Voltas' (NS:VOLT) performance in recent months was influenced by weaker market sentiment towards the end of 2018, which (despite the subsequent rebound) translated into a marginal (c 1%) negative return in H119 ending on 31 January. Returns in February and March were mildly positive, bringing the ytd performance to 4.0%. Importantly, the cash flows generated by Volta’s portfolio remain strong. Moreover, AXA IM used the recent increase in market volatility to deploy the rest of Volta’s dry powder and increase its exposure to CLO equity tranches at attractive prices ahead of any potential turn in the credit cycle.
Investment strategy: Active approach to credit cycle
Volta aims to provide a stable quarterly dividend stream based on a diversified portfolio of structured finance assets, in particular CLO debt and equity tranches which made up c 83% of the fund’s portfolio at end-March 2019. The dividend payments are currently well covered by interest and coupons from underlying assets, which reached €19.6m on a six-month trailing basis at end-March 2019. AXA IM follows an active approach to the credit cycle and seized the opportunity to deploy the remaining cash during the recent market downturn (it is now fully invested), sourcing new investments with projected IRR of 12.7% in H119. At end-March 2019, CLO equity tranches (including capitalised manager vehicles and warehouses) made up 43.3% of Volta’s portfolio, compared to 24.0% a year ago.
Market outlook: Default rates remain low for now
The recent deterioration in market sentiment resulted in an increase in credit spreads (affecting the market prices of CLO tranches), although the spike was partially reversed this year. Corporate default rates remain close to historical lows, assisting cash flows from underlying loan pools. However, this is accompanied by a weakening quality of loan collateral (with the share of covenant-lite loans as high as c 80%). In this context, a good selection of CLO managers (on top of market timing and exercising CLO control measures) remains an important factor determining future returns.
Valuation: Offering a c 8.9% dividend yield
Volta Finance is a research client of Edison Investment Research Limited
At 7 May 2019, Volta’s shares traded at a 12% discount to last reported NAV (as at end-March 2019). The fund has consistently delivered a dividend per share of €0.60–0.62 pa and offers a c 8.9% dividend yield.
Fund profile: Leveraged exposure to corporate debt
Volta Finance is an investment fund registered in Guernsey and listed on both the Euronext Amsterdam Stock Exchange and LSE Main Market. The fund aims at preserving capital across the credit cycle and delivering a stable quarterly dividend stream through investing in a diversified portfolio of structured finance assets, which provide leveraged exposure to portfolios composed of a broad range of cash-generative debt assets. These include corporate loans, sovereign and quasi-sovereign debt, residential and commercial mortgage loans, automobile loans, student loans, credit card receivables, leases, as well as debt and equity interests in infrastructure projects. However, more than 90% of Volta’s current exposure represents corporate debt. Importantly, Volta’s exposure to second-lien loans is capped at 10% of gross asset value (GAV).
Volta does not declare a particular target return pa, but has highlighted in its monthly reports back in 2016 that it aimed at a return of 9–11% pa (although it also added that this was only an indicative target for information purposes only). This is confirmed by the recent statements of the investment manager in the FY18 and H119 reports, that Volta was able to source investment opportunities in line with target levels at a projected yield of 11.2% and 12.7%, respectively. To achieve its investment goals, Volta is primarily investing in CLOs, synthetic and cash corporate credit and asset-backed securities (ABS). For an in-depth description of the structured finance instruments in Volta’s portfolio see our initiation note.
The fund manager: AXA IM
The manager’s view: Harvesting the volatility
For the next six-month period ending July 2019, AXA IM remains optimistic that Volta should deliver returns at or above target. This should be driven mainly by ongoing cash flows generated by assets as well as some appreciation on portfolio components given that current asset prices in Volta’s portfolio are visibly below par. Although the investment manager acknowledges that we are most likely approaching the end of the credit and economic cycle, it does not foresee any significant deterioration in the coming quarters. Potential risk factors that could translate into higher volatility include US administration, the continuous increase in corporate debt and the difficulty in finalising the Brexit deal. However, AXA IM does not expect a disorderly Brexit to translate into material losses for Volta, as currently its exposure to UK market is limited to 6% of underlying credits.
Volta’s performance should be assisted by: 1) high portfolio diversification (more than 700 underlying corporate credit issuers); 2) a healthy level of cash flows from currently held assets, which may be reinvested at discounted prices in the event of increased market volatility; and 3) a combination of long-term assets that may be held throughout the whole credit cycle (CLO equity tranches with long reinvestment periods) and short-term, liquid positions (eg some of the CLO debt tranches). AXA IM also notes that maturity and credit curves are very steep (the same rating assets are yielding far more with a long maturity than with a mid- to short-term maturity), which illustrates the high level of investor caution with respect to capital deployment. This limits the risk of an extreme rise in volatility and encourages AXA IM to deploy cash at depressed prices. As at end-March 2019, Volta is fully invested.
Strategically, AXA IM intends to continue increasing the CLO equity bucket and correspondingly to decrease the CLO debt bucket over the next six months. With the expected decrease of the CLO debt bucket, AXA IM might also further reduce the leverage in place on CLO debt tranches at some point. In aggregate, the investment manager will target a reduction in the number of positions, favouring ‘controlling positions’ to increase the value that can be added from deal restructuring (refinancing/resetting/calls/repackaging). CLO warehousing transactions are part of this strategy.
Market outlook: Lower prices create opportunities
Global markets experienced elevated volatility in recent months, both in equity and credit markets, and also translated into lower valuations of structured finance instruments. The spreads on US AAA debt tranches widened to a two-year high of 138bp in February and remained at similar levels in March, according to Refinitiv. However, the levels seem to be acceptable for equity tranche investors, as there are still CLOs being set up with US$39.4bn sold ytd until 19 April in the US, which is even slightly ahead of the US$38.7bn in the same period of 2018. On the back of recent issues, the US CLO market crossed the record-high US$600bn mark. At the same time, the wider spreads dampened the refinancing and reset volume (Q119: US$9.1bn, -71% y-o-y).
However, concerns around a slowing economy and political turmoil were not accompanied by higher corporate default rates, which have remained at low levels over the last 12 months in both the US and the European loan markets. According to Moody’s, the default rate in advanced economies fell to 1.6% in 2018 from 2.3% in 2017. This creates an opportunity to invest in CLOs at lower prices to facilitate par building while retaining the solid cash flow profile of the portfolio. Nevertheless, we are wary that we may be approaching the end of the credit cycle and at some stage default rates are likely to increase. Some assurance in the future performance of Volta’s assets is provided by the fact that projected returns and valuations assume default rates at 2% pa, which have not been seen in the portfolio over the last 10 years, and that Volta’s positions experienced default rates below the market average on an LTM basis.
Although the Q418 uptick in credit spreads was rapid and led to some disruptions in the market (eg difficulties in converting some of the warehouses into CLOs), they remain at historically low levels. US high-yield credit spreads reached a local peak at 535bp (523bp in Europe) at the beginning of 2019 (visibly below peak levels from early 2016) and have been narrowing recently. Currently, high-yield credit spreads stand at around 375bp in the US, and 363bp in Europe. Even though we acknowledge that high-yield bond spreads may exhibit some differences versus corporate loan spreads (which are relevant to the structured finance products in which Volta invests), we still believe that they are a good illustration of the general trends in the credit markets.