Fair Oaks Income (FAIR) has announced its annual results for the year ended 31 December 2023, during which it provided an NAV total return for its 2021 shares of 12.98% (31 December 2022: -0.90%) and 13.82% per realisation share (31 December 2022: 0.5%). Share price total returns were stronger at 30.94% for the 2021 shares and 16.09% for the realisation shares. In comparison, the total return for the JP Morgan US leveraged loan index in 2023 was +13.17%, the JP Morgan US high yield total return was +13.77% and the JP Morgan US CLO B rated index returned +26.77%.
As at 31 December 2023, the company’s total market capitalisation was US$238.6m, comprising US$210.1m of 2021 shares and US$28.4m of realisation shares. During the year, the 2021 shares traded at an average discount to NAV of 11.71%, while the realisation shares traded at an average discount of 4.29%. FAIR declared dividends of 8.00 US cents for both the 2021 shares and the realisation shares during the year and the dividend yield for the 2021 shares was 14.5% as of the end of December. FAIR’s chairman, Richard Burwood, says that dividends during the year were well covered by distributions received by the master funds and that the quality of the master funds’ portfolio and the robustness of the CLO structure are evidenced by the dividend’s resilience.
Cash flows and dividends
The CLOs in which the master funds holds control CLO equity investments have experienced an annualised default rate since inception of 0.31% and had CCC and below exposure of 5.58% as at 31 December 2023, which Burwood says are both well below the market’s average of 1.79% and 7.09%, respectively. As a result of the strong fundamental performance of the portfolio, all CLO equity and debt investments made their scheduled distributions in 2023.
Portfolio review
As at 31 December 2023, the master funds held 19 CLO equity positions and 13 CLO mezzanine investments offering exposure to 1,430 loan issuers and 20 CLO managers. Control CLO equity positions represented 84.0% of the portfolio’s market value. While no new CLO equity and mezzanine investments were completed in 2023, the master funds have committed to the opening of a CLO warehouse investing in European broadly syndicated loans. Additionally, the master funds sold one mezzanine position during 2023, which was initially purchased opportunistically during 2020, achieving an IRR of 14%. The manager says that the active management of the portfolio was instrumental to allowing the master funds to de-risk while taking advantage of tactical market opportunities in 2016 and 2020, which generated efficient risk-adjusted and asymmetric returns.
The manager says that ESG considerations also impacted FAIR’s asset allocation. All control CLO equity investments (including reset and refinancings) completed since July 2019 have included ESG exclusion criteria in the CLO’s documentation. CLO investments subject to ESG investment criteria represented 76.8% of all CLO equity investments in the portfolio as of the end of 2023.
In Fair Oaks Capitals’ opinion, the focus on originating and controlling CLO subordinated note investments has resulted in superior fundamental performance. Lower fees in primary investments also allowed the construction of more conservative portfolios with no need to “stretch for yield”. It says that, as a result, the master funds have benefited from below-average exposure to sectors such as retail or energy.
According to the manager, while there is some variability in distributions from quarter to quarter due to differing payment periods, equity distributions in October 2022 and January 2023 were impacted by the mismatch between one-month and three-month LIBOR, as borrowers opted to benchmark loans to the shorter rate while CLO liabilities remained based on three-month LIBOR. Looking at the sustainability of these cashflows, the OC test headroom, which determines whether distributions may be temporarily diverted from the CLO Equity, remains covered, reducing the potential for any future cash-flow diversion, it adds. As it expected for certain US investments which have now exited their reinvestment periods, this headroom has declined in 2023. The average CLO equity test value is 4% above its threshold. Assuming 70 percent recovery in case of default, it would require in excess of 12% cumulative defaults to generate the par loss required to erode 4% headroom, before considering the positive effect of any cash-flow diversion.
US loan market update
The trailing 12-month loan default rate rose to 1.53% in the US (from 0.72% in December 2022). The US distress ratio (loans trading below US$80c, a potential indicator of the direction of future defaults) decreased from 9.59% in December 2022 to 6.36% in December 2023.¹
According to Pitchbook LCD’s December 2023 quarterly survey of market participants, the expectation is that the US loan default rate, at the end of 2024, will be between 2.5% and 3.0% in the US. Forecasts from rating agencies and bank research range from 3.0% to 5.0%.
There were net outflows of $17.3bn from prime loan funds in 2023, compared to $13.5bn of outflows in 2022.
At the start of 2023, loans maturing within the next two years represented a recent historical high of 5.9%, a proportion not seen since year-end 2012. Despite tightening credit conditions, loan maturities were successfully pushed out through ‘amend and extend’ transactions and alternative sources of capital – contributing to the lower-than-expected default rate at the end of 2023. The notional of US loans maturing in 2024-2025 has fallen from $273bn as of year-end 2022 to $93bn as of year-end 2023.
Private credit has competed for large refinancing transactions in the broadly syndicated loan market as a consequence of large capital inflows into the asset class. We believe this willingness to underwrite loans which were challenging to refinance in the broadly syndicated loan market has had a beneficial effect by creating a positive quality bias in the loan market.
European loan market update
The trailing 12-month loan default rate increased to 1.62% in Europe (from 0.42% in December 2022). The European distress ratio (loans trading below €80c, a potential indicator of the direction of future defaults) decreased from 9.91% in December 2022 to 4.32% in December 2023.
European loan default rate forecasts from rating agencies and bank research for 2024 range from 2.5% to 4.0%.
The average bid price of the Morningstar European Leveraged Loan Index was €96.02c at the end of 2023, compared to €91.34c at the end of 2022.
In Europe, the notional of European loans maturing in 2024-2025 has fallen from €61bn as of year-end 2022 to €13bn as of year end 2023 (Figure 2.19). The proportion of loans due in the next two years is lower than that at the start of 2023 (4.7% vs 8.2%) largely due to a similar dynamic observed in the US, as the loan market addresses near-term maturities through ‘amend and extend’ transactions and alternative sources of capital.
US CLO market update
US primary CLO new issuance was $116bn in 2023, compared to $129bn in 2022. 2023 refinancings and resets totalled $5bn (14 deals) and $20bn (43 deals), compared to $5bn (12 deals) and $20bn (35 deals) in 2022. Forecasts for CLO new issuance in 2024 are $110-115bn and forecasts for refi/reset volume are $40-50bn.
European CLO Market Update
The European CLO market saw new issuance of €27bn in 2023, which is the same level of issuance as in 2022. 2023 refinancings and resets totalled €0bn and €2bn (5 deals), compared to €2bn (5 deals) and €5bn (11 deals) in 2022.⁵ Forecasts for European CLO new issuance in 2024 are in the range of €25-30bn and forecasts for 2024 refi/resets are €8-10bn.
CLO issuance in Europe was unexpectedly high given the unattractive CLO arbitrage during much of 2022 and 2023. This can be attributed to existing managers using previously raised captive equity funds to support CLO issuance and a high number of new managers entering the market. The tightening of liabilities over 2023 has created a more constructive outlook for CLO issuance in 2024 as CLO equity returns look more attractive.
Given the relative value and operational simplicity of CLOs, it is believed that investor interest in CLO debt will continue to support demand. Whereas CLO notes can be settled on a T+2 basis using Clearstream or DTC, loan settlements are challenging and can be subject to long delays.
Outlook
FAIR’s manager believes that the company and the master funds are well positioned to generate attractive risk-adjusted returns in 2024, citing the following:
- Stable and attractive dividend yield: current dividend yield of 14.5%.
- Interest rate expectations: Fed and ECB rate cuts may support investor demand for risk assets, potentially supporting CLO liabilities. The potential for lower CLO financing rates will support new CLO equity investments and the optimisation of the capital structure of existing CLO equity investments.
- Existing, high-quality portfolio: all CLO equity and debt investments made their scheduled distributions in 2023.
- Strong sourcing ability: the master funds benefits from strong, long-term relationships with CLO managers, including preferential access to Fair Oaks Capital-managed CLOs.
- Structural advantages: supported by a rigorous valuation policy and fixed life of the master funds.