges. So on a net basis, that’s a big deal. The flip side of that coin is like it really depends on both aspects of the market.

I say this all the time. It’s about time in the market as opposed to timing the market. Private debt actually accrues to your benefit, provided that you don’t own it in a vehicle where everybody else in the fund is heading for the hills and trying to redeem, and they’re putting up the gates.

I think this is a period where it’s in the news. There are clearly funds that are seeing redemptions. This will blow over as well. Prices will reset. Coupons that they’re charging will go up. The pendulum will swing back to more liquid credit if the private credit side gets choppy or there’s an extended period of dislocation where the valuation or part of the capital markets are more open in loan and bond land.

That’s part of the reason why we think that the coin will flip back to public markets again in terms of the types of deals that we see. The credit quality will move as it relates to that. But you actually, unfortunately, cut out a little bit when you asked your question there. Did I answer your question enough?

Yeah, yeah, yeah. I guess on liquidity, and you did touch on it a bit earlier. But you know, you look going into this year there were expectations of acceleration of growth. And then we had all of the volatility around Iran. It kind of felt like people started really sitting on their hands for a little bit getting nervous.

But then you look at recent numbers, the amount of flows just going into funds, the amount of growth and energy that you’re seeing starting to look like it’s flowing through the economy. It’s almost like higher oil prices are being completely taken in by the consumer without really any issues. Where is all this cash coming from?

Government stimulus in the view in the form of tax cuts. You’re not paying tax on tips anymore. One big beautiful bill is supportive by reducing the tax burden on middle and lower class working individuals. There is a very real impact to job availability and who’s working in those jobs effectively—the impact of immigration and migrant labor.

There are fewer migrants working non-Americans working in the United States today than there was a year and a half ago. That means Americans are actually working those jobs and getting paid more. You’re seeing that in wage inflation. Those three things right there—employed, getting paid more, and paying less in tax. Those aspects may not have affected you and I in terms of what we do for a living, but it matters if you’re a bartender and a waitress for sure. That’s fantastic and it’s great, and it’s offsetting part of the cost of gas.

You know, we’re also living on the back of a wave of multiple years of government spending from COVID. They dumped a lot of stimulus in terms of debt-fueled stimulus on the United States in particular, I think did it worldwide.

When you look at savings rates, the national savings rate in terms of the definition of how much disposable income you have after certain expenses, that’s lower. But if you actually look through and channel check the data in terms of the actual national banks’ credit card and savings account balances compared to 2019 for their average client—and what they are now, they’re higher across the board regardless of where you are in the income spectrum. Lower, middle, and upper class all have more cash on an inflation-adjusted basis than they did in 2019. That’s a strong consumer. That consumer is going to have some dry powder to fight through stubbornly high prices at the pump for a while.

The flip side of that coin is that inflation will be here and potentially be stickier for a while.

Are there any other kind of underlying concerns around the consumer—whether it’s a locked-in housing market that is becoming more and more bifurcated in terms of mortgage rates, inflation of course is a key one, but are there any other underlying trends or risks relative to the consumer that you are keeping an eye on? Whether it’s real estate or jobs numbers, are there any things everybody should always focus on jobs.

If you start to see a pickup in layoffs because of AI as an example, that could obviously be problematic.

The housing side of things—we’ve been living with for an extended period of time, the velocity of homes changing hands is just not there. I think you see certain rebuild, remodel type of home building activity pick up, maybe not to the same degree as new housing starts would have otherwise picked up.

Look, I think that until we normalize and the price of oil comes down and the price of gas comes down, we’re going to again—it’ll happen at some point. That’s really what’s driving the inflation narrative. That’s what’s giving corporations the cover to charge more. And as long as the consumer is employed with cash in their account, they’re going to spend.

And now, with six months of having a nice, lesser tax, smaller tax bill than they would have had last year, it’s a pretty supportive environment to go spend. It now based on mall-based retailers, and we’re seeing that in the data. There’s been 2 or 3 companies that have posted really, really decent numbers for mall-based and internet-based retailers.

And you say, "Okay, well, people who were pulling money out of the high yield market six months ago did not have that in their bingo card out of these companies because their consumers are so strong in the United States at a time where they’re not to the same degree in Europe. That’s the difference. The moral of the story is don’t bet on America to fail."

We’re just the government is simply throwing too much money at the problem.

So you know, you are the head of US high yield. You manage portfolios. I kind of run the gambit of leverage finance. If I were to go back to where we started the presentation, I look at the ecosystem of leverage finance, focused obviously on the liquid side. But where are you finding opportunities today, whether it’s sector or certain pockets of these markets in particular? How are you? What are you seeing? What are you excited about? What are you worried about?

Well, we’re hired managers. We just get paid to worry. That’s what we do. But I would say what we’re worried about—we are neurotic about making sure that we’re underwriting to the highest standard to make sure that we don’t get blindsided with bad numbers. Thinking about and having adherence to levels where we want to take our trades off that we’ve put on, whether it’s a spread level or a yield level. When it gets to our level, we’re going to take it off, not getting stuck in trades where you can’t find liquidity to get out.

It’s part of the reason why we’re constantly looking through the liquidity profile to make sure that they’re still trading.

As I look at the universe in the chart you’ve shown here, the portions of CLO liabilities where you are buying those IG-rated tranches at wider levels and high yield corporate bonds at wider levels than corporate investment grade corporate bonds—that’s a fairly interesting market. It’s not the largest and gives it a bit harder to trade than a corporate bond market. But those are very interesting.

As I think about loans versus bonds, on one hand, the credit quality is so much better in high yield than it is in leverage loans. We’re overweight high yield relative to leverage loans in the vehicles and products that do invest in both.

But our regular high yield fund doesn’t have loans or CLO liability. It’s a down-the-fairway US high yield fund. We’re buying high yield bonds in dollars. And companies are going to pay back when the money comes due—when the debt comes due.

At the end of the day, we have an up-in-quality bias in the actual loans we own because there is an underlying technical of B3 which could be really, really ugly if you start to see a wave of downgrades. But where we like taking risk would be in structured credit on the liability debt side. I think those are an asset class relative to some of the other pockets out there—ABS, CMBS—also more interesting we think.

But again, you can’t force the price. The valuations are the valuations. As we sit here in early June, spreads are just over 300 over the kind of long-term average, which sounds okay relative to the index being such high, so much higher quality today than it was for a lot of that average.

But I don’t want to mislead the audience here to say that the market is screaming cheap. You should be invested in it if you want to solve for short duration current income with low default rates that are well-rated, and it certainly carries less risk than some of the other cohorts of leverage finance. But by the same token, you’re playing for a coupon plus, which is still going to be, I think, high single-digit returns for the year.

So talk maybe for just a few minutes. Let’s talk about CLOs. You have the leverage loan market—CLOs have gained a lot of traction. We’re talking about leverage loans with about 14 to 15% exposure to software. Again, of course winners and losers. Don’t call that all 100% not good, not going concern business. But what is the impact or what are your mentioned concerns about the B3? And how can that structure either help navigate this or potentially amplify it in a very tail risk scenario?

How does the vehicle math work with ratings?

Or just, if you know, the majority of the loan market is owned by these CLOs, so it becomes kind of a layered, structured product on top of underlying leveraged loans.

If you start to see, again, this is getting very high—but seven, eight, nine, 10% of defaults. I’m not saying we would get there, but what’s the level of default you need to start seeing in the loan market?

Before we become—yeah, yeah. Before we get to 7 or 8% defaults, you are going to have a wave of downgrades which will cause problems for CLOs.

And again, this is not going to happen this year. We’re halfway through this year already. With the economy humming, it’s going to be very challenging to see some of these downgrades and defaults pop up. But to your point, your starting point on how many CCCs are in the loan market, how many B3 corporate family rating deals are in the loan market—how many? What capacity do they have before these vehicles, which are, and you mentioned it, CLOs, are about 70% of the loan market.

So if you’re 70% of the loan market and you own a B3 that matures in 2028 and they haven’t refinanced it halfway through 2027, you’re probably getting a little twitchy that there might be a problem, and everybody else that owns that loan is doing the same.

Right. So how many buyers do you possibly have that will take that down? And by the way, you’re competing with private debt outflows from private debt funds, which just put the gates up, that they’re trying to clear blocks of paper that may not have too far of a difference in terms of credit quality from what your B3 loan is looking like.

So the downgrade and the direction of travel really matters. What’s interesting is from in-text data that you see—the data that our liability PMSs will look at—there haven’t actually been much transactions or portfolios changing in CLOs around software like most managers haven’t really done much. Our team, I think, got all the fantastic job as the leads of our business in the US to get us to a good place in those vehicles where we haven’t had a problem in software. Others have, and I think they’re very well placed to invest on the winners there.

Sure, everybody’s saying that about their portfolio. But be interesting if we’re one of the few that actually made material changes in the vehicle in the portfolios. So when it’s all said and done again, I think the order of magnitude is going to be: is there a downgrade because there’s a downgrade to get refinanced in bond form and make the bond market a little lower quality, or does it cause problems for CLOs to your point? And when do the Triple Bs really start to price that in? Or is this purely something where you just know you’re very well covered because of the overcollateralization in those vehicles, which you are—that that ends up being a storm in a teacup.

And I actually think you’ll see some price volatility, but it is going to be more of that. Right. Like you’re not going to see large-scale impairments in those parts of the vehicle of a CLO because they’re so overcollateralized.

Awesome. Thank you, Tim. Incredibly insightful. And thank you for spending the time. Really enjoyed the conversation. Maybe just if I could end with a few quick answer questions for you. Don’t think too much about them, but I’m going to give you a few questions.

The first one is going to be at year end, credit spreads in high yield. What’s the level? What’s the potential range? You don’t want to stick to a level to hike, cut, or hold for the next Fed meeting. And number three, will there be data centers in space? Lastly, what is your biggest prediction over the next year relative to leverage finance?

Got spreads 25 wider and nobody knows as a price to stay the same. I think we hold at the next Fed meeting. I think we see a cut before we see a hike. I have no idea about data centers and space. Feels like a better question for someone else. And what was the other question?

The biggest prediction over the next year for your market?

That high yield outperforms investment grade.

Sure. Awesome. Thank you very much.

Great. My pleasure. Thanks for having me.