16% Yield From A Great Financial Crisis Tested Asset Class, By Oxford Lane

Co-produced with Treading Softly and PendragonY for High Dividend Opportunities

Investment Thesis

This is article 2/4 on a series of report we are currently working on the topic of our investors can boost their income by investing in Collateralized Loan Obligations, or CLOs. The first report was an introduction to CLOs, entitled: "How To Boost Your Income With CLOs."

Oxford Lane Capital (OXLC) is a high-yielding, immediate income-style stock. Investors should look to OXLC for income generation but limited capital appreciation. The focus of CLOs is high income generation - perfect to fire up a portfolio's yield when mixed with more conservative investments.

OXLC's CLO Investments

OXLC focuses on growth and steady income via CLOs. It is invested in 80 different CLOs, of which in 77 it holds an equity position. This provides OXLC a high rate of income, which it readily distributes back to shareholders.

Oxford Lane obligators

(Source: OXLC Earnings Slides)

These various CLOs provide OXLC with a vast and diversified borrower base. This means that as one of its 1568 borrows collapses, only 0.79% of the total portfolio is at risk in the worst-case scenario, and on average only 0.06% is at risk should this happen. This wide-scale diversity adds a measure of safety amongst OXLC's higher-risk focus.

What About the NAV Premiums?

CEF investors often look to the fund's NAV to be discount (which is the norm) versus premium to determine entry points. For CLO funds, this methodology doesn't work. Why?

Because CLOs are comprised of hundreds, if not thousands, of individual loans. Those loans all have individual values which change as each loan payment is made. Pre-payment also affects the loans' values. These loans comprise the total CLO and its entire structure, which is then broken into tranches. So now those tranches have to be assigned parts of the value of the total CLO. Lastly, OXLC is comprised of multiple CLOs, all of which have shifting NAVs. To further confuse things, CLOs are highly illiquid assets. Unlike real estate or trading in bonds, preferred or common equity. CLOs don't trade on a regular basis, and typically are bought or sold on appointment only. Meaning the value of the loans within the CLO may not impact its sales price as heavily as the variations of OXLC's NAV may lead you to believe.

Imagine if you're assigned to apprise the value of a CLO. You would be dependent on whoever was assigned to value the individual loans and if their acceptable margin of error was 10% (yes, this is exceptionally high, I'm sure). Now your data is only 90% accurate and your margin of error stacks on top of this. This is why I consistently tell people that determining OXLC's NAV is an art, not a science.

OXLC just recently reported its NAV from December. Essentially, OXLC updated its NAV - as it usually does - 3 months delayed and when CLO NAVs were at their worst.


Data by YCharts

A close peer to OXLC, Eagle Point Credit Corp. (ECC) also recently updated its NAV. Both are updated on a delayed basis, but both suffered the almost exact same fate - CLOs saw tremendous NAV depreciation in December. But ECC updates monthly, and as a trend, ECC and OXLC's NAVs move in lockstep on a percentage basis. These are all unrealized losses. This is key to remember. Unless OXLC sells out of these CLO positions, the NAV change doesn't truly reflect its performance.


Source: OXLC Earnings Slides

During the last quarter, OXLC saw realized gains from selling out of CLO positions of $0.01 per share; meanwhile, its unrealized losses were $2.37. Management addressed this during the last earnings call as well. CEO Jonathan Cohen spoke of the overall valuation of the CLO markets:

Moreover, we know that the S&P/LSTA leveraged loan index has rebounded significantly since December 31st from 93.8% of par to 96% of par as of February 5, 2019. According to the Wells Fargo CLO research team, the median US CLO equity net asset value has recovered with the increase in loan prices.

After bottoming on January 2, 2019, at 24.5%, the Wells Fargo CLO research team estimates the median US CLO equity net asset value currently stands at approximately 43.3% as of February 1, 2018.

Our Views on NAV Trends

This downtrend explains the pressures on ECC's and OXLC's NAVs. It also explains recent choices by CLO managers to upsize their CLOs. Saratoga Investment Corp. (SAR), for example, nearly doubled its CLO's size to take advantage of this downturn. OXLC does not have any CLOs managed by SAR, but another favorite stock on Seeking Alpha finds its CLO owned by OXLC - Ares Management's (ARES) CLO is one of OXLC's largest positions.

When OXLC reported its NAV as of December 31st, 2018, the CLO market was being valued at its lowest in years. Since then, CLO values as a whole have rebounded. Meanwhile, the value of the equity position has nearly doubled in reflection to its par value - from 24.5% to 43.3%. Considering that OXLC is overwhelmingly invested in the equity tranche of CLOs, OXLC's NAV is clearly not declining due to mismanagement but is a trend as a whole with recovery in sight.

Highlighting The Right Focus - Cash Flows that Pay You

With the NAV showing completely unrelated changes to OXLC's activities, we must evaluate OXLC on what management can control: cash flow. The real question we must ask is: Does OXLC cover its high-yielding monthly dividend? The short answer is, absolutely yes.

OXLC Coverage

Source: OXLC Earnings Slides

For the past three quarters, it has strongly covered its dividend each quarter from the cash flows. No cut is coming as this trend continues. Furthermore, OXLC saw an increase in cash flows this past quarter - of $900,000. But this isn't the only increase coming - OXLC is expected to have additional cash flow increases later this year as new positions it already owns start paying out.

OXLC nonpaying CLOs

Source: OXLC Earnings Slides

OXLC is forecasting an additional $66.2 million worth of CLOs to start paying it back this quarter and an additional $8.7 million next quarter. We would expect the next quarter's figure to increase as it makes additional CLO purchases.

Now, to avoid confusion, OXLC isn't expecting an additional $66.2 million in cash flow, but expects those investments to start paying it back. Its equity CLO positions as of last quarter had an effective yield of 15.8% - meaning the positions starting this quarter would bring in approximately $10.46 million annually, or an additional $2.6 million quarterly. Growing cash flow means stronger per share dividend coverage. These CLOs are already factored into the shares issued and have been sitting waiting to pay out to investors.

How To Mix OXLC into Your Portfolio

Many investors may baulk at adding in a fund they view as risky into the mix. At "High Dividend Opportunities," we emphasise a need for diversity to ensure success. But for the sake of illustration, imagine if we had a simple four-security portfolio. These safe yields all offer 7%. Imagine if we made it a mix of four safe 7% yielding securities (like preferreds or bonds, for example) and add in OXLC. By making OXLC 25% of the portfolio, it provides an immediate 2% boost to the portfolio's yield - from 7% to 9%. In a portfolio of $100,000, that's an extra $2000 annually without a major increase in risk.

OXLC is designed to provide a steady stream on income to its holders - just like CLOs. OXLC can be added to your portfolio to increase its yield and provided much-needed cash to reinvest into options you feel are safer or future High Dividend Opportunity picks!

A Checkered Past That Everyone Loves to Visit

No OXLC article is complete without mentioning its past. Investors need to be aware that it hasn't always been a well-balanced choice.


Data by YCharts

OXLC saw strong NAV declines during the energy credit crisis, from which it hasn't fully recovered. Why? It was forced to sell performing CLOs at rock-bottom prices due to the structure of its leverage. OXLC had its debt covenants connected to NAV and not cash flow. This has since been resolved by management adding in a reverse purchase agreement to their preferreds. But when this occurred, OXLC's NAV suffered lasting damage which its peer was able to avoid as seen above. During this time, it was forced to cut its dividend - just once. Many incorrectly argue OXLC has had two dividend cuts - but often mistake an extra $0.10 special dividend as a regular one. Currently, it pays its dividend monthly, and management has shown their ability to overcome a past mistake to focus the fund's debt accurately on cash flow.

Investor Takeaway

Investing in OXLC, you get:

  • Skilled management that is able to overcome past errors.
  • Investments in an asset class that has withstood the Great Financial Crisis of our generation.
  • A rock-solid and covered 16% yield paid monthly.
  • The ability to take advantage of the market's general lack of understanding of CLOs.

We are excited to place a Strong Buy recommendation on OXLC as we pivot our High Dividend Opportunity to withstand any coming recession, while also providing us with a high level of predictable cash flows. Investors get the dividend on a monthly basis. The stock goes ex-dividend around the 20th of each month, and the payment date is at the end of the same month.

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Disclosure: I am/we are long OXLC, ECC, SAR. 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.