Checking Out The Latest Baby Bond From Eagle Point Credit Company

Summary

• ECC is planning to issue its third baby bond - ECCW - with a 6.75% coupon maturing in 2031 and callable in 2024.
• We take a look at the relative value picture both across the ECC capital structure as well as relative to the OXLC baby bond.
• Our view is that while ECCW should look more attractive versus the ECC bonds and preferred, it will be less attractive versus OXLCL.
• Looking for more investing ideas like this one? Get them exclusively at Systematic Income. Learn More »

After several years of an unchanging CLO CEF baby bond population, it quickly doubled over a span of a couple of weeks. While this is likely overstating the growth of the sector as we've gone from just 2 to 4 bonds, it is still a notable event in our view. In this article we take a look at the recently announced baby bond from the Eagle Point Credit Company (NYSE:ECC). Our main takeaway is that, while ECCW should look more attractive versus the other ECC bonds and preferred, it will be less attractive versus OXLCL.

A Bigger Picture

Is the additional issuance of two new baby bonds a coincidence or is there a broader trend at work? In our view, the recent issuance of two new CLO CEF baby bonds is a direct result of four different dynamics.

The first is that both of the CLO Equity baby bond issuers deleveraged in the previous year which left room for them to add borrowings. Secondly, the funds' NAVs held up remarkably well this year, which left these funds with lower leverage than their target due to the prior deleveraging. Thirdly, bonds carry lower interest rates than preferreds, all else equal, though at the expense of additional 1940 Act conditions, and so can be more attractive to funds on a pure leverage cost basis. And fourthly, none of the funds have been tempted to use bank-facing borrowing instruments like credit facilities or repo despite their significantly lower interest cost versus senior securities.

Prior to the COVID crash, the Oxford Lane Capital Corp. (OXLC) was the only CLO Equity fund using a repo for a part of its borrowing at a rate that is almost exactly half of its recently issued bond. The fact that none of the funds have been tempted back to repo highlights the advantage of senior securities for funds with extremely volatile and illiquid holdings such as CLO Equity. We often hear comments to the effect that funds have to maintain a certain asset coverage ratio with respect to senior securities but that's actually not the case. Funds can merrily go along running at less than 3x coverage for bonds and less than 2x for preferreds, however, they face certain limitations on some of their actions such as common distributions and buybacks, and an eventual control of the board by senior security holders, though this can take years. This fairly lax conditionality stands in strong contrast to the hard daily conditions of bank-facing leverage instruments, which were on display earlier this year from the wave of forced deleveraging in the mREIT sector.

And Then There Were Three

With apologies to fans of Genesis, ECC now has three baby bonds outstanding:

• ECC 6.6875% Due 2028 (ECCX)
• ECC 6.75% Due 2027 (ECCY)
• ECC 6.75% Due 2031 (ECCW)

And this is how the basic features look, assuming ECCW is priced at par when it opens.

Source: Systematic Income

ECCX does not look particularly attractive as it is trading about a percent above "par" in clean price terms and hence will deliver a small hit to new investors if it is redeemed on its first call date in a few weeks. Even if it carries on till maturity, it doesn't look great as it will have the lowest YTM of the three bonds. The best thing we can say about ECCX is that its lowest coupon may mean it may be the last to get redeemed, though this is truly a small advantage as lots of things have to go in its favor for this scenario to play out.

ECCY is currently callable and will offer a 0.02% YTW advantage to ECCW assuming ECCW is priced at par. Normally, yields slope upwards for credit securities, particularly in the current market environment as both interest rate and credit spread curves are strongly upward sloping. However, for callable retail income assets this is not always the case because retail investors prize "call protection" and are willing to pay up for it. In this context, the higher yield of ECCY, which is currently callable versus ECCW, which is only callable in 2024, is not sufficiently high to balance out its lower call protection.

In short, ECCW, assuming it is priced at or around par when it opens, is the most attractive bond of the ECC bond trio. The new OXLC bond started trading below par so the advantages of ECCW over its counterparts may even grow as it starts trading.

When carrying out a yield analysis it may be tempting to simply line up all the ECC bonds against Treasury bonds of the same maturity and look at yield differentials to calculate the additional spread provided by each bond. This analysis will show that ECCW is significantly less attractive than the other 2 bonds given the steepness of the Treasury yield curve. This analysis will be incorrect because of the fact that 1) ECC bonds are callable and 2) have a high "delta" i.e. are fairly likely to be redeemed prior to their maturity. What this means is that the ECC bonds should be lined up against Treasuries, not of the same maturity, but of the same duration and, in fact, this is how this sort of analysis would be performed by institutional investors. The upshot here is that the additional term premium of ECCW is much less than its longer maturity may indicate.

Impact on the ECC Capital Structure

The impact of the new bond is also relevant for the ECC preferred as it shifts the relative value on offer across the capital structure. In other words, income investors have not only the choice of the three bonds but also the preferred: ECC 7.75% Series B (ECCB) which is trading at a 2.8% YTW given its $25.77 clean price and Oct-2021 first call date and a 7.09% YTM.

What is interesting is that the stock has not yet adjusted for the planned bond issuance. This is strange for two reasons. First, the new bond further subordinates the preferred in the capital structure and increases fund leverage, both of which make the preferred riskier. And secondly, the issuance increases the likelihood of its redemption (full or partial). This is precisely what OXLC did recently when they redeemed one of its preferreds with some of the proceeds of their new bond. In our view, the preferred offers very poor risk/reward at these levels. The best, and pretty unlikely, scenario for ECCB is that it is not redeemed and delivers a yield that is 0.34% per annum in excess of ECCY or ECCW (if priced at par).

A pickup of 0.34% for the high redemption risk and terrible risk/reward does not look very appealing. The chart below shows the ultimate payoffs of the debt and the preferreds based on the recovery of the fund's underlying assets. The chart shows that asset recovery has to reach about 25% for the preferreds to get anything back at all and 32% for them to be paid off in full.

Source: Systematic Income

Looking Beyond ECC

For investors not particularly wedded to ECC and who like to allocate across the broader sector, the obvious question is what is the relative value between the OXLC and ECC bonds?

The answer here is very simple and has to do with (1) the fact that OXLCL and ECCW have the same coupon and very similar redemption/maturity features and (2) OXLC has fewer bonds in its capital structure relative to preferreds.

In short, OXLC has debt as 1/3 of its cap structure and ECC has debt as 70% the cap structure so OXLCL is going to be more attractive as there are fewer bonds to split any asset recovery. And because both are going to have the same coupon (and likely a similar yield when ECCW starts trading) this is an easy decision in favor of OXLCL. Unless ECCW opens very weak, OXLCL will remain our choice across the two issuers.

Takeaways

Two new baby bonds have been issued in quick succession in, what is probably, the smallest income sub-sector - CLO Equity baby bonds. Our view is that within the ECC capital structure, ECCW will be more attractive relative to the existing bonds and preferred unless it opens very weak. More broadly, however, OXLCL - the latest baby bond from OXLC - will remain a more attractive pick due to the smaller debt footprint in the OXLC capital structure which should allow its bonds to retain more value, all else equal. Investors choosing ECCW over OXLCL are implicitly taking the view that in a real crisis event, ECC assets will recover more than those of OXLC.

Analyst’s Disclosure: I am/we are long ECCW. 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.