Eagle Point Credit, ‘Reading The Tea Leaves’ In Its Monthly Report (NYSE:ECC)

Eagle Point Credit: Reading the Tea Leaves

Eagle Point Credit (NYSE:ECC) is a closed-end fund that owns the equity in collateralized loan obligations (CLOs). CLOs are legal vehicles that essentially resemble “virtual banks.” Just like when you buy the equity of a real bank, like Bank of America (BAC) or JP Morgan Chase (JPM), when you own the equity of a CLO you collect the difference between the income from a portfolio of loans, and the cost of the debt (i.e. deposits and other borrowings) used to fund those loans.

Sounds easy, right? You lend at 6%, pay perhaps an average of 3% to your depositors and other creditors, as well as for your employee salaries and other costs, and keep the difference. So 6% minus 3%, leaves you a 3% margin, but since your equity is leveraged about 10 to 1, all that margin comes down to the equity, so you make about 10 times 3%, or 30% on your investment.

Well, not quite. Credit losses also have to come out of that margin, so if in a bad year, like a recession, you were to lose an average of 3% on credit losses across your portfolio, that 3% times 10, or 30%, would also come out of your equity return, leaving you in our simplified example with zero. Fortunately 3% in losses, given most of your loans are secured and recover most of their principal when they default, would be historically a very high loss rate and therefore seldom happens. But you get the idea how the math works.

Collateralized loan obligations (“CLOs”) are virtual banks, with the same assets and liabilities, and therefore the same operating dynamics in terms of how they make or lose money as banks, but without the bricks and mortar, tellers and other infrastructure. (For more details and explanations, please check out this Seeking Alpha article, which is a reprint of a chapter on CLOs in my book, The Income Factory.)

For many years, CLO investing was the exclusive province of large institutional investors. Over the past decade, two closed-end funds, first Oxford Lane Capital (OXLC), and then a little later ECC, introduced the CLO asset class to retail investors. Since CLOs are more complex than most other financial vehicles, the entire retail market has been on a bit of a learning curve getting up to speed and understanding them.

ECC publishes a monthly Portfolio Update (link here) that has some very useful information in it, if you dig into the details. One item about halfway down the report is the “Weighted Average Market Value of Loan Collateral,” which for the report dated 10/31/2022 shows a figure of 91.75%. If you look a few lines above that, you see that the number of obligors (i.e. borrowers) represented in the approximately 120 individual CLOs that ECC owns is 1,868. That means the loans issued by those 1,868 borrowers are trading, on average, on the secondary loan market at 91.75% of their par value, or at a discount of 8.25%.

Accounting 101

That has major implications for the “market value” of the CLOs in ECC’s portfolio. Assume that the equity value (i.e. the “net worth”) of a CLO (or a regular bank, or indeed any company or even any person at all) equals its total assets minus its liabilities. That’s pretty obvious to anyone, even if they’ve never taken an accounting course. Our assets may fluctuate in value, up or down, but our liabilities do not. Just because my house drops in value, it doesn’t mean I owe any less on my mortgage. Same with a CLO or corporation. If the value of its loan assets decreases, the CLO’s debts are still the same, so the drop in value directly comes off the equity.

Let’s take this basic principle (Assets – Liabilities = Equity) and apply it to ECC over the past year.

• At the end of 2021, ECC’s Monthly Portfolio Update showed the underlying portfolio loans in its CLOs having an average market price of 98.34 cents on the dollar
• By the end of October this had dropped to 91.75
• In other words, the discount on the loan portfolio had gone from 1.66% to its recent 8.25%, a jump of 4 times as much
• Meanwhile the reported Net Asset Value (“NAV”) of a share of ECC went from $13.39 to its recent estimated $9.71; a drop of $3.68, or about 27%.

It looks pretty obvious that such a big drop in the value of the loan portfolio would likely be a major contributor to the drop of the reported NAV.

But meanwhile, during the past 10 months, as ECC’s NAV has dropped from 13.39 to 9.71, the fund has managed to (1) increase its distribution by 17% and (2) pay an additional “special” distribution that is quite a bit larger (178% actually) than its regular distribution. Hardly the actions of a fund that is losing value as its decreasing NAV estimates would seem to indicate.

Fortunately, There Is More To The Story

Looking at a CLO’s value from a pure mark-to-market perspective is simple, but fails to capture how CLOs (or banks) actually work. If a CLO (or a bank) were to go out of business, and had to dump all its assets on the market, then the discounted market price would indeed be the way to value it. In fact, such a “distress sale” would probably result in even bigger discounts.

But the market price of a loan is irrelevant to a CLO or bank that is a functioning business, and holds its loans to maturity and collects them at par. The fact that a loan may trade on the market at a discounted price means nothing to the borrower or the lender when the loan matures and the borrower has to pay it back at its original par value.

But the story gets even better for CLOs, since at times like this when skittish credit markets have bid down the prices of otherwise healthy loans (and bonds too, but we’ll get to that later), CLOs can take the principal repayments they receive (100 cents on the dollar, i.e. at par) on their existing loans and re-invest the cash flow in loans purchased on the secondary market at 92 cents on the dollar. That benefits ECC in two ways:

• They collect a higher current yield on their new investment than the loan’s stated coupon rate, having bought it for 92 cents on the dollar; and
• In a couple years when the loan matures they’ll collect 100 cents on the dollar, giving them a capital gain of the 8 cents discount; further increasing the yield-to-maturity when they spread the 8 cent pickup over the loan’s remaining life.

This is why we have to look beyond the static accounting numbers to understand the actual business going on in managing a portfolio of CLO equity. It also helps explain that the positive, enthusiastic picture of the business that ECC’s CEO Tom Majewski projected in the recent interview published here on Seeking Alpha was not inconsistent with the recent NAV trend.

In investing in complex asset classes like CLOs, retail investors should recognize two important points:

• For decades, even centuries, until the 1990s, banks and other lenders never traded their loans, and secondary markets did not really exist. There was a reason for that and it relates to the idea that the real value of a loan is the ability to “put” it back to the issuer for its original par value, regardless of what is happening in other asset markets or in the economy in general. The only way a borrower can avoid paying its loan back at par value is to go bust, default, and go out of business. But that’s a stiff price to pay, which is why default rates are so low.
• Likewise in the CLO market where, back when it was exclusively an institutional market, investors made no attempt to mark-to-market their CLO equity investments, but evaluated their total return based on their cash flow over time. So in putting CLO investments into a closed-end fund “wrapper” we’ve forced ourselves to try to measure some things that have not previously been measured (i.e. mark them to a market that is highly idiosyncratic and illiquid, to say the least), raising some interesting and sometimes challenging issues.

One Further Thought, Re Eagle Point Income (NYSE:EIC)

Some of these same issues, and some slightly different ones, apply to ECC’s sibling fund EIC. EIC mostly holds CLO debt (about 2/3rds of its portfolio), rather than equity. It too publishes a Monthly Portfolio update (link here).

The debt EIC buys is currently marked to market at an average price of 80.25 cents on the dollar. Last January’s report (link here) shows the price at 95.54 cents on the dollar. So while EIC is investing in a different part of the CLO liability structure than ECC (i.e. above the equity and therefore less risky) it too (like its sibling) is in a position to take advantage of a market that is seriously overcompensating investors for perceived credit risks (as I discussed a week ago here). In EIC’s case, it can collect the debt it owns at par and then repurchase new debt at about 80 cents on the dollar, which it then holds to maturity, collects at par for a capital gain, etc.

One reason the market tends to overcompensate credit investors comes from a fundamental misunderstanding of the relationship between the headline “default” risk and what that means in terms of actual net credit losses to investors. Two examples relevant to this article:

• In the secured loan market, an 8% discount (i.e. 92% mark-to-market) suggests that investors might face a loss of 8% on their loan portfolios. But loans (which are secured by collateral) have traditionally recovered about 75% of their principal, when they default (i.e. losses of 25%, after the 75% recovery). So to lose 8% of your loan portfolio you would need to have about 32% of it default, since 32% times 25% equals 8%. Even in the “great recession” of 2008/2009, the default rate never went above 11%, which would result in losses of less than 3%. So to justify an 8% discount, you’d have to be expecting defaults that were about two and a half times as bad as those in 2008/2009. Yet not even the most pessimistic economists I have seen expect anything even close to the 2008/2009 experience.
• Meanwhile, the double-B rated CLO debt of the sort EIC owns is discounted even more, at close to a 20% discount. Now double-B rated CLO debt of this sort is unsecured, although it has a very good default record (much better actually than ordinary double-B rated corporate debt). But the main point is that unsecured corporate debt tends to recover 40-50% of its principal when it defaults. If we assume the lower recovery of 40%, that means when it defaults you lose 60% of your principal. So you would need to have about 33% of your portfolio default in order to incur losses of 20%. In other words, you’d need defaults about three times as great as the “great recession” experience. This is why EIC is also having a great year and has been able to raise its distribution twice.

These factors are clearly at play in regard to funds like ECC that buy CLO debt and equity. But the same factors affect other credit funds, right now, including senior loan funds and high yield bond funds, where you can collect “discounts on discounts” because so many of the funds themselves are discounted, as well as the loans and bonds that they hold. A number of famous investors over the centuries have opined that the time to make investments is when there is “blood in the streets” and assets are at fire-sale prices. I’m not sure we’re at that level of distress in the credit markets, but there certainly are signs that current prices are overcompensating us for the credit risks that are reasonably foreseeable.