Preferred Stock For OXLC And Other CLO Equity Funds: Cheap Dividends

Summary

• Are preferred stock for CLO equity funds expensive leverage, or cheap dividends?
• Looking at OXLC's newly issued preferreds, the OXLCP's.
• The use of leverage, and in particular preferred stock, is a positive from the standpoint of the common shareholder.
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Author's note: This article was released to CEF/ETF Income Laboratory members on February 15, 2020. This article was co-produced with Alpha Male.

Preferred Stock: Expensive Leverage Or Cheap Dividends?

The main thesis of this article is to explain why issuing preferred shares as leverage benefits CLO equity closed-end funds.

Oxford Lane Capital Corp (NASDAQ:OXLC) made news when they announced they had priced a new preferred stock offering, raising ~$87.5mm by issuing preferred shares with a coupon of 6.25% (to commence trading within 30 days of 2/11/20 under the ticker: NASDAQ:OXLCP). Some people wonder why they’d do this as that seems to be expensive debt at a time when debt is relatively cheap. I’m here to say this was a good move by OXLC and should be viewed positively for OXLC management and OXLC common shareholders alike. As the title alludes, within the closed-end fund space some people wonder whether preferred stock issuances should be viewed as expensive leverage or a cheap distribution. My answer is ‘why can’t it be both!?’

For a fund like OXLC, whose distribution rate is much higher than 6.25% (currently ~17% to be exact), this move creates wealth for the common shareholders. Using the figures given to us by OXLC we know the fund earns ~16% on their CLO Equity positions, on average. With that in mind the fund is earning roughly 10-11% of “excess income” on that $87.5mm. That equates to ~$8-9mm annually that can flow to the common shareholders via the distributions. It’s this leverage that allows OXLC to pay such a handsome distribution rate to the common shareholders in the first place.

I view this issuance side-by-side with other financing alternatives and this one is the clear winner – let’s look the options:

• First, OXLC already uses reverse repurchase contracts (or “repo’s”) to obtain financing on some of their positions. According to the most recent Semi-Annual report dated 9/30/19 we see the fund had borrowed $35mm under this method, incurring interest at a rate of 3-month LIBOR +2.90% (which would equate to roughly 4.50-5.00% over the last year). But while this would appear to be the lowest rate and cheaper than the preferred shares they just issued this route has its limitations; namely, it subjects the fund to margin calls and additional clerical work for the fund due to either monthly or quarterly resets. If the positions drop in market value while you are borrowing against their value the counterparty is likely to ask for either more collateral or for you to paydown your loan (otherwise known as a “margin call”). These margin calls can be nuisances to deal with as they often pop up at a time when you may not have the cash on-hand, thus leading to sales of assets that you may not have wanted to sell on that specific day. On top of that it requires more day-to-day tracking/bookkeeping for the fund, which equates to costs. And because the positions being used to borrow against are considered highly risky and highly illiquid it requires a substantial amount of “overcollateralization” in order to borrow that $35mm – at 9/30/19 OXLC had to pledge positions they paid $92mm for in order to borrow that $35mm, (almost a 3-1 ratio!!) – you can see that going this route doesn’t get you very far. Overall using repo’s can help bring down the average cost of borrowing but you won’t be able to get all your financing from it.
• The next option would be to get a secured financing facility with a bank – the problem is that seems to be non-existent when a fund is made up primarily of CLO Equity. The fact that there are several closed-end funds in the market holding a majority stake of CLO Equity and none have bank financing should tell you one thing – no bank wants to loan against those assets. So this isn’t even an option for a fund like OXLC (or ECC or OCCI for that matter).
• Lastly, a fund can issue preferred shares. Preferred shares typically allow you to obtain a coupon rate much lower than what you’re earning on the assets you’re investing in and they allow you to increase your overall fund leverage (using preferred shares a fund can borrow up to 50% compared to 33% using a bank credit facility). Also, you won’t have to deal with margin calls or daily monitoring costs associated with repos. As long as the preferred stock coupon rate is reasonably close to the rate you could obtain through repos then this is a no-brainer. As previously alluded to, the coupon may be higher than the repo rate but it’s also substantially lower than the common distribution rate; therefore, it’s a win-win for all.

**I will mention I believe OXLC is not taking full advantage of the opportunities they have in front of them. Contrast what OXLC is currently doing (putting their CLO Equity positions on repo) with what a competitor fund is doing (Highland Income Fund (HFRO) putting CLO Debt positions on repo) and you’ll notice an even cheaper rate could be obtained by borrowing against these safer positions. Looking at HFRO’s 6/30/19 Semi-Annual report we see they’re borrowing ~$80mm using ~$100mm+ of CLO Debt positions and paying somewhere in the region of 3-month LIBOR + 1.40%, a full 1.5% cheaper than what OXLC is getting by borrowing against their CLO Equity. If closed-end funds are able to get cheaper borrowing rates and borrowing more on repo’s by using CLO Debt positions why isn’t OXLC using their ~$25mm of CLO Debt positions too? Definitely a questions I’d like to ask OXLC management but for now we’ll assume they have a reason.

Next, OXLC announced this week they’d be using ~$30mm of the proceeds to pay-down some of the old existing 7.5% preferred shares (the NASDAQ:OXLCO-OLD’s or the “Series 2023’s”, which represents a 1/3 paydown on the $90mm outstanding). This swap of $30mm at 6.25% (the new rate) instead of 7.50% (the old rate) will save the fund almost $400,000 annually and that savings amount will probably go up assuming they continue to paydown more of the old 7.50% shares. This move was expected as they told us they would be using a portion of the proceeds to pay down higher coupon preferred’s. As of now we don’t know if they will continue paying down more of the OXLCO’s but I would imagine they will chip away at the remainder over the next few quarters.

Overall I’m seeing a trend in the CLO Equity closed-end funds issuing preferred’s – they’re getting lower and lower. OFS Credit (OCCI) issued their preferred’s (OCCIP) at 6.875% a year ago and now OXLC has undercut that rate by a fairly wide margin. As I’ve mentioned previously it’s this fact pattern that leads me to believe Eagle Point Credit Company (ECC) will be looking to issue a new preferred offering themselves and pay down their 7.75% Series B (ECCB) within the next year. The current YTC (“Yield to Call”) of the Series B is around ~4% and will only keep going down as long as it’s still trading around $26.50. ECC also just used excess cash to pay down their Series A with the same coupon rate – definitely something to keep an eye on for any holders of ECCB out there.

Conclusion

Ultimately my view of leverage, and in particular preferred stock, is a positive one from the standpoint of being a common shareholder. In a scenario where you’re earning more than twice what you’re paying to finance the underlying positions that’s always going to be a favorable equation. To put it simply, if I’ve got $16 to split between two people and I can convince one guy to accept $5 (the preferreds) then the other guy gets the $11 (the commons).

Analyst’s Disclosure: I am/we are long THE STOCKS IN THE PREMIUM PORTFOLIOS. 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.