Two 10% Yields On Sale, Extremely Misunderstood

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Co-produced with Treading Softly

Have you ever felt misunderstood? It’s a frustrating feeling.

Imagine operating a perfectly sound business that everyone was sure was going to fail simply because they didn’t understand what you do. That would be frustrating too.

Especially if these same folks were daily raving about their amazing investments in some business almost identical to what you were operating!

When investors claim to be in love with Business Development Companies (“BDCs”) like Main Street Capital (MAIN), or PennantPark Floating Rate Capital (PFLT), yet refuse to understand Collateralized Loan Obligations (“CLOs”), it blows my mind. Considering that investing in the common equity and baby bonds of a BDC focused on holding a portfolio of senior secured loans is essentially identical to a CLO fund buying the equity tranche (think common shares) and debt tranche (think bonds) of a CLO. The big difference is that CLO debt is to publicly rated debt often of publicly traded companies, while BDCs invest in the unrated debt of usually private companies.

It would be calling one identical twin prettier than the other when they are carbon copies of each other.

So today, I want to present two BDC, ahem, CLO funds to you. One that focuses on the equity tranches and the other that focuses on buying up CLO debt. Both are higher specialized and run by fantastic CEF managers who invest in the equivalent of a vast array of private BDCs.

The misunderstood nature of these funds allows us to enjoy extremely high levels of current income in our coffers while others blindly and ignorantly accept less money while owning something nearly identical.

Let’s dive in.

Pick #1: ECC – Yield 13.6%

Eagle Point Credit Company Inc (ECC) announced results for Q1 three weeks ago. ECC primarily invests in CLOs (collateralized loan obligations). These are bundles of leveraged loans that banks originate to companies with B/B+ credit ratings. These are senior-secured, first-lien loans, which means they are at the top of the capital stack.

The key metric is their cash flow, of which $0.20 was from CLOs that were called (redeemed in full). That’s good, in that their position was fully redeemed for a profit, but those funds are excluded when you look at their “recurring” cash flow table. As a result, Q1’s recurring cash flow came in a bit lower than in recent quarters. However, there is still plenty of cushion with the dividend covered by recurring cash flow at 188%. (Source: ECC – Q1 Investor Presentation)

ECC Portfolio

ECC – Q1 Investor Presentation

ECC did some trading in Q1, with the effective yield on new investments averaging 18% – higher than their portfolio average of 16.8%. Management announced they have approximately $30 million they are looking to deploy in Q2.

The good news is that it’s a great time to be buying CLOs right now. They are still attractively priced, and ECC’s cash flow will grow even more as it deploys that capital.

Additionally, ECC still expects to pay a special dividend this year to meet its distribution obligations and resolve its problem of having “too much” taxable income.

Here are the facts:

  • ECC is yielding over 12%
  • Raised its dividend by 17% in Q2
  • The dividend is covered by a recurring cash flow of 188%.
  • ECC will be determining how large of a special dividend will be needed in the next quarter because their double-digit yield wasn’t enough to meet their distribution obligations in 2021.

What does it take to make the market happy!?

No doubt, some in the market are concerned about declining loan prices. The S&P/LSTA leveraged loan index is down over 3% year-to-date, which for leveraged loans is a fairly large downswing.

On the earnings call, SA’s Steven Bavaria asked an insightful question about the relationship between NAV and earnings potential and how lower NAV actually improves earnings potential. Tom Majewski responded (emphasis added):

I’ll show an extreme. If you think about April 1, 2020, loans were down 10 points in the month of March. CLOs are 10 times levered. At a high level, every CLO was wiped out from an equity liquidation value. On the surface, that sounds bad. Well, you’ve seen what happened to our NAV over that two-year period. It’s the other way in that we can see — you mentioned that put option back to the company, every loan will either default or pay off at par, it’s a binary outcome. And our CLOs in every loan and every CLO has to mature before the CLO debt is due. So we’ve got the runway to see it through to the other side. And that option, in our opinion, is mispriced by the market. Some people get very focused on what’s the liquidation value we don’t have to liquidate. And we’ve got the runway to hold these — every loan will do one or two things, and we can find out which one. And the vast majority of loans have a funny habit of paying off at par.

Hmm… That sounds almost like something we say here at HDO all the time: Our goal is to have a portfolio so that we only have to sell at our convenience, not because we are forced to!

ECC has the same outlook. They are investing for the income and are willing to hold through whatever volatility the world brings. They know that even in extreme scenarios, most corporate borrowers pay off their debt.

Most companies don’t go bankrupt, and even a large number of bankruptcies lead to a material recovery for senior lenders. After all, the job of a bankruptcy court is not to magically erase the debt. The job of a bankruptcy court is to maximize the recovery to the stakeholders by seniority. Senior secured debt is number 1 in line to collect that recovery.

The theoretical liquidation price in the interim doesn’t matter. ECC is buying CLO positions with the intent to hold them until maturity. They sell positions only when it suits their needs, as they did in Q1, to take advantage of market mispricing to invest at higher yields.

ECC is a cash-flow beast. It should be recognized that in crisis events like March 2020, there is a risk that the cash flow is paused while funds are redirected to prepay senior tranches. Yet, in the long-run, patient investors are rewarded when most borrowers do repay the loans.

Even throughout the Great Financial Crisis, 96% of CLO equity positions had a positive total return. In an environment like today, when interest rates are rising, ECC’s strategy of using fixed-rate leverage to invest in floating-rate assets is a very effective one. Add on historically low default rates, and you have the ingredients for unprecedented cash flow, which is passed along to us as dividends!

Pick #2: EIC – Yield 10%

Eagle Point Income Company Inc. (EIC) is operated and managed by the same firm that oversees ECC. The key difference between the two is the risk they take on.

ECC focuses on the Equity tranche of a CLO – the highest risk and highest reward position. The current low default rate, the large amount of liquidity, and strong economic outlook provide ECC the ability to earn and cover its outsized dividend.

EIC moves further up the capital stack to find more safety but accepts lower levels of income. Overall EIC focuses on buying the debt issued by CLOs rated at BB. This provides them with more surety than ECC gets for revenue, but less revenue in good times. (Source: EIC Investor Update – May 2022)

EIC assets

EIC Investor Update – May 2022

Similar to ECC, EIC is not strictly CLO debt and does own about 32% in CLO equity tranches. ECC is the opposite, holding 6% in CLO debt and the vast majority of its portfolio in Equity tranches.

EIC assets

EIC Investor Update – May 2022

EIC’s ability to generate income has historically exceeded its dividends, requiring special dividends to be paid out to its shareholders. EIC raised its dividend and has barely missed coverage by $0.01 per share last quarter. We’d like to see this coverage climb as the year goes on to ensure NAV continues to grow.

EIC should be viewed as a specialized bond fund – focusing on CLO debt – and less comparable to CLO funds like ECC, Oxford Lane Capital (OXLC), or OFS Credit Company (OCCI).

However, with fixed income on sale – including the low-level CLO debt tranches – EIC is a good route to gain CLO exposure with a lower risk than more conservative investors will enjoy. Plus investors can get EIC at a healthy 7% discount to NAV.

So conservative income investors celebrate, even if you now have an outstanding source of double-digit lower risk income available to you!

Dreamstime

Dreamstime

Conclusion

ECC and EIC provide high levels of immediate income that appeal to various levels of risk acceptance. ECC trades at a premium to NAV and offers more money today with a higher likelihood of additional dividend raises down the road. EIC trades at an attractive discount to NAV but has a little legwork to do to fully cover its new higher dividend rate.

Together they both offer CLO exposure from a top-notch CLO fund manager as well as a wider exposure to the larger U.S. economy as a whole. Investing in these CLO funds allows you to enjoy the potential upside of the economy while also enjoying large sums of income now.

More risk-averse? Go for EIC. More Risk accepting? Go for ECC. You can also have a little of both as well. My retirement portfolio greatly enjoys the regular monthly income deposits from both funds to propel my account and income cash flow to new heights.

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