Oxford Lane Capital Corp. (NASDAQ:OXLC) is a highly levered collateralized loan obligation (CLO) CEF with extremely high concentration in the illiquid subordinated loan tranches of CLOs. We view this high-risk CEF, which incorporates three levels of leverage along with exorbitant management fees as the poster child for what went wrong in the collateralized mortgage obligation market in 2008. The likely high correlation among its top 5 holdings, which account for over 50% of its portfolio, means that in a period of distress in the high-yield market, investors are likely to experience a significant loss of principal.
What is a CLO?
A CLO is a structured product securitized by a portfolio of high-yield bank loans. It is structured in various tranches that have different credit ratings and interest rates with different priority claims on the underlying collateral. As one moves down in the CLO capital structure, the more susceptible to defaults the tranche becomes, and thus the riskier it is. The highest rated tranche of a CLO is typically rated AAA and sold to pension funds. This tranche is typically priced at Libor + 125bp and enjoy high default protection since the lowest tranche in the capital structure, typically the equity tranche will begin to absorb losses first.
Above the equity tranche is the subordinated tranche, which is the space that Oxford plays in. These tranches are highly speculative usually with ratings in the BB or B category with yield in the mid to high teens. If the underlying portfolio of loans begins to default, this tranche will quickly begin to experience losses.
How Does Oxford Calculate NAV?
Levels 1, 2, and 3 describe a company's assets based on the degree of certainty around the asset's underlying value. Level 1 assets can be valued with certainty because they are liquid and have clear market prices. At the other end of the spectrum, Level 3 assets are illiquid and estimating their value requires inputs that are unobservable and reflect management assumptions.
Level 1 securities are securities whose values are based on unadjusted, quoted prices for identical assets in an active market (examples include active exchange-traded equity securities, listed derivatives, most U.S. government and agency securities, and certain other sovereign government obligations). Level 1 assets can be looked up on a major exchange to determine price.
Level 2 securities are assets whose values are based on their quoted prices in inactive markets, or whose values are based on models - but the inputs to those models are observable either directly or indirectly for substantially the full term of the asset. Level 2 inputs include restricted stock, corporate and municipal bond most over the counter derivatives such as interest rate and currency swaps, mortgage-related securities.
Level 3 securities are assets whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management's own assumptions about the assumptions one would use in pricing the asset. Examples include private equity, residential and commercial mortgage-related assets, and CLOs. Level 3 assets trade infrequently. As a result, there are not many reliable market prices for them. Valuations of these assets are typically based on management assumptions or expectations.
100% of Oxford's investments are level 3. This means the NAV is determined via Oxford management's models using its assumptions as inputs. Ten different analyses by 10 different managers would almost certainly come up with 10 different values for NAV considering their own proprietary models and input assumptions. I'll leave it to the reader to determine if they believe Oxford would err on the side of caution when calculating its portfolio NAV.
Oxford's Top Five Positions
Given that Oxford owns a majority of the class in each subordinated tranche it owns, liquidity is low to non-existent at prices close to its modeled values. Five subordinated tranches comprise almost 60% of Oxford's portfolio. This high concentration means that only one investment needs to become impaired for CEF investors to lose substantial principal.
Three Layers of Leverage
Oxford's portfolio of CLOs is leverage upon leverage upon leverage.
The first layer of leverage inherent in the portfolio is due to the nature of the underlying collateral itself. High-yield banks loans, while typically secured, are usually part of the capital structure of highly levered junk-rated companies. These companies by their very nature use a high degree of leverage to generate returns.
The second layer of leverage inherent in the portfolio results from the tranches in which Oxford concentrates its investments. The subordinated tranches of CLOs that substantially comprise the entirety of Oxford's portfolio are leveraged investments themselves. They offer high returns in exchange for high exposure to default rates. These are among the first tranches to become impaired if the underlying collateral begins to experience defaults.
The third level of leverage results from the use of Mandatorily Redeemable Preferred Stock to further lever the portfolio.
It's easy to see how in good times this triple leverage will juice returns. However, in times of distress, this can lead to a significant loss of principal.
Are You Getting Compensated for the Risk?
Assuming Oxford's portfolio is priced at fair value or close by definition, investors in the CEF will never be paid the appropriate risk premium for the risk they are assuming. This is simply because the management fee of 10% is likely removing all of the alpha this portfolio can generate. This means that if an index of CLOs to which this CEFs return could be compared existed, the likelihood that Oxford would outperform this index is almost zero. In other words, any likely excess return resulting from Oxford's good management is being eaten up by fees.
Oxford's five-year total NAV return was 9.4% which means gross return was close to 20% before Oxford took its fees. Ouch!
Premium to NAV
Over the years, Oxford has traded at a significant premium to NAV reaching almost 22% in 2016. Over the past two years, it has traded at an average of roughly 8% to NAV. It currently trades at a slight discount to NAV of 2% as a result of a drop in market price after the company announced it was cutting its dividend 33%.
Given Oxford's net total return since inception and very high management fees, we believe it should trade at a substantial discount to NAV to compensate holders for the underlying risk. We would avoid this CEF and re-evaluate should its discount approach 10%.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.