Oxford Lane Capital: A Look At The Preferreds Post Results
- OXLC has reported financial results for its last quarter, and we take a look at asset coverage implications for its preferreds.
- OXLC preferreds are trading at substantially higher yields than the ECC preferred, likely owing to their lower asset coverage; however, we find the yield differential excessive.
- We like OXLCO within the stack as we would expect it to be repurchased on further NAV stress.
- Overall, we still find value in the ECC baby bonds for their 9% yield and estimated 340% asset.
- This idea was discussed in more depth with members of my private investing community, Systematic Income. Get started today »
The CEF preferred stock sector is, on average, one of the safest; however, the average hides a lot of variation. In addition to having well-behaved CEFs with high asset coverage, it also boasts extremely volatile CEFs with low coverage such as a number of CLO funds. These funds have taken a beating over the last few weeks due to a drop in loan prices, rising CLO equity discount rates and credit downgrades. In this article, we consider the implications of the current market environment on these funds and take a look at the Oxford Lane Capital Corp. (NASDAQ:OXLC) preferreds. We also compare them to the Eagle Point Credit Co. (ECC) preferred and baby bonds.
Our takeaway is that the OXLC preferreds are trading at significantly higher yields than the ECC preferred which is likely due to their lower asset coverage although a 2-3% advantage seems too high. Within the OXLC preferred stack, we like OXLCO which is likely to be the first series to be repurchased or redeemed by the fund on further stress. Overall, however, we still find value in the ECC baby bonds at 9% yield owing to their estimated 340% asset coverage.
What Just Happened?
Earlier this week, the Oxford Lane Capital Corp. (OXLC) reported its quarterly results. The key message was a potential reduction or suspension of the distribution alongside a sharp drop in NAV which has fallen by nearly 65% in the last two years. Another CLO equity fund the Eagle Point Credit Co. has fared only marginally better in the same span.
The biggest challenge for CLO managers in the current market environment is dealing with the coming downgrade wave. This is exacerbated by the fact that CLOs came into this period with larger lower-rated buckets than we have seen historically.
Over the last few years, the B- bucket of the loan market has been growing and although CLOs tend to hold higher-quality assets than the broader market, by virtue of being the biggest buyers of assets, they are unlikely to emerge unscathed here.
The downgrade cycle has already begun with S&P and Moody's cutting ratings on 20% of loans held by CLOs. Why are downgrades problematic for CLO equity? It largely has to do with the OC asset-coverage test and the size of the CCC-rated bucket.
Firstly, CLOs holding more than 7.5% of CCC-rated credits will begin to carry these loans at mark-to-market rather than par value. This will cause a further drop in the value of the CLO portfolio and exacerbate a drop in equity valuations.
Secondly, failing the OC test will likely cause a diversion of cash flow away from the equity tranche to senior-most tranches which will pressure distributions from equity CLO funds.
Thirdly, to avoid these issues, some CLO managers will begin to sell down CCC credits which will further pressure this part of the market, further damaging CLO and equity valuations. We may be beginning to see precisely this dynamic as CCC-rated loans are lagging the higher quality part of the market. Overall, Bank of America estimates that 20-30% of CLOs could breach their OC test.
It's true that during the financial crisis, CLOs across all tranches including equity performed very well. There are two key differences, however, between then and now. First, the financial crisis developed over a longer period of time giving both corporates and CLO managers more time to develop a strategy. And secondly, the financial crisis was fundamentally a mortgage and banking crisis and not a corporate credit crisis. This is reversed now with the hit to earnings due to a drop in activity impacting corporate credit more than banks or mortgages.
It's not all bad, however. A wider credit spread environment can provide a benefit to equity CLOs which can be thought of conceptually as being long call spreads on credit spreads. In other words, they can benefit if credit spreads rise by being able to allocate cash flow into attractive and higher-yielding assets. This is only true of CLOs trading in their reinvestment period, however, and it works up to a certain point where a really distressed environment will deliver more downside than upside to equity CLOs.
CLO Equity and NAVs
CLO equity investors are used to the refrain that "NAVs don't matter". What proponents of this really mean is that CLO equity NAVs, as Level 3 assets, are particularly opaque and not always indicative of the fund's income-generating ability. We have some sympathy with this view as CLO equity funds are more of a trading strategy than a portfolio of static assets. That said, NAVs sometimes matter a great deal and, in particular, they can really matter when they drop.
There are two big picture reasons why NAVs matter for CLO equity when they drop: on the portfolio level and on the CEF wrapper level. On the portfolio level, a sharp drop in NAV, as has been the case in the last few weeks, is indicative of a worsening credit quality profile of the portfolio. As we touched on above, this worsening credit profile may lead to the fund locking in losses by having to sell down downgraded loans as well as having to route cash flow away from the equity tranche to more senior tranches. Both of these will impair the income-generating ability of the fund.
On the CEF wrapper level, the drop in NAV also matters because of the asset coverage conditions in the 1940 Act. Because CLO equity funds tend to finance themselves with preferreds, they fall under the scope of the legislation. Over the last month or so, the MLP CEF sector has shown what happens when sharp drops in asset values collide with the 1940 Act. With respect to CLO funds, we only need to go back to 2016 when OXLC breached its 200% asset coverage ratio ending March 2016 at 191%. In the subsequent quarter, the fund initiated a preferred stock repurchase program which was largely responsible for a 10% drop in GAAP investment income over the previous quarter.
In their most recent communication, the fund indicated that they may reduce or suspend the distribution despite robust cash flow. This is again a function of the drop in NAV which has brought asset coverage close to the regulatory minimum.
A Check-Up Of Asset Coverage
In order to gauge the relative attractiveness of CLO preferreds, we should look at three things at minimum: 1) the yields on offer, 2) the relative volatility of the underlying portfolios, and 3) current asset coverage.
Unfortunately, we don't have official asset coverage figures from either fund, so we have to try to reconstruct the balance sheet from the bits and pieces provided in press releases and investor presentations. We reviewed the ECC balance sheet estimates in a previous article, so let's take a look at OXLC. Net asset value we have high confidence in as the components are provided as of March-end. Cash we assume is the entire net investment income for the quarter which is likely to be wrong but not critically so. With this assumption, we calculate preferred asset coverage to be 201% at the end of the quarter.
Source: Systematic Income, ECC, OXLC
Since more than a month has passed since these figures we can try to estimate "live" asset coverage. The main issue that prevents us from doing this is the fact that OXLC only reports NAV on a quarterly basis. We address this by calculating daily estimates on the basis of three other funds with CLO holdings that provide daily NAVs. We estimate that OXLC NAV is around 3.90 or about 8% higher than at the end of the quarter which equates to about 210% asset coverage currently.
Source: Systematic Income
One unusual feature of the OXLC preferreds is the apparent requirement to maintain asset coverage of 200%. Standard 1940 Act rules do not require funds to maintain coverage levels - they just condition certain actions by the fund on being above the regulatory minimum. More specifically, if the asset coverage falls below 200% at the end of the quarter and is not cured within 30 days, then the fund is required to redeem a sufficient number of shares to restore the 200% asset coverage within 90 days. Importantly, the redemption will be done at the liquidation preference plus accrued dividends which, at current prices, holds a lot of upside. Even if the fund were to repurchase the stocks in the secondary market at prevailing prices, it should put upward pressure on the stock and benefit preferreds holders. Of course, rather than going the redemption or repurchase route the fund could just issue additional common shares to boost the numerator of the asset coverage ratio. This may even be accretive to NAV if done at a premium.
Turning to portfolio volatility in the chart below we plot the normalized NAV moves of ECC and OXLC by interpolating daily between official figures. On this basis, the two funds are equally matched having similar volatility and drawdowns.
Source: Systematic Income
The Relative Yield Picture
Finally, let's take a look at what's on offer in yield terms.
Source: Systematic Income
The OXLC preferreds are trading 2-3% higher than the ECC preferred in yield terms. This likely reflects the lower asset coverage of the OXLC preferreds. Both the ECC and OXLC preferreds have the unusual hard coverage mandate that requires them to redeem shares in case of asset coverage breaches. And the underlying portfolios look pretty similar and behave in similar ways. The main difference between the two sets of preferreds looks to be asset coverage. A 2-3% yield pick in OXLC shares for a marginally lower asset coverage seems too high, however. Even if OXLC were to repurchase a substantial number of preferreds, it would still have a larger underlying portfolio making it more of a viable going concern going forward.
Within the three OXLC preferreds, OXLCP is trading at much lower yield. It's not clear why this is the case. The best explanation we have is that because the three stocks are trading at comparable stripped yields (8.59% to 8.75%) retail investors are likely analyzing these stocks on this basis rather than the more correct yield-to-maturity basis. Calculating YTM is not trivial and is typically not required as most preferreds do not have maturities so perhaps investors are skipping this step.
Within the OXLC preferreds, we would go with OXLCO despite the somewhat lower yield than OXLCM as we would expect it to benefit from any forced repurchase by the fund given its highest coupon or a redemption as it's the only stock that is currently redeemable though OXLCM is not far behind. The stock's drawdown has also been more restrained, likely owing to this expectation. Overall, however, in the CLO space, we still find the Eagle Point baby bonds attractive given their estimated 340% asset coverage and 9% yield. We maintain the Series 2027 6.75% Notes (ECCY) on our Systematic Income Focus List.
Source: Systematic Income Focus List
One attractive feature of the preferreds and baby bonds of CLO funds is that they are providing an effectively higher yield to investors than for common holders who bought in prior to this drawdown despite their stronger position in the capital structure. For example, ECC was trading around $15 and distributing 0.2 per share monthly which equated to 16% yield. With the distribution down to 0.08 per share per month the effective yield on the $15 purchase price is now 6.4% or about half of the preferred yield. Of course, this is just illustrative as those investors who bought the common long prior to the drawdown have a higher total return and some may have bought at lower prices. The common distribution could also go up whereas the one on preferreds and baby bonds is fixed. That said, this outcome is indicative of the inherent volatility of this income sector.
CLO funds have taken a beating over the last few weeks. Once NAVs of these funds drop substantially the regulatory considerations of preferred stocks can come to the forefront. In particular, further NAV stress may lead OXLC to begin repurchasing their preferreds. For this reason, we would go with OXLCO within the preferred stack owing to its highest coupon. Overall, however, we still find the Eagle Point baby bonds attractive due to their strong asset coverage and attractive yields.
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Analyst’s Disclosure: I am/we are long ECCY. 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.
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