- Oxford Lane is a closed-end fund focused on investing in CLO equity tranches.
- Based on its $0.075 monthly distribution, it is currently yielding 17.3%.
- I estimate OXLC's NAV dipped in March, due to the regional banking crisis impacting CLO valuations.
- Looking forward, I see more signs of economic deterioration. Given the leveraged nature of CLO equity returns to leveraged loans performance, I recommend investors avoid OXLC.
Regular readers will recall that I have been warning about worsening economic conditions since late 2022, and as such, recommended investors avoid leveraged credit investments like Oxford Lane Capital (NASDAQ:OXLC). So far, my warning appears to have been inaccurate, as the economy continues to grind along and the much anticipated recession has failed to materialize. Am I wrong, or am I early (which can also be considered wrong)?
Since my initial article on OXLC more than 8 months ago, the stock has returned -3.9% in total return, underperforming the S&P 500 with a 1.0% total return, but hardly a disaster (Figure 1).
As analysts and investors, we must constantly reassess our forecasts and expectations given incoming data and reports. To stick with a wrong bearish thesis risks missing out on potential gains at best (if one is on the sidelines) or losing money at worst (if one is short). Let us review some of the recent data and news on the economy and leveraged loans market to see if one jump in to buy OXLC now.
GDP Flashing Stagflationary Signals
My worries on the economy were not unfounded. In fact, as the recent advanced GDP report for Q1/2023 showed, real GDP grew at a minuscule 1.1% YoY growth rate, far below the 2.0% that analysts were expecting.
Combined with core Personal Consumption Expenditures ("PCE") inflation averaging 4.6% in Q1, one can conclude that the U.S. economy is suffering from a bout of 'stagflation', characterized by slow to negative growth and persistent inflation (Figure 3).
Furthermore, the economic news only got worse as time went on in 2023.
Regional Banking Crisis Leading To Tighter Credit Standards
By now, everyone should be well aware of the U.S. regional banking crisis that occurred in March which saw the largest bank failures since 2008. The root cause of these regional bank failures was the Fed's interest rate increases since 2022 that caused mark-to-market losses on securities (from duration risk) held by banks and deposit flight as deposit rates were not competitive with money market yields.
While the direct impact of regional bank failures on Oxford Lane is limited, one should not under-estimate the knock-on effects from the banking crisis. As Fed Chairman Powell noted in his March FOMC press conference, "events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses" going forward.
Corporate Defaults Were Already At Multi-year Highs Through February
Tighter credit conditions and higher interest rates will likely push more companies into bankruptcies throughout 2023. Through the end of February, there have already been 111 corporate bankruptcy filings in the U.S., more than double 2022's pace and the highest level since 2011 (Figure 4).
Leveraged Loan Defaults At Multi-Year Highs
Elevated corporate bankruptcies are a sign of corporate distress and are directly correlated with leveraged loan defaults. For example, there were over $18 billion in U.S. leveraged loans in default in the trailing 12 months to March 2023, the highest level since May 2021 (Figure 5).
However, on a historical basis, the default rate is still benign, at just 1.32% by volume and 1.35% by issuer count, below the 10-Yr average (Figure 6).
Looking forward, analysts broadly expect leveraged loan default rates to double in the next twelve months to 2.5-2.99%, consistent with a mild recession. This is higher than the historical average default rate but nowhere near as bad as during the COVID pandemic where they reached over 4% and the Great Financial Crisis when defaults reached over 10% (Figure 7).
CLOs Built On Leveraged Loans
Collateralized Loan Obligations ("CLOs") are synthetic fixed income instruments that package up diversified baskets of leveraged loans and tranche their cash flows into securities of various credit ratings. The CLO debt tranches (AAA to BB in figure 8 below), are protected from losses by structural enhancements such as overcollateralization and interest diversion.
CLO equity tranches, the securities that make up over 96% of Oxford Lane's investment portfolio, are the instruments that provide credit protection to the CLO Debt tranches in figure 8 above (Figure 9).
Therefore, OXLC's returns are highly levered to the returns of the underlying leveraged loans. When the leveraged loan market catches a cold, OXLC catches pneumonia, as we saw in Q1 2020 when OXLC's NAV dropped by 47% QoQ as the Morningstar LSTA US Leveraged Loan 100 Index ("LSTA Index") fell by 10%.
OXLC NAV Vs. LSTA Index
Figure 10 plots the reported NAV of OXLC against the LSTA Index. Sharp-eyed readers will note that while leveraged loans have performed well in the past decade, delivering 3.4% CAGR return from March 2015 to March 2023, OXLC's NAV has actually been in a perpetual decline, falling from $14.08 in March 2015 to a recent $5.03 estimate as of February 2023.
There are a number of reasons for OXLC's perpetual NAV decline. First, OXLC pays a very high distribution yield. OXLC's distribution is currently set at $0.075 / month or 17.3% annualized. In some years, the fund does not generate sufficient net investment income ("NII") to fund its distribution, so it had use return of capital ("ROC"), which depletes its NAV (Figure 11).
Another reason for OXLC's NAV decline is due its outrageous fee structure. From the fund's latest semi-annual report, we can see that the OXLC fund paid annual expenses of 12.57% to management (Figure 12). How can unitholders win when the manager takes such a big slice of the pie?
But that's not all. Buried within the fee disclosure, we see that if indirect CLO fees are included, the fund's total annual expense would have been 41.01% (Figure 13)!
Finally, from figure 11 above, we can see that rain or shine, the fund is perpetually issuing more shares, which dilutes existing unitholders. In the latest quarter alone (calendar Q4/2022), OXLC issued 7.2 million shares, or a 4.5% quarterly dilution on 159.9 million shares as of September 30, 2022.
The combination of these negative factors is why Oxford Lane's NAV has declined at a 12.4% CAGR while the LSTA Index has compounded at a 3.4% CAGR.
OXLC Q1/2023 Preview
Looking at OXLC's NAV vs. the LSTA Index, we can also see that OXLC's quarterly NAV returns has a 70% correlation to the LSTA Index's quarterly return. This makes sense since CLOs are built on leveraged loans, so the two should be correlated.
In fact, we can build a simple regression model using the LSTA Index's quarterly returns to estimate OXLC's quarterly return (Figure 14). This simple model has a R2 of 49%, meaning 49% of OXLC's NAV return can be explained by LSTA's quarterly return.
Using this model, I estimate OXLC's March 2023 NAV to be $4.88, a 5.5% gain from December's $4.63 NAV, but a slight decline from February's $5.03 NAV estimate.
I believe my $4.88 NAV estimate is directionally correct, as the LSTA index dipped in March following the regional banking crisis (Figure 15). Presumably CLO valuations would have been negatively affected as well.
Although Oxford Lane has performed better than expected in the past few months, I remain concerned about the economy and the potential negative impact to leveraged loans and CLO valuations.
Historically, when the leveraged loan market stumbles, CLO equities crash. Given the widely expected outlook for a mild recession in the coming months, I believe there is still significant downside to OXLC's share price. I recommend investors avoid OXLC.
This article was written by
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