The 10-year Treasuries hit a new high for 2016 last Thursday, and there seems to be less and less doubt among market participants that the era of ultra low interest rates is finally coming to an end. And when rates rise, people start worrying about fixed income prices and how those will be affected by the new macro environment. Some, worried about capital losses, choose to leave the fixed income field altogether and others, who stay, want to know what interest risk they are taking on. Naturally, duration as a metric of interest rate sensitivity jumps up in importance and I, like many other fixed income traders, have been wondering how it will affect my universe of tradable securities.
A big chunk of the securities I trade are preferred stocks, and in a recent article, I wanted to address the general dislike for those instruments in a rising interest rate environment due to their high duration. The article focused on a subsection of preferred stocks called term preferred stocks that actually have a predetermined maturity date and are much closer to bonds as a financial instrument than they are to traditional preferred stocks. I also made a promise in that article that I am going to take a deeper dive and review some of the term preferred stocks in greater detail, and this article is a way for me to owe to that promise.
In the following paragraphs, I will be focusing my attention on three instruments issued by the same entity - Eagle Point Credit Company (NYSE: ECC). The securities in question are the 7.70% Notes due in 2020 (NYSE: ECCZ), the 7.75% Series A Cumulative Term Preferred Stock due in 2022 (NYSE: ECCA) and the 7.75% Series B Cumulative Term Preferred Stock due in 2026 (NYSE: ECCB). Before I review each of the instruments in more detail, however, let me look at a brief look at the parent company.
Eagle Point Credit Company
ECC is a company that invests in equity and junior debt tranches of collateralized debt obligations (CLOs). The primary investment objective of the company as defined by the management itself is to generate high current income and that is clearly visible from the high payout ratio of 127% that the company has commanded in 2015. ECC's revenue model revolves around earning interest on its holdings and expenses are mostly in the form of different fees that include: 1) an incentive fee paid to an advisor for his day-to-day management and advisory services; 2) a management fee is paid to that same advisor at the rate of 1.75% of the "total equity base" defined as the net asset value attributable to common shareholders 3) administration fee which is paid to a subsidiary of the company's advisor which is responsible for performing various reporting services. Part of Eagle Point Credit's expenses is also in the form of dividends on its preferred stock and interest on its debt instruments. A snapshot of the company's financials as of the date of the last mandatory filing could be seen below:
Source: Company's webpage
Let's now look at the company's portfolio of assets as it is the main driver behind ECC's profitability. Below you can find a distribution of the portfolio's underlying assets by rating and by maturity.
Source: Company's latest investor presentation
In terms of underlying obligators and industry exposure, the picture looks like this:
Source: Company's latest investor presentation
Bear in mind that the company does not have a direct holding in these securities but actually invests in the equity or junior debt tranches of CLOs on those securities.
A key strength of CLOs is that the debt is committed for the life of the transaction. The debt covenants in a typical CLO are based on cash flows, not market values, and thus, the market price of the underlying loans does not impact the covenants of the CLO. The only thing that matters is whether the underlying debt is paying interest.
How is this impacting ECC's revenue model? Well, since it is investing heavily in the junior debt tranches and equity tranches of the CLOs, that means whenever underlying securities stop paying interest and go into default, the first to take the hit are companies such as Eagle Point Credit. You can see below what actually happened to equity holders in CLOs during the Great Recession:
Source: Bain Capital
For a whole year, equity holders in CLOs did not receive any distributions. At the same time, however, those CLOs did not go bust, but actually increased their holdings, buying debt at heavily discounted prices. That's why when markets started to cool down and bounced back from their lows, the CLO distributions for the equity holders were actually higher than they used to be before the recession.
Bear in mind, however, that the recession of 2008/2009 was somewhat unusual as lots of companies went in the recession with strong earnings, high interest rate coverage ratios and low debt to equity ratios. That's why the level of defaults was significantly lower than it used to be during the dotcom crash and the recession in the '90s. The V-shaped recovery of financial markets and the quantitative easing programs in Europe and the US also helped to ease the pressure on credit markets. The next recession, however, might not be as forgiving.
As of December 31, 2015, the instruments used as collateral in the CLOs that ECC holds were trading at close to 77% of their original cost. After the first three months of 2016, the loans were trading even lower, at 75%. That, however, had little impact on Eagle Point Credit's profitability, as the company is holding loans to maturity through CLO vehicles. On the contrary, the dip in credit prices allowed ECC to increase its asset exposure at favorable prices and reap some benefits in the way. That is visible by the uptick in the ratio of interest fees to average assets at acquisition cost, which rose from 15.8% at the end of 2015 to 16.9% in Q3 of 2016.
So, in summary, if I have to sum up how Eagle Point Credit does business, it would be like this: Borrow at the capital markets at a cost of debt of 7.75% (the nominal yield of the fresh new Series B issue), buy junior debt or equity tranches of CLOs that have a current yield of 16.9%, pay different fees for managerial and administrative services, pay interest on your debt and dividends on your preferred stocks and distribute the profits to your common shareholders. Collect principal from maturing tranches and invest it in new ones. Default rates are currently low, so you don't have to worry too much about decreasing flow of interest income. Market fluctuations do not concern you as you are holding to maturity. Looks quite nice to me.
What are the pluses and minuses of the business model?
First, you have limited exposure to interest rate risk as CLO facilities hold to maturity, and even during the Great Recession, default covenants were not triggered for such facilities as is visible from the table below. So you are essentially bearing the credit risk of the underlying portfolio, amplified by the fact that you hold the most junior tranches of it.
Source: Bain Capital
Second, the margin between cost of debt and interest income in normal market conditions is hefty and allows you to generate decent profits.
First, high default rates in the underlying portfolio could completely dry up the interest income and leave you with practically no revenue.
Second, the high payout ratio makes you vulnerable to changes in the macro environment.
Third, reliance on outside financing for growth and working capital needs. Debt cannot expand forever, and taking on more of it makes you even more susceptible to a credit crunch.
Despite the minuses listed above, the business model of ECC has some attractive features, so I wanted to see what will happen to the company in a typical recession scenario. As a holder of a preferred stock or a debt security in ECC, I want to know when my investment will be in danger of not paying interest or dividends or, even worse, not paying its principal. A recessionary scenario is worth considering before I even consider putting my money on the line. So what happens when the music stops?
I showed you already that underlying assets behind CLOs declined to 77% of their original cost at the end of 2015, so in a real recession, I believe that those same loans could be trading as low as 40%. That fact, in itself, does not worry me too much, however, because loans in CLO structures are held to maturity. One more note before I carry on - in the following writing, I will be assuming that no CLOs will actually go into default, which is not an unrealistic assumption, given what I showed you in the table above.
Now, the decline in market value of the collateral could actually have a positive impact on Eagle Point Credit, at least in the short term, as the management fees ECC is paying would be reduced. Assuming asset growth rate of 15% over the next 3-4 years, which is below historical growth levels, I come up with a range for management fees in a recessionary environment of $2.5 million to $4.4 million. A similar calculation for the incentive fees leads me to a range of $3.5 million to $6.2 million. I assume that administrative fees, professional fees, directors' fees and other expenses would be growing at the rate of assets, so I come for a range for all of them of $2.9 million to $5.1 million. So, in total, expenses before interest on debt and preferred stock would be in the range of $8.9 million to $15.7 million. Add to that the dividends on the preferred stock and the interest on the debt, which total $10.1 million and you have expenses of between $19.0 million and $25.8 million that ECC has to handle.
For the revenues, I am expecting that if a recession hits, the interest income would completely dry up as it did in 2009. What about other sources of cash such as maturing CLOs? What would happen to them in a recession? Currently, the average CLO ECC holds is overcollateralized by 4.27% and in the recession of 2008/2009, the default rates of speculative grade issues were close to 13% as seen in the chart below.
Loss given default for speculative grade securities was around 8% - close to double the level of overcollateralization. Since in a typical CLO today, the equity usually represents the lower 10% of the capital structure, in a recession, I expect Eagle Point Credit to incur losses of 30-40% on its maturing CLOs. Is this bad - yes. But it also means that there will be some cash coming in the company even during recession and that cash could be used to pay interest and dividends on the outstanding securities. This is something that makes me more comfortable when I am considering an investment in the ECC's notes or preferred stocks.
Just to put some numbers behind my logic above. In the first three quarters of 2016, Eagle Point Credit had close to $100 million of principal maturing, so if we assume losses of 35% on those assets there are still $65 million remaining to pay interest, preferred dividends and operating expenses, if the recession were to occur immediately. That is more than enough compared to the $19 million-$25.8 million we calculated before.
OK, seems like ECC will have enough cash to handle its interest and dividend obligations, while also covering its operating expenses. But what about principal?
I would assume a fire sale in the middle of the recession at market prices that imply capital losses of 50% of the equity holdings in the CLO structure. At current levels of assets on the books, that results in cash from the sale of $182.4 million. On top of that, Eagle Point has $26.2 million in cash. I am not going to consider other assets and liabilities as they pretty much balance each other. So, that means in a fire sale, ECC would have $208.6 million in cash to satisfy debt and preferred stocks of $135 million. It is not great, but it is good enough for me. It even leaves me enough cash to cover interest expenses, preferred dividends and all the other operating expenses I enlisted above.
The three brothers
Up until now, I wanted to see the fundamentals of Eagle Point, so I can figure out what credit risk I am taking on when I am buying any one of its securities. As it turns out, under current circumstances, the company seems to be well capitalized, so I am not too worried about credit risk. What about relative value then? In the table below, you can find some metrics about the two preferred stocks and the notes that would help you put them all into perspective.
Source: Author's spreadsheet
All securities are trading above par even after the current surge in interest rates, which seems to indicate that I am not the only one thinking that ECC looks like a sound and well-capitalized company. Of the three issues, ECCB is the youngest, just a couple of months old. It matures in 2026 and bears a nominal yield of 7.75%. I see this as a good indication as to what the cost of debt of ECC is over the 10-year part of the curve. Since ECCA is maturing earlier than ECCB, in 2022, and at the same time, bears the same interest rate as ECCB, I would assume, given upward sloping yield curve, that ECCA is likely to be called at its call date in 2018 and be substituted with a lower-yielding security. So, in the case of ECCA, I am going to use the yield to call as the relevant metric for my analysis. Same goes for ECCZ, even though it ranks higher in the capital structure than the other two securities. The notes are trading above par and the yield to call is 5.65%.
I like ECC from a fundamental standpoint, and I am not too afraid of going down the capital structure, if there is no danger of more debt being issued ahead of me. ECCZ does not have any covenants precluding such issuance, and as I already mentioned, the business model of ECC revolves around borrowing and buying more assets, so a new debt issue is not out of the question. The only limitation that ECC has to abide by in terms of its indebtedness is the one imposed in the 1940 Act regarding asset coverage ratios. According to that act, the asset coverage ratio could not fall below 300% with respect to senior indebtedness and below 200% with respect to senior indebtedness and preferred stock taken together. At the moment of the last quarterly filing, those two ratios were 595% and 263% respectively. There is some room for additional indebtedness, as you can see, but not much. In my estimate, it is a little over $40 million. What happens if any of the ratios are broken? In case the first ratio is breached, all the notes become redeemable at once, and in case the second one is breached, all the preferred stocks become redeemable.
Two things to consider here. First, what happens if the market value of underlying assets declines and the asset coverage triggers a redemption. For that to happen, asset should start trading at 76% of their original cost. That scenario is not that far-fetched as such an event already occurred in the beginning of 2016. Which ratios are going to be broken in that case? The answer is the 200% asset coverage ratio. And which securities are going to get redeemed if we breach the 200% asset coverage covenant? The answer is the preferred stocks. Not all of them, but the amount necessary to increase the ratio above 200% once again. ECC, however, has the option to actually buy more shares so to increase the asset coverage ratio to 285%. In this case, bondholders will have to wait in line to get their money.
Second, what is stopping ECC from purposefully breaking the 200% asset coverage ratio in order to refinance its outstanding preferred stocks prior to their call date. The answer is nothing. And in that case, bondholders would also be left hanging.
So what yield should an investor expect, if ECCA or ECCB are redeemed prior to their call date? It depends when the actual redemption will occur. Below is a chart comparing yield to call for ECCA and ECCB depending on the date in which a redemption could potentially occur.
Source: Author's spreadsheet
As you can see, negative yields are quite possible if the redemption occurs before May, 2017.
In the end, what is really better - the preferred stocks or the notes? With the preferred stocks, you know that if things start to go south, you have a high chance of being redeemed ahead of the bonds, but you might also realize a negative yield in that case. If, however, you don't get redeemed, you could be looking at higher yields, but with corresponding higher maturities as well. Personally, I do not like that scenario. With the bond, the most likely scenario is for you to realize the yield to call. Even if the recession scenario unfolds, chances are that you are still going to get your money back.
To sum up, of the three securities, the notes look the most attractive security to me. Moreover, the call date for the latter is in one year's time and the nominal yield on the issue is 7%, paid quarterly. Both these features are extremely valuable in a rising interest rate environment. What about the preferred stocks? Should you short them? At this point - no. But I will be monitoring the credit markets, and in any sign of weakness, I would consider opening a position in ECCA or ECCB.
Now, if you are looking for an investment, you have to decide for yourselves how a yield of 5.65% for a one-year investment sounds to you. Does it compensate you well for the risk you are taking on? I myself, am liking it. Fundamentals seem strong and coverage is also nice. And 5.65% yield for a one-year holding is quite generous in the current low yield environment.
In this article, I wanted to take a look at Eagle Point Credit in more detail and see how I can trade its securities. Some covenants in the prospectuses of the preferred stocks and the notes completely change the dynamic among the instruments. That just goes to show you how important it might be to read in detail any documents accompanying the securities you trade with or invest in.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ECCA, ECCB, ECCZ, ECC over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.