Eagle Credit Company Baby Bonds Are Attractive Plus Preferred Market Update

Summary

  • Preferred stocks had a strong November, along with most asset classes.
  • ECCX is a CEF baby bond with a 6.68% coupon trading below par and a 2028 maturity date.
  • The CEF structure is very resilient - No CEF has ever gone bankrupt!
  • ECCX's coverage and safety level is back to pre-pandemic levels but the price is not.
  • I do much more than just articles at Yield Hunting: Alt Inc Opps: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

(This report was published to members of Yield Hunting on Dec. 3. All data herein is from that date.)

Like most asset classes, preferred stocks had a strong November. They even outperformed IG and high yield bonds by over 100 bps. It appears that tax loss selling came early this year and ended on Oct. 30.

Chart

Data by YCharts

With investment grade preferreds at nosebleed levels, much of the outperformance in November was driven by high yield and unrated preferreds. The best (only?) opportunities in the preferred space are currently among unrated preferreds which are typically not owned by institutions or funds.

A good measure of where we are in the preferreds market are recent IPOs. PSA is the bellwether of preferred stock safety and they IPOed a 3.9% coupon on 11/9. This is actually a slightly higher yield than the 3.875% preferred they IPOed in September. Both preferreds are trading near stripped par. This indicates that there has been little upside in the highest rated portion of the market since September.

Moving down in quality to high-quality-high-yield (BB, BB+), we've seen some greater upside movement. Brighthouse Financial (Insurance) IPOed a split IG (BBB-/Ba2) preferred at 5.375% which quickly rocketed to $26+, demonstrating substantial demand at that portion of the credit spectrum. Later in the month, Assurant (Insurance) IPOed a BB+/Ba1 long duration baby bond at 5.25%. After that, CNO (Insurance) priced a slightly lower quality long duration baby bond at a slightly lower coupon -- 5.125% for BB/Ba1/BB.

Perhaps most surprising was the VNO IPO. VNO is an office building REIT that IPOed a 5.25% preferred. While the preferred is technically split-IG at BB+/Baa3, I would characterize their underlying business as "hanging in there" at best. Physical occupancy at office buildings is down 80% from pre-pandemic levels with some major markets like San Francisco down 90%. I walked around downtown Washington, D.C., recently and it was a ghost town. Certainly, office occupancy will rebound significantly post vaccine and VNO has leased their offices to strong counter parties who will continue to make good on their leases regardless of occupancy but 5.25% is very strong pricing for the preferreds. However, it's not too surprising since their other 5.25% preferred VNO-M is trading at par.

If you want to buy a REIT preferred that's at least as safe as the ones from VNO but at a better yield, you have to look to unrated preferreds where you often find the best values. I recommend LANDO (farmland) with its 6% coupon and 24.85 price or MNR-C (warehouses) with its 6.125% coupon and $25 price. Both are at least as safe as VNO and the higher yield is mainly because they are unrated. The article discussing the investment case for these preferreds is here.

Another unrated security that is only a tad riskier than MNR-C and LANDO (if that) but has a 80 bps higher yield is ECCX at 24.85 with an ex-div of 12/14.

ECCX: 6.6875% 2028 Sr. Unsecured Baby Bond

Risk Rating: 7/20 Buy Under: $25.25

ECCX and its sister security ECCY are the only baby bonds ever issued by a CEF. They are backed by ECC which is a CEF that invests in equity CLOs. The bonds are unrated, as are all CLO CEF preferreds from ECC, OXLC and the privately held PRIF.

Like BDCs, CEFs are required to maintain asset coverage ratios on their debt but the coverage requirements are more stringent. CEFs are required to maintain 300% asset coverage on their bonds and 200% asset coverage on their preferreds. That asset coverage requirement is the key to their safety and why no CEF has ever gone bankrupt.

CEFs have been merged or liquidated out of existence but the value of the common stock has never gone to zero. CEF preferred and bondholders have never been impaired. This is a pretty remarkable track record and owes to four key features of CEFs that make their balance sheets incredibly resilient:

  • Diversification: Even CEFs that are concentrated on a single risky sector such as MLPs are diversified across a large number of securities. In a worst-case scenario such as oil prices going negative, a pandemic and unprecedented volatility, diversification allows CEFs to retain significant value in their investment portfolios.
  • Liquidity: CEFs typically own investments with some degree of liquidity. So long as their investments have value, and there's sufficient liquidity, CEFs can sell assets to deleverage and avoid bankruptcy.
  • Access to Capital: The flip side of selling assets to deleverage is raising equity capital to deleverage. Ideally, CEFs raise capital at or above NAV but if necessary for survival, they can also sell common stock below NAV.
  • Price Transparency: Asset coverage ratios only have meaning if you can accurately determine the fair value of those assets. This factor is related to liquidity as liquidity leads to price discovery and transparency.

Rated CEFs have all four features in spades which allows them to obtain stratospheric credit ratings at the A level (reminder, PSA which is the benchmark for safety among preferreds is BBB+). What you don't see on this list is anything related to the riskiness of the CEF's holdings or the income generated by the CEF. They really aren't a factor in the safety of a CEF's preferreds and bonds.

CLO CEFs rate poorly on the liquidity and price transparency of their holdings. So, they are not in the same league of safety as the A-rated CEFs. However, they have very good diversification as each CLO is comprised of a diversified set of senior loans and a fund like ECC owns 28 different CLOs. CLO CEFs also do very well with access to capital. Historically, CLO CEFs usually trade at a premium to NAV making it easy to access common equity capital by issuing shares. During distressed periods of high volatility they slip to a discount but given the high starting point, they have plenty of opportunity to issue shares to deleverage if needed.

What the Heck is CLO Equity Anyway?

CLOs are structured securities that are comprised of a set of senior loans (they are "collateralized" by the loans in the way a mortgage backed security is collateralized by mortgages). The senior loans are structured into tranches as follows:

Source

CLO CEFs like ECC typically hold the Equity Tranche at the very bottom of the stack. Essentially, that means if any loans default, the equity tranche loses value first and only when the equity is totally exhausted is any other tranche impaired. Interest payments made by the underlying loans are used to pay the coupons on the CLO's senior and junior debt and the remaining payments go to the equity tranche. In a distressed scenario, it's possible that all payments made by the underlying loans are redirected to CLO debt holders to deleverage the CLO. In that scenario, the equity tranche receives nothing until the CLO is back in shape.

However, even if there are a significant number of defaults in the underlying loans, the equity tranche may not take a loss. This is because senior loans historically have an 80% recovery rate in bankruptcy. So, interest payments may stop and the CLO equity tranche may not generate any income for a period but the high historical recovery rate on loans is why only 4% of CLOs have had a negative return.

Source

ECCX: Back to Pre-Pandemic Levels of Safety

ECC's performance in the recent crisis is illustrative of the resilience of CEFs in maintaining balance sheet health. As a reminder, the safety of CEF bonds/preferreds is largely derived from their asset coverage. While the common stock is off 36% since the start of the year, coverage for ECCX is more or less the same. The reason coverage is at similar levels is ECC issued common stock and bought back debt to deleverage.

Currently, ECC has $93M of debt covered by $406M in assets. One year ago they had $99M of debt covered by $455M in assets. So coverage has gone from 4.6x to 4.3x which is a small decline but not nearly as much as you'd expect from the decline in the common stock price. The coverage level is still well above the regulatory minimum of 3x.

While the safety of ECCX is back to pre-pandemic levels, the price is not. Prior to the pandemic, ECCX was trading in the upper 25s and would have likely been higher were it not for call risk. The current stripped price is more than 2% below par. Based on where ECC's preferreds and preferreds from other CEF CLOs are trading, the market would have to go substantially higher before it would make sense for ECC to refinance ECCX. ECCY also provides a "call buffer" as it would be called first since it has a slightly higher coupon and slightly shorter maturity.

Conclusion

At this point in the economic cycle, defaults are at or near their peak and the worst is already priced into senior loans and CLOs. There's little risk to ECC's solvency until the next down cycle and we have a long way to go in this cycle before reaching that point. ECC's model has proven itself resilient through the Great Financial Crisis and the Pandemic Liquidity Crisis. The balance sheet has bounced back to its prior level of safety and ECC is well prepared to survive the next down cycle whenever it may occur.

Highlights from the Preferreds Chat in November

LANDO

11/10: I did a little more digging into LANDO. It IPOed 1/10/2018. Let's assume its 6% coupon represented a fair value price at the time. BAC-B was issued a few months later on 5/7/2018 and also has a 6% coupon. The preferreds market as measured by PFF was actually slightly lower at that time. I wouldn't say BAC-B was issued at fair market value because I remember it being a very good deal at the time and quickly getting bid above par. However, it's worth noting that BAC-B now trades at 27.22 vs. LANDO at 24.25. Also, due to rates being lower in general, BAC now issues preferreds at 4.375%. What coupon would a LAND preferred have if a new one was issued today? Arguably, well below 6%. Another example is KIM-M. Same credit rating as BAC prefs. KIM-M was issued with a 5.25% coupon about a month before LANDO but that was wildly overpriced and it was trading at $21 by the time BAC-B was issued six months later. KIM-M probably should have IPOed at the same 6% coupon as BAC-B. KIM-M now trades at 26.36. Triangulating off this data, I'd say if LAND issued a pref today the coupon would be about 50-75 bps higher than BAC's most recent issuance. So, probably 5%. LANDO would have to be well over par to have a YTC of 5%.

ESGRO

11/18: Decision to trim most of my ESGROIt is callable in about three years and it's at high risk of call on the call date or soon after that. It has a 7% yield for a BB+ rated preferred. Another similar sized insurance company just IPOed a BB+ preferred for 5.25%. If ESGR can save 175 bps by refinancing the preferred when callable, they are likely to do so. The YTC is under 4% which just isn't enough for more than a small position. Now, I also own a lot of GAB-K which is a super safe A1 rated preferred of a Gabelli CEF. That also has a YTC under 4% with four years to go until call. However, given the 5% coupon, I don't think the risk of a call is high when callable. CEFs are notoriously slow to call preferreds and this is the lowest coupon preferred out there for Gabelli and they have many (so Gabelli will be calling many other preferreds before this one). Arguably, I should swap the Ks into the Gs and Hs which are callable and above par but are unlikely to be called and have a higher current yield. It's also come too far too fast. It peaked in a spike at 27.45 just prior to ex-div and now it's back to that same level just a few days after ex-div. Including the div, it's moved $1.60 since the end of October.

RPT-D

11/19: Fitch assigns BB rating to RPT-D. It is now the highest yielding BB rated preferred at 8%. Higher yielding than EPR-E which is arguably more risky. Comparable BB rated strip center preferreds from SITC yield 6.5%. Fitch Assigns First-Time "BBB-" IDR to RPT Realty; Outlook Stable.

Original article on RPT-D here.

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This article was written by

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Disclosure: I am/we are long ECCX. 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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