This is an extract from an earlier article at Systematic Income Premium
CLO (collateralized loan obligation) equity closed-end funds (“CEFs”) like Oxford Lane Capital Corp (OXLC) and Eagle Point Credit Company Inc. (ECC) continue to appeal to income investors due to their high distribution rates. In this article, we highlight some of the misconceptions that surround these funds.
CLOs will do X because of Y
This is a bit of a pet peeve but a lot of commentary across both CLO Equity and CLO Debt securities speaks blithely about “CLOs” as in CLOs will do X or Y in this or that market environment. It doesn’t make any sense to speak about CLO performance or behavior in general terms. That’s because CLO Debt and CLO Equity have extremely different risk / return profiles.
Higher-rated CLO Debt securities are: 1) static securities; 2) are short a call option; and 3) are some of the highest-quality securities available in the fixed-income space outside of Treasuries with an incredible track record (i.e., no defaults on CLOs originally rated AAA ever and only 1 for AA-rated CLOs).
On the other hand, CLO Equity are: 1) better described as dynamic investment strategies than securities; 2) long the refi and reset options; and 3) have highly variable performance due to greater dependence on CLO vintage and manager alpha.
5Y CLO Equity total returns are negative now or compare poorly to some other funds, e.g., SJNK, SPY
It may sound counterintuitive but an asset class that happens to have a low return over a given period does not actually tell you a whole lot. There are tons of examples of major asset classes going through periods of low or negative returns. The chart below shows the rolling 5Y return of the High Yield corporate bond market. Just in the last three years, we have seen the 5Y return move close to zero on two different occasions. There were two other instances where the 5Y return moved into negative territory this century. Does this make HY corporate bonds uninvestable? No. Are there many more 5Y periods where the HY market had fantastic performance? Yes.
HY bonds are not alone here. There are also multiple decade-long periods where U.S. stocks delivered no returns. Does this make U.S. stocks uninvestable as an asset class? No.
This will come as little surprise to most income investors, but asset prices can fall and sometimes they can fall a lot. 2022 is one of those times. Therefore, it’s not shocking to find that CLO Equity has delivered a low 5Y total return – the same is true for most other asset classes. Having a low 5Y return in 2022 tells us nothing about whether a given asset class is worth allocating to or not. In fact, previous low return periods have marked fantastic entry points.
The other reason why the 5Y period total return is misleading is that CLO Equity CEF valuations have fallen significantly. In other words, a big reason for the low 5Y total return of CLO Equity CEFs like OXLC and ECC has to do with the deflation in the funds’ premium rather than any collapse in NAV returns. The following chart shows that the valuation of ECC fell from north of 20% to about zero. As many investors know, buying any fund at a 20+% premium is asking for trouble.
If we focus on total NAV returns, they look much better – the 5Y total NAV return for OXLC and ECC is 10% and 5.9% CAGR, respectively – that’s better than the vast majority of credit CEFs, even the vaunted PIMCO credit CEFs.
In short, using the 5Y total return window is a misleading way to analyze securities given today’s credit valuations and it is particularly poor at getting a sense of CEFs, whose returns are influenced as much by moves in discounts as by their total NAV performance.
Holding CLO Equity going into a recession is dumb
This view is very intuitive. After all – CLO Equity is a leveraged play on bank loans. And loans, as well as other credit assets, tend to struggle during recessions. The chart below shows that loan defaults tend to spike during recessions as they did during the GFC, the near Energy shock recession. and the COVID recession.
However, this is another example of where a little knowledge is a dangerous thing. The point is that CLO Equity is not just a leveraged play on loans. As we suggested above, it is more akin to a dynamic allocation strategy. Specifically, CLO Equity benefits from a number of embedded options such as the reinvestment option and the call option which allow CLO Equity to generate additional returns in a weak market environment.
Specifically, in a period of elevated default rates, CLO Equity benefits from reinvested principal prepayments and amortization payments into loans trading at depressed prices. Since the majority of these loans tend to redeem at par, this accrues directly to the CLO Equity tranches. The chart below shows that CLO Equity delivered stellar results through the GFC specifically because of this dynamic.
Overall, we view the CLO Equity space as attractive right now. Within the sector we currently favor ECC which trades at a 15.4% yield, despite its highest valuation in the CLO Equity CEF trio.
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