OXLCZ - EICB: New 7.75% Term Preferred From CEF EIC That's Worth A Look

2023-08-02 11:26:55 ET

Summary

• CLO CEF Eagle Point Income Co Inc is issuing another preferred - EICB - with a 7.75% coupon and a 2028 maturity.
• At "par," EICB has a significant yield advantage over its sister preferred EICA, so a switch to EICB from EICA makes sense.
• The underlying portfolio of the issuer EIC is higher-quality than the broader CLO CEF population.
• We view EIC preferreds as more attractive than the fund's common shares, despite the 14% yield on EIC.

In this article, we highlight a new term preferred issued by Eagle Point Income Co Inc ( EIC ). The EIC Series B ((EICB)) features a 7.75% coupon, a 2028 maturity, and a 2025 first call date. We view the stock as attractive for investors with an allocation to ( EICA , the other preferred of the fund) and/or EIC common shares or those who want to diversify their CLO senior security exposure. The stock's distribution is expected to be non-QDI.

Meet EICB

EICB is the second preferred issued by the CLO (collateralized loan obligations) closed-end fund ("CEF") Eagle Point Income Co Inc EIC is allocated predominantly to CLO Debt securities (74% of the portfolio) with the rest in higher-beta CLO Equity.

EICB has a sister preferred EICB which has a 2026 maturity and trades at a 7.15% yield. The significantly higher 7.75% coupon of EICB looks quite a bit more attractive relative to 7.15%, so we would expect this yield differential between the two to converge. This is particularly because the sub-investment grade yield curve is inverted, i.e., shorter-dated securities (EICA has a shorter maturity than EICB) tend to trade at higher yields than longer-dated securities, all else equal.

EICB has a number of attractive features, one being its maturity. There are few term preferreds in the broader sector, however, they are quite common in the CEF preferreds sector, particularly those preferreds issued by CLO Equity CEFs.

Term preferreds tend to have a lower beta profile because of pull-to-par, which means that for each dollar drop in the price, the yield of the term preferred will increase by a larger amount than the yield of a perpetual preferred, all else equal. The chart below shows two preferreds issued by another CEF ECC - term preferred ECCC and a perpetual preferred ECC.PD. It shows that ECCC has tended to see a lower volatility profile. ECC.PD has outperformed recently which has made it quite expensive at the moment, however, we don't expect this to last.

Another attractive feature of EIC, at least within the CLO CEF preferreds space, is that it has a higher-quality allocation. Most preferreds in the sector are issued by funds that hold predominantly CLO Equity such as OCCI, OXLC, ECC, and the unlisted Priority Income Fund. This means that EIC preferreds will likely hold up better in a crunch. The chart below shows that EICA has done better than ECCC, for instance, since the start of 2022.

One way to get an intuition about the reasonable worst-case performance of the EIC preferreds is to stress test EIC and see what's left over for the preferreds. This is something we do for the broader sector regularly.

Specifically, we assume a 10% recovery for CLO Equity securities and a 40% recovery for BB-rated CLO Debt. If we run these numbers for EIC, we get a residual value of around 70% for EIC preferreds. Viewed another way, for EIC preferreds to recover "par," CLO Equity can go to zero, but CLO Debt has to trade above 60%.

This scenario would be roughly equivalent to a 24% cumulative default rate in the portfolio (assuming a conservative 50% recovery on loans). This is well above what we have seen this century. Overall, this is a very serious stress test, so it should make investors feel pretty comfortable with the underlying risk of the EIC preferreds.

The chart below shows the yields on offer in the CLO CEF preferreds sub-sector, with orange bars denoting perpetual preferreds, i.e., those with no maturities. EICB will come in at the lower end of this chart, which makes sense given its risk profile relative to the other preferreds.

A reasonable question is why not own EIC directly and get paid nearly double the yield of 14% in EIC common shares? Our view here is that EIC has done surprisingly poorly and has hugely underperformed the preferreds. This may seem surprising, but it's actually not that unusual - in fact, in the fixed-income CEF and mREIT (mortgage real estate investment trust) space we often see preferreds outperform common shares.

Since the issuance of EICA about 20 months ago, EIC common has underperformed EICA by around 10%.

EIC defenders may say that the starting point of the analysis is bad because the EIC premium was very rich at the start. This is very true, however, it doesn't fully explain the underperformance of the common (it explains only about half). In fact, even if we take the since-inception total return NAV return of the common shares which controls both for the time period and the discount, the common shares have returned less than 1% annualized - a fry cry from the double-digit yield, something that EIC proponents never bother to explain.

Takeaways

The new preferred from CEF Eagle Point Income Co Inc. looks very interesting. It's particularly compelling for investors who already hold EICA given its higher coupon or even those who hold the common shares. We expect the yield differential between the two preferreds to converge over time, i.e., for the EICB price to rise relative to EICA.

It can also be compelling for investors who want to diversify their CEF preferreds allocation or those who may be maxed out on Oxford Lane Capital Corporation (OXLC) bonds such as (OXLCZ) or (OXLCL), which remain our favorite picks in the CLO CEF senior security subsector.

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