Recently we've released a series of articles focusing on the CLO sector. This sector is filled with myths, falsehoods and a general lack of understanding by retail investors and many market analysts. We've actively debunked these myths and put forward various securities that provide exposure to this sector. Today we're pleased to provide a general sector update as we continue our coverage.
Common Questions About CLOs
We've answered these questions many times in various articles but I wanted to put some of them here, right at the top so new readers can have them nailed down before we delve farther.
"Didn't they cause the Great Financial Crisis?!"
No. In our original article we tackled this misconception, but it continues to be repeated by readers and SA contributors who lack a complete understanding of CLOs. As before we noted that Voya expressed the success of CLOs in the financial crisis as follows:
CLO debt and CLO equity were tested through a market cycle that included the biggest financial crisis since the Great Depression. Investors who held their CLO investments through the 2008–2010 period were rewarded with strong IRRs... equity tranches returned a median IRR in the mid-teens, B-rated tranches returned a median IRR in excess of 10%, and BB-rated tranches returned 6%–10% depending on the vintage.
We'll remind that this means that CLO equity tranches out performed vs. the S&P 500 during that same time frame of over 24%.
"CLOs are just like CDOs!"
Again this is a common misunderstanding. CDOs are collateralized debt obligations and did cause the GFC. CLOs are made up of senior secured loans. CDOs are comprised of any type of debt. CBO or collateralized bond obligations are made up of junk bonds. Out of all of these, CLOs performed the strongest in the GFC and are the only real asset type from that period that continues to exist in strength. CLOs have strong regulatory oversight and are not filled with worthless loans. Eagle Point Credit (ECC) with a yield of 14.2% for example owns CLOs that Dell (DELL) took out. Senior secured loans are generally below investment grade loans and are often made out to many well-known companies.
"The Equity Tranche will die in a Recession! Its TTTOOOO RIIISSSKKKYYYY!!"
Risk is a judgment call by every individual. However, equity tranches saw strong price depreciation during the GFC. They still continued to receive their payments. The equity tranche is often viewed as "highly leveraged" and CLOs are "highly leveraged assets," this saying is often misunderstood as to how an equity tranche works. Let's not call a CLO a CLO but a company we love instead. Company ABC offers various bonds and some preferred shares. The bonds are secured or backed by the company’s assets and the preferred shares are used to provide additional collateral for the bonds.
So ABC gets money, they pay out their income like this:
- AAA Bonds
- BBB Bonds
- CCC Bonds
- Preferred shares get all the extra
The preferred shares get paid after everyone else - just like a normal stock on the market functions if it has no common stock or doesn't pay a common stock dividend. So when Annaly (NLY) pays its preferred shares before its common stock but after its other debts - no one panics. NLY has a bundle of loans that generate income in which it pays out to its various debts and equity. A CLO functions similarly. CLOs technically are a company with external management. CLOs offer bonds - called debt tranches - and preferred shares - the equity tranche. Yes, the equity tranche technically is not backed by the loans that collateralize the CLO and actually function as a means of leverage to purchase additional loans. The equity tranche does not get whipped out if the CLO loses 10% of its value since the preferred shares aren't redeemed and the safety levers in a CLO protect it.
Also, CLOs are typically leveraged "10x." This doesn't mean that the CLO has $10 of leverage for every $1 invested, but that the equity tranche is equal to 10th of the CLO debt tranche values. This means a $500 million worth of debit tranches has an equity tranche worth $50 million at start up for a total CLO value of $550 million. Than $550 million worth of loans are purchased, over-collateralizing the CLO's debt tranches, providing a cushion for the CLO in case of defaults.
So yes a CLO does have risks, but actually is less risky than hold a single senior secured loan. The equity tranche is not backed by the loans in the same manner as the debt tranches and thus isn't eliminated if 20% of a CLOs loans default.
CLO Equity Tranche Values
In our previous articles we highlighted that CLOs have seem depressed values since the December market action. Oxford Lane Capital (OXLC) with a yield of 16.2% reports their NAV quarterly and ECC reports estimates monthly and audited numbers quarterly. Both have reported 03/31/19 numbers which saw a clear rise from December - ECC reported an additional rise in their April numbers.
Net asset value (“NAV”) per share as of March 31, 2019 stood at $8.32, compared with a NAV per share on December 31, 2018 of $7.56
ECC reported a rise to $13.70 per share from $12.40 per share in December. Their un-audited April NAV numbers again reflect a further rise in value to $14.38 per share.
During OXLC's earning call, their portfolio manager Deep Maji stated:
However, the market continued to lag the broader market, and as such, according to Wells Fargo CLO research, the median U.S. CLO equity net asset value is estimated to be 48.1% as of April 1, 2019, which remains approximately 30 points below October 1, 2018 level of 78.2%.
CLO equity values have risen from being all-time lows, but still have plenty of upside left to achieve their previous values. As the market for CLOs continues to normalize, ECCs and OXLCs NAV should continue to rise.
Cash Flows Continue to Increase
Cash flows is the number one way to determine the success of a CLO investment. If the funds like OXLC or ECC, and even XAI Octagon Floating Rate & Alternative Income Term Trust (XFLT) with a yield of 9.3% see rising cash flows. They are covered their distributions. ECC included a very handy slide in their earning release to show how well their cash flows are covering the distribution and expenses:
Source: ECC Earning Slides
When it comes cash flow, ECC is seeing its ability to pay its expenses and distributions increasing.
OXLC also saw improvement:
Source: OXLC Earning Slides
XFLT reported improved cash flows in their semi-annual report, reporting six months ending on 3/31/2019:
Net Investment Income: $3,781,209
XFLT is strongly covering its conservative distribution - and this lead to its increasing the distribution.
All of these funds benefited from the December lows. ECC opportunistically invested in new equity tranche positions that had an average yield of 15.88% vs. their average portfolio yield of 13.58%. This is extremely positive for them. OXLC and XFLT actively invested in CLOs during this time - while the value of CLOs were depressed their cash flows did not stop meaning like a mispriced preferred that we have at different times captured at HDO the yield was significantly higher than normal.
Reaffirmed Resilience of CLOs From December
ECC's CEO described December’s volatility with regard to their overview of various CLO managers like this:
The fourth quarter was a little bit of like a rehearsal dinner perhaps for whenever more significant volatility comes... This was a small period of time, you kind of have six to eight weeks of opportunity and we’ve reevaluated and evaluated frankly all of the major collateral managers in our portfolio... So, we generally saw a good performance. If you line up the collateral managers in our portfolio to a research report published by Wells Fargo, related to the CLO market broadly, you’ll see quite a few, they ranked collateral manager performance, I believe during the fourth quarter. You’ll see quite a bit of overlap of names in our portfolio and names that were on the, their top 15 list.”
ECC's management proactively reviewed their CLO positions and most importantly the managers who managed them. They liked what they saw. During that time the managers with whom ECC is invested in were proactive to build value in their CLOs. How strong is the CLO market given the recent volatility? They shared thoughts on this also:
From our perspective, as long-term CLO equity investors, an environment of technically driven loan price volatility without an increase in defaults over the near-term to medium-term is extremely attractive.”
Default rates for senior secured loans in hit lows that haven't been seen in years - showing continued strength in this market. OXLC's management explained it this way:
U.S. loan default rate remains low. According to Leveraged Commentary and Data, also known as LCD, a service provided by S&P Global, the S&P/LSTA Leveraged Loan Index trailing 12-month default rate is approximately 0.93% by principal amount, which is the lowest level in nearly seven years and remains well below its historical average of approximately 3%, according to LCD. The loan maturity wall continues to be termed out. According to LCD, there are approximately $90 billion of loan scheduled to be repaid by year-end 2021. This aggregate amount represents less than 10% of the overall size of the S&P/LSTA Leveraged Loan Index.”
ECC and OXLC both assume a 3% default rate on their portfolios. This assumes that in the end their CLOs will not return 3% of their original principle - not including all the interest received.
So a nine-year CLO equity tranche yielding 15% would generate $13.5 million on a $10 million equity tranche. Than the assumed 3% of principal loss would mean you would receive $9.7 million at closing. This provides a total return of 132% after nine years. This is why equity tranche positions even with the assumed 3% default are high income generators. Right now, the rate is 0.93% - extremely low. So December’s price action devalued the sticker price of the loans - not the productivity of them.
To further understand that CLOs are recession resistant, consider Ladder Capital Corp's (LADR) new CLO investments. Management has invested in AAA rated CLO debt tranches as a bulwark to future lower rates.
Brain Harris, CEO of LADR, explained their view this way:
On a relative value basis, we've been able to acquire AAA CLO paper at yields that, in our opinion, would make those liquid safe investments with 50% subordination much more attractive rather than owning the whole loanat LIBOR plus 300.”
LADR's CEO isn't alone in looking to CLOs as a safe investment to bolster a portfolio. Japan's national banks have been buying AAA rated CLO debt hand over fist the last few years. Japan's Agricultural Bank holds $61 billion worth of AAA debt tranches alone. They understand the recessional resilience of their positions.
Looking at the CLO market and the senior secured loans comprising them. We can walk away with an understanding that:
- CLOs remain undervalued versus normal market valuations.
- NAV's should continue to rise as CLO levels normalize.
- CLOs continue to prove to be recession resilient investments.
- The sticker price drop did not correspond to a higher default rate in the loans.
- CLO managers performed strongly and intelligently in the recent pricing change.
OXLC, ECC and XFLT remain strong buys and investors should consider one or all three of them for their portfolios based on their risk tolerance. "High Dividend Opportunities" currently contains all three of these choices in our model portfolio and will continue to hold them for their income generation. This is exactly what CLOs are designed to do, and their high yields are strongly covered, and this is why we are invested in these three super high yielders as part of a highly diversified income portfolio.
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Disclosure: I am/we are long OXLC, ECC, XFLT, LADR, NLY. 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.