OXLC - Eagle Point Credit: Analyzing Q2 2023 Earnings Results

2023-08-15 14:27:48 ET

Summary

• Eagle Point Credit is a high yield stock that offers a steady monthly income of $0.16, leading to an annual yield of 16%.
• Eagle Point's Q2 results show strong cash flow and easily cover the next 3 months' distributions.
• ECC is well positioned to generate strong cash flows and may offer another special dividend at the end of the year.

Now that I have officially “retired” from my full-time position as an information systems manager after a 40-year career, I am seeking income from my investments, not just alpha. While I was working and enjoying a steady paycheck, I was interested in growing my portfolio value and capital appreciation was important to me. Now that I have entered the next phase of my financial life, a steady stream of income to replace that bi-weekly paycheck has become a more important goal for me. One way that I expect to achieve that goal is by investing in high yield income producing vehicles that offer a steady distribution that is paid on a regular basis in the form of dividends. Eagle Point Credit Company ( ECC ) is one of the high yield stocks that I hold for the income it generates, which is paid monthly.

When I last covered ECC back in November 2022, I rated it a Strong Buy due to the strong cash flows generated from the company’s CLO investments (despite the poor macro conditions and bear market in 2022) and the excess distributions that it was paying in the form of a special dividend of $0.50 in addition to the monthly dividend of $0.14. While some debated the merits of a stock that was not showing much, if any, price appreciation, others realized that the strong cash flows that enable the monthly distributions to be well covered have shared with me in capturing that monthly income.

Since I wrote that article nine months ago, ECC has been paying out a steady monthly income of $0.14 plus an additional supplemental dividend of $0.02 each month since April of this year and announced the same payment schedule through the end of 2023. At the current share price, that $0.16 monthly distribution leads to an annual yield of 16% and is in no danger of being cut in my view.

CLO Funds Offer High Yield Income with Limited Risk

While in past years most investors in CLOs were primarily institutional investors, more retail investors now have access to funds that generate income from CLOs, which are essentially packaged leveraged loans with strict requirements. The credit markets have received more downgrades than upgrades over the past 3 quarters with fewer new CLO issuances than in previous quarters. However, the market for middle-market CLOs (those that trade on the secondary market) have been on the rise, according to this recent report from S&P Global.

Middle-market CLOs have seen significant volume this year, even as the corporate credit landscape still faces higher interest rates and slowing growth. Through July 21st, year-to-date BSL CLO issuance is down 37%, while middle-market CLO issuance is up 103% over the same period last year.

This means that the expectation of credit defaults is expected to increase, which could negatively impact the issuance of new CLOs, but it also means that the pricing of leveraged loans that CLOs hold are lower than they were when issued. This situation potentially offers an opportunity for savvy CLO managers who can purchase those CLOs in the secondary market at discounted prices.

More fund managers are recognizing that the opportunity is ripe for CLOs to generate a steady risk-adjusted income stream and we have witnessed the inception of some new ETFs being launched recently such as Janus Henderson B-BBB CLO ETF ( JBBB ) and Panagram BBB-B CLO ETF (CLOZ), which were recently covered by fellow SA Analyst Steven Bavaria.

While those ETFs focus more on the safer, higher-rated debt tranches of CLOs, funds like ECC can offer a higher yield by investing in the CLO equity portion, which has lower credit ratings and therefore offer higher yields to compensate for the additional perceived risk.

Another fund that invests in the equity tranches of CLOs is Oxford Lane Capital (OXLC). In May of this year OXLC raised the monthly distribution that it pays out due to the increasing income that it is realizing from its CLO portfolio.

Eagle Point Credit Q2 Results

Today, August 15, 2023, before the market opened ECC announced Q2 results. There is some good news and some not so good news, but overall cash flow remains strong and easily covers the next 3 months’ distributions. I continue to rate ECC a Strong Buy as they take advantage of mispricing in the secondary market of CLO equity.

The good news is that the company received $53.7 million in recurring cash flows during the quarter, which translates to $.90 per weighted average common share, easily covering the next 3 months of $0.16 distributions. They also deployed $29.7 million in net capital into new CLO investments during the quarter.

The NII generated was $0.27 after accounting for net realized losses of $0.05 per share during the quarter. That figure compares to $0.32 in NII for the quarter ending March 31, 2023, so there was a QOQ decline due to realized losses, however, recurring cash distributions are what really matters when it comes to covering the distribution. In the press release footnotes, there is an explanation included to help investors understand the difference between NII and recurring cash distributions from CLOs.

“Recurring cash distributions” refers to the quarterly distributions received by the Company from its CLO equity, CLO debt and other investments and distributions from loan accumulation facilities in excess of capital invested and excludes funds received from CLOs called.

Therefore, unlike other CEFs where the NAV of the fund and the NII generated each month are important metrics to consider when evaluating fund performance, those metrics are less relevant to a CLO fund like ECC. In fact, the NAV also showed a slight decline from the previous quarter weighing in at $8.72 per common share as of June 30 compared to NAV of $9.10 as of March 31. However, the estimate for NAV subsequent to the end of Q2 is estimated to be between $9.08 and $9.18 as of the end of July.

The primary reason for the fluctuations in NAV is due to the mark to market estimates of CLOs based on pricing in the secondary market, which can change considerably over time and enables the fund managers to take advantage of that market mispricing that occurs as explained by CEO Tom Majewski:

“We continued to focus on the more attractive secondary market, deploying $30 million of net capital into investments that we believe will generate compelling risk-adjusted returns.”

The company also further strengthened the balance sheet during the quarter by issuing approximately $44 million in new common shares at a premium in ATM (at the market) offerings. Also, subsequent to the end of the quarter the company issued an additional 3.8 million shares in ATM offerings while the shares are trading at a premium to NAV raising an additional $38.5M in net proceeds. This approach to raising cash by taking advantage of premium market pricing due to reduced NAV is an intelligent use of company resources, especially since 100% of the company debt is based on fixed rate financing in the form of preferred shares.

Some of the bad news included a comprehensive loss of $6.9 million during the quarter. There were also realized capital losses of $16.1 million reported and financing and operating costs of $12.5 million offsetting the GAAP net income of $31.7M.

Subsequent to the end of the quarter and as of the date of the report, the company reported an additional $48.1 million of recurring cash distributions, which indicates that they are on track to report another solid quarter in Q3. With the additional cash raised from ATM offerings and additional CLO investments in the secondary market, ECC is well positioned to continue to generate strong cash flows and may have sufficient spillover income to offer another special dividend at the end of the year given the strong balance sheet and recurring cash flows from previous CLO investments along with new investments made during Q3 of $29.3M as of July 31.

Also, as of June 30, 2023, according to the press release :

- The weighted average effective yield of the Company’s CLO equity portfolio (excluding called CLOs), based on amortized cost, was 15.23%. This compares to 15.83% as of March 31, 2023 and 16.71% as of June 30, 2022. ⁴

- The weighted average expected yield of the Company’s CLO equity portfolio (excluding called CLOs), based on fair market value, was 27.46%. This compares to 25.96% as of March 31, 2023 and 22.18% as of June 30, 2022. ⁴

⁴ Weighted average effective yield is based on an investment’s amortized cost whereas weighted average expected yield is based on an investment’s fair market value as of the applicable period end as disclosed in the Company’s financial statements, which is subject to change from period to period.

This is yet another indication that the expected yield of new and ongoing CLO investments is rising, not declining, and this also bodes well for another strong quarter in Q3 and beyond.

Risks and Caution

There has been considerable press coverage of the recent US credit downgrade, leading some to believe that we are in a dangerous phase of looming credit defaults and fears of higher loan losses after the bank failures that occurred in March. If those fears were to be realized and the loan default rate were to suddenly spike higher, that could negatively impact the outlook for ECC and CLOs in general going forward.

On the other hand, some believe that those fears are already priced into bank loan valuations based on an expectation of the worst possible outcome of a hard landing and declining interest rates. According to Wellington , the current loan pricing environment offers an opportunity for leveraged loan funds because the likelihood of significantly higher loan defaults is less of a concern now that it was earlier this year, as is the possibility for interest rates to decline any time soon.

With the Morningstar/LSTA Leveraged Loan Index at an average price of US$94.2 as of June 30, we believe loan prices imply a significantly worse economic outcome than we expect over the next 12 – 18 months. While we acknowledge the weaker credit quality of the asset class relative to previous cycles, the current roughly six-point discount in bank loan prices already reflects the market’s expectations for heightened defaults and losses. In fact, a price of US$94.2 implies a default experience equal to the worst-ever trailing 12-month default experience for the loan market. We think this is an unlikely outcome and the loan market has more than priced in an economic slowdown already.

Summary

As I suggested in my previous article about ECC and as others have explained , the low loan prices of CLOs along with the relatively benign credit environment with historically low default rates has enabled ECC to benefit from strong recurring cash flows. Those healthy cash flows are then passed along to income investors in the form of a 16% yield paid monthly with occasional supplemental or special distributions on top.

Another strong quarter reported in Q2 supports the continued payment of a $0.02 supplemental dividend through the end of 2023. With additional funds raised through ATM offerings at a premium to NAV, new CLO investments in the secondary market are being made at reduced prices enabling the weighted average expected yield to increase even more, which is likely to result in even stronger future cash flows.

I continue to rate ECC a Strong Buy for income investors who are interested in a steady source of monthly high yield distributions. The current market environment for CLO investments is strong and ECC is taking advantage of mispricing in the secondary market to strengthen their portfolio even further.

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